With the S&P 500 down 23% year to date on a total return basis, it's possible that you have investments in the red. Of course, no investor wants to have losses, yet even the most successful investors can have a mix of potential winners and losers. As the year draws to a close, it may be time to think about your federal tax bill—if you haven't already—by considering tax-loss harvesting opportunities.
Tax-loss harvesting explained
Essentially, tax-loss harvesting is selling stocks, bonds, mutual funds, ETFs, or other investments you own in taxable accounts that have lost value since purchased to offset realized gains elsewhere in your portfolio.
An unrealized gain/loss can exist for investments you still own: It is the difference between the current market price of a position you currently hold and the original purchase price (cost basis). A realized gain/loss can exist for investments you've sold: It is the difference between the price at which a position was sold and its cost basis.
If you want to maintain the characteristics in your portfolio provided by investments you are considering selling for tax-loss harvesting purposes, they can be replaced with similar, but not substantially identical, securities in order to maintain a similar risk/return profile.
It's worth noting that you shouldn't 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, considering the tax implications of any investment decision you make may help enhance your overall returns.
Tax-loss harvesting using funds
If you have unrealized taxable investment losses, you may be able to manage your tax bill and continue to achieve your investing objectives with the help of ETFs and mutual funds, in addition to other investment vehicles and strategies. If you want to realize an unrealized loss, and you want to reinvest that money, then ETFs and mutual funds may be an effective means of redeploying those sale proceeds.
We'll focus here on selling individual stocks 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 is to sell an individual stock that has incurred losses and replace 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 generally 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 of the date you sold the loss-generating investment.
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 example
Suppose you own a technology stock whose current price is below your cost basis, 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 technology sector. In essence, you no longer think the fundamental prospects for this specific company are strong, but you still think the industry has strong prospects and are looking for more diversified exposure to the industry.
If you have realized gains in other parts of your portfolio, you might consider selling the stock and replacing it with a technology ETF. You could choose a broad technology sector ETF, or you might opt instead for a more narrowly focused consumer staples industry ETF if you'd like to focus on a particular segment of the technology sector—such as software, semiconductors, or electronic equipment products. You might also consider a comparable mutual fund with exposure to the technology sector.
Obviously, ETFs and mutual funds have their own characteristics and risks that should be carefully considered before making any decision. For one thing, a technology ETF, even one that's focused on a segment of the technology sector, provides much broader exposure than the individual security that you sold, and it may have quite different 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. Make sure you understand the impact that this change will have on the risk and return characteristics of your overall portfolio. Evaluate the fundamental prospects for the position you own and determine if you still want to own it. Then, and only then, you might consider the tax implications.
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 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 different, albeit not substantially identical, ETF or mutual fund. However, you should be aware that in these and in similar instances, the replacement of one ETF or fund with another can change your risk and return exposures significantly.
Weigh the benefit of the tax-loss harvesting against the change to your portfolio's characteristics, as it may or may not be worthwhile. Consider consulting with a tax advisor to make sure that the securities you are evaluating are not substantially identical. 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.
Maximizing your returns
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 professional when considering tax-loss harvesting.
While 2022 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.