Overview of Capital Gains Harvesting
This episode of DIY Money — titled "Capital Gains Harvesting" — answers a listener question about using custodial (UGMA/UTMA) brokerage accounts to realize long-term capital gains up to the child’s tax-free/kiddie-tax threshold each year. The hosts explain how the kiddie tax works, cost-basis choices when selling holdings, practical steps to “harvest” gains tax-free, and pitfalls to avoid (wash-sale confusion, mutual-fund distributions, trading frequency). The discussion is practical and aimed at parents using custodial accounts to shift small amounts of taxable gains into 0% tax brackets annually.
Key takeaways
- Kiddie tax basics: For the year discussed, the first $1,350 of a child’s unearned income is tax-free, the next $1,350 is taxed at the child’s rate, and amounts above ~$2,700 may be subject to the parents’ tax rate (kiddie tax). Confirm current thresholds each tax year — they can change.
- Capital gains harvesting = intentionally selling appreciated holdings in a child’s custodial account up to the tax-free threshold to realize gains at 0% tax.
- Mutual funds default to average cost basis when sold; ETFs and stocks generally use FIFO (first-in, first-out) by default. You can usually elect specific lot identification at the time of sale to choose which lots to sell.
- Wash-sale rules apply to losses, not gains. Selling a gain and repurchasing is allowed, but frequent buy/sell activity could trigger pattern-day-trader rules in the account.
- Include dividends and capital-gains distributions when calculating the child’s unearned income — these can push you over the threshold unexpectedly.
- Keep the strategy simple: sell only the amount needed to stay within the tax-free zone, repeat yearly, and consult a tax pro for complex situations.
Topics discussed
- Explanation of the kiddie tax structure and purpose
- Cost-basis methods: average cost, FIFO, LIFO/last-in-first-out, specific lot identification
- Differences between mutual funds, ETFs, and stocks when selling (mutual funds → average cost default; ETFs/stocks → FIFO)
- Interaction of dividends/capital-gains distributions with harvesting strategy
- Wash-sale rule vs. gains (clarified that wash-sale disallows loss recognition; it does not block gains)
- Pattern-day-trader warnings for very active trading in small accounts
- Practical alternatives (e.g., sell S&P mutual fund and buy a total market fund to avoid repurchasing the same instrument)
Practical action steps (how to harvest gains safely)
- Check current kiddie tax thresholds for the tax year before you sell.
- Add up the child’s unearned income so far this year (realized gains, dividends, interest, capital-gains distributions).
- Decide how much additional realized gain you can recognize without exceeding the 0%/kiddie-tax breakpoint.
- Review the holding type:
- Mutual funds → expect average cost basis by default.
- ETFs/stocks → FIFO by default, but you can usually specify lot(s).
- When placing the sell order, choose specific-lot identification if you want to pick lower-cost lots (maximize realized gain up to your target).
- Consider buying a similar-but-not-identical fund (e.g., Total Market vs S&P 500) if you want market exposure without repurchasing the exact same fund — simplifies bookkeeping and avoids potential confusion.
- Avoid over-trading — don’t repeatedly sell and repurchase the same security in short intervals to dodge rules or create administrative headaches.
- Repeat this check annually — small gains compound into meaningful tax savings over time.
- If uncertain or you’re near threshold limits, consult a tax professional.
Common pitfalls & cautions
- Mutual-fund distributions (dividends and capital gains) count toward the child’s unearned income and can push you over the threshold unexpectedly.
- Average cost basis on mutual funds may make it harder to isolate specific lots unless you actively designate lots.
- Wash-sale rules don’t apply to gains, but they do apply to losses — don’t confuse the two.
- Very frequent trading can subject the account to pattern-day-trader rules or additional restrictions.
- Tax rules change — verify current figures and rules each year or with a tax advisor.
Notable quotes
- "The secret to wealth is very simple. Live on less than you make, invest the rest, and do so for a very long time. And maybe every once in a while, capital gain and harvest so you don't end up paying a lot in taxes."
Extra notes
- The show offered a $25 Amazon gift card for listener questions.
- This episode included multiple sponsor messages (1-800-Flowers, Progressive, Wayfair, etc.).
- Advice on the show is educational; consult a tax or financial professional for personal tax decisions.