After a sharp August pullback, you may have some positions that are in the red. Depending on your outlook for those positions, you might want to consider a tax-loss harvesting strategy using ETFs to reduce your tax bill this year.
In the event that you are now bearish about a losing investment, but remain bullish about the sector or theme in general, consider buying an ETF to maintain exposure to the idea without running afoul of the IRS's wash sale rule (more on that below).
A method of tax-loss harvesting involves selling securities that have decreased in value in order to offset realized gains from other investments.
The IRS allows you to offset realized capital gains with realized capital losses. Suppose, for example, that you have a portfolio consisting of just two investments, Stock X and Stock Y. Stock X has increased by $2,000, while Stock Y has decreased by $2,000. If you were to sell both stocks by year-end, you would not have to pay any taxes on the $2,000 capital gain on Stock X because of the loss on Stock Y, assuming they were each held for periods that qualified the gain/loss as both short or long term.1
Any excess losses you have after you have offset all realized capital gains can offset ordinary income, up to $3,000 annually. Losses not used in one tax year can be carried forward indefinitely to future tax years.
Beware the wash sale rule
What if you want to take advantage of tax-loss harvesting, but do not want to sell positions that have incurred losses?
You could sell a security, purely for tax purposes, and then repurchase it shortly thereafter. The problem here is if you sell a security at a loss and then buy the same or a "substantially identical" security (in the same or different account) in the 61-day period beginning 30 days before the sale and ending 30 days after the sale. The loss is disallowed for tax purposes under the IRS "wash sale rule" and is effectively deferred until the new shares are sold. The IRS provides examples of substantially identical securities here.
Keep in mind that tax-loss harvesting is possible only in taxable accounts; it does not work in tax-advantaged accounts (such as an IRA or HSA).
Tax-loss harvesting with ETFs
Consult a professional
One way to manage your tax bill and continue to execute your strategy is to employ ETFs. Essentially, ETFs (and mutual funds) may be used to replicate a position that you are selling for the purpose of harvesting a tax loss.
Consider a hypothetical situation in which you purchased five different securities, in five different sectors of the market, in January of this year. Four have increased in value by $1,000 each, and you plan to sell the positions to realize the gains. One of the five is an energy stock that, over the course of the year, has lost $2,000 in value. Despite this poor performance, you still think energy stocks are attractive and could rally in the future.
To take advantage of the underperforming stock while still maintaining exposure to energy stocks, you could sell the stock (to offset $2,000 of the $4,000 gain realized from selling the other four stocks) and purchase an energy ETF, such as the Fidelity MSCI Energy Index ETF (FENY).
Here, you would not be subject to the wash sale rule, assuming the IRS does not view it as a “substantially identical” security, even though it serves the purpose of replacing the energy stock by providing exposure to the energy industry.
Of course, this ETF provides much broader exposure to energy stocks than the individual security that you sold. Consequently, the energy ETF may not perform the same as the energy stock that you sold. Be sure to do your research to understand how the an ETF affects your overall portfolio positioning and strategy.
ETFs and taxes
Generally, ETFs are considered tax efficient relative to some mutual funds. That's because most broad based, passively-managed ETFs make very low (if any) capital gains distributions compared to mutual funds with similar investment approaches. Also, capital gain distributions are subject to taxation when held in taxable accounts.
ETFs can be a helpful tool in managing your tax bill. But beware making investing decisions based solely on tax implications. You should also consider your investing objectives, risk constraints, and liquidity needs.
The ETF universe is quite large, offering 1,400 different ETFs/ETPs, with total assets exceeding $1 trillion. Consequently, there is a strong probability of finding an investment to replace the position you might sell, in order to harvest a tax loss to reduce your tax bill.