No investor aims to incur losses, but even the most successful investors, with broadly diversified portfolios, can have a mix of winners and losers. Generally speaking, this year hasn’t been as good to investors as previous years—the S&P 500 is flat, as of early December, whereas stocks gained roughly 20% in 2017. As 2018 draws to a close, it may be time to think about your tax bill—if you haven’t already.
Essentially, tax-loss harvesting is selling stocks, bonds, mutual funds, ETFs, or other investments in taxable accounts that have lost value since purchased to offset realized gains elsewhere in your portfolio. Once these securities have been sold at a loss, they can be replaced with similar, but not substantially identical securities in order to maintain the appropriate asset allocation and sector exposures.
Of course, you should not let the tax tail wag the investment dog; which is to say that you should not make investing decisions based primarily on tax implications. However, you should always consider the tax implications of any investment decision you make. If you have taxable investment losses, you may be able to manage your tax bill and continue to achieve your investing objectives with the help of exchange-traded funds (ETFs) and mutual funds, in addition to other investment vehicles and strategies.
Assessing tax savings
Short- and long-term losses must be used first to offset gains of the same type. However, if your losses of one type exceed your gains of the same type, you can then apply the excess to the other type. If any losses remain after all gains have been offset, you may then offset the remaining losses against up to $3,000 of ordinary income. Finally, any losses beyond that can be carried forward to future years.
Tax-loss harvesting up close
We'll focus here on selling individual securities and replacing those with ETFs or mutual funds. However, this is just one possible approach to implementation of tax loss harvesting, and in general the efficacy of tax-loss harvesting applies regardless of the investment vehicles involved.
Many investors have mutual funds and/or ETFs, along with individual stocks, in their taxable portfolios. One common tax-loss harvesting strategy entails selling an individual stock that has incurred losses and replacing it with an ETF or mutual fund that provides exposure to the same asset class, and often a similar segment of that asset class.
Implementing tax loss harvesting in this way can achieve several goals, including generating losses to offset gains, potentially reducing the overall risk exposure of your portfolio (by reducing exposure to individual investments), and avoiding the wash sale rule. The wash sale rule states that your tax loss will be disallowed if you buy the same security, a contract or option to buy the security, or a substantially identical security, within 30 days the date you sold the loss-generating investment.
Suppose you own a health care stock that is down for the year, and while you're not convinced that it will come back over the short term, you still believe in the long-term prospects for all or some part of the health care sector. If you have realized gains in other parts of your portfolio, or even if you don't but you'd like to reduce the taxes on any future gains and/or offset up to $3,000 of ordinary income, you might consider selling the stock and replacing it with a health care ETF. You could choose a broad health care sector ETF, or you might opt instead for a more narrowly focused health care industry ETF if you’d like to focus on a particular segment of the health care sector—such as biotechnology, medical equipment providers, health care providers, life sciences services, or pharmaceuticals.
Of course, you should be aware that ETFs and mutual funds have their own characteristics and risks that should be carefully considered before making any decision. For one thing, a health care ETF, even one that's focused on a health care subsector like biotechnology, would typically provide much broader exposure than the individual security that you sold, and it may have quite different risk and return characteristics. So be sure to do your research to understand how the ETF affects your overall portfolio positioning and strategy.
Similarly, if you bought a dividend-paying stock to generate income for your portfolio, but the stock has an unrealized loss in your account, you may want to sell the stock and replace it with a diversified dividend-focused ETF. In doing so, you may be able to generate the desired tax effect—incurring a loss to offset gains—while improving the diversification of your portfolio and still generating income. Again, be careful to make sure you understand the impact that this change will have on the risk and return characteristics of your overall portfolio.
These are just 2 examples amid a broad range of investment strategies where tax-loss harvesting can be implemented with the help of an ETF or mutual fund. Also, bear in mind that diversification, which in some cases may be enhanced through the replacement of individual investments with ETFs and mutual funds, does not guarantee against losses nor ensure gains. Still, in many cases it can help you improve your returns relative to the level of risk you are willing to take, and by replacing individual investments that are below their cost basis with ETFs or mutual funds with similar characteristics, you may be able to implement a tax-loss harvesting strategy and enhance diversification at the same time.
Replacing funds with another fund
It is also possible to implement a tax-loss harvesting strategy by selling an ETF or mutual fund that has a loss and replacing it with a similar, albeit not substantially identical ETF or mutual fund.
For instance, if you have a losing position in an S&P 500® ETF, you might consider harvesting those losses and replacing that position with an ETF tracking a different index—such as the Russell 1000. If you have a losing position in a biotech health care ETF, for example, you might consider harvesting those losses and purchasing a pharmaceutical ETF or a broad health care sector ETF. However, you should be aware that in these and in many similar instances, the replacement of one ETF or fund with another can change your risk and return exposures significantly. Be sure to carefully weigh the benefit of the tax-loss harvesting against the change to your portfolio's characteristics, as it may or may not be worthwhile.
Also, when making this decision, you should evaluate all costs associated with buying and selling investments, including commissions and any other expenses. And always keep your investing objectives and risk constraints in mind.
Achieving better outcomes
Tax-loss harvesting may not be appropriate for everyone; it requires time, attention, and expertise. Those who are unable or unwilling to implement it themselves should seek the help and advice of a tax professional or an investment advisor when considering tax-loss harvesting.
While 2018 isn't over yet, and the April tax filing deadline is still several months away, you may want to start thinking about your tax bill—if you haven't already. If you have investment losses, you may want to consider tax-loss harvesting before the new year.
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