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Tax-loss harvesting using ETFs

You may be able to reduce your tax bill by using exchange-traded funds (ETFs).

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The end of the year is right around the corner, and that means it’s a good time to think about potentially saving more of your money by managing your tax bill. Most people know that ETFs can be a powerful investing tool. However, ETFs can also be an effective tax management tool.

Tax-loss harvesting involves selling securities that have decreased in value in order to offset realized gains from other investments. It may be possible to use ETFs in a tax-loss harvesting strategy.

Tax-efficient tips

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.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.

ETFs and taxes

ETF 411

For the basics on ETFs and how you might use them in your portfolio, visit the Exchange-Traded Funds section on Fidelity.com for more information.

Generally, ETFs are considered tax efficient relative to some mutual funds. That’s because most broad-based ETFs do not typically make capital gains distributions—which are subject to taxation when held in a taxable account.

That helps make ETFs particularly useful for tax-loss harvesting—the tax strategy of selling securities that have declined in value, in order to offset capital gains from other securities.

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.

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

If you’d like to tax loss harvest, consider consulting a tax advisor regarding the application of wash sale rules.

One way to manage your tax bill and continue to execute your strategy is to employ ETFs in order to avoid wash sales. 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 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 a technology stock that, over the course of the year, has lost $2,000 in value. Despite this poor performance, you still think technology stocks are attractive and could rally in the future.

To take advantage of the underperforming stock while still maintaining exposure to tech stocks, you could sell the stock (to offset $2,000 of the $4,000 gain realized from selling the other four stocks) and purchase a technology ETF, such as the Fidelity MSCI Information Technology Index ETF (FTEC).

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 technology stock by providing exposure to the technology industry.

Of course, this ETF provides much broader exposure to technology stocks than the individual security that you sold. If that tech stock was in the semiconductor industry, for instance, and you still wanted that particular industry exposure, you could purchase a more targeted ETF—like the iShares PHLX Semiconductor ETF (SOXX).

Use ETFs to your advantage

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.

Learn more

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Before investing in any mutual fund or exchange-traded fund, you should consider its investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus, offering circular, or, if available, a summary prospectus containing this information. Read it carefully.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and are subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risk, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility as well as the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NA V), or indicative value in the case of ETNs. Each ETP has a unique risk profile, which is detailed in its prospectus, offering circular, or similar material, and which should be considered carefully when making investment decisions.
1. Dividends are not considered in this example.
Investment comparisons are for illustrative purposes only and are not meant to be all inclusive. There may be significant differences in investments that are not discussed here.
Diversification does not ensure a profit or guarantee against a loss.
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