Using ETFs to Harvest Tax Losses

Smart investors don’t just pick the right investments to build a wealth-generating portfolio; they also take into consideration how gains and losses will impact their bottom line in terms of taxes. Managing tax liabilities for the short and long term can harvest tax losses. When investors use exchange-traded funds (ETFs) as part of a tax-loss harvesting strategy, they may be able to get some benefits.

What You Need To Know

• When tax losses are harvested, they are used to offset capital gains on a very similar security.
• ETFs have made tax-loss harvesting easier because many providers offer similar funds that follow the same index but are constructed differently.
• It is possible to reduce tax exposure using tax-loss harvesting, but traders must focus on avoiding wash trades in order to do so.

What Are The Benefits Of Investing In ETFs?

Harvesting tax losses explained

Firstly, it is important to understand how capital gains taxed in order to understand what the benefits of tax-loss harvesting are. Capital gains tax applies when you sell an asset at a profit. When you hold an investment for a shorter period of time, you will be taxed at ordinary income tax rates. A high-income investor may be taxed at a maximum of 37% on short-term gains.

A long-term capital gains tax applies to investments held for more than one year. For the tax year 2020, long-term capital gains rates are set at 0%, 15%, or 20%, depending on an individual’s tax bracket.

Losses can be harvested through tax loss harvesting strategies, which involve selling off underperforming assets and purchasing them again within a 30-day window to minimize the tax impact.

Using the proceeds of the sale, you would then buy another similar investment. The net effect is that you maintain roughly the same position in your portfolio, while deducting the loss from your gains. 

Rule of Wash-Sale

Tax losses can be harvested when the wash-sale rule is followed. For example, if a security is sold at a loss, within 30 days of the sale or 30 days afterward, you cannot buy one that is substantially identical to replace it. The Internal Revenue Service (IRS) will disallow you from including the loss on your tax filing, so you won’t receive a tax benefit from it.

Since the IRS doesn’t provide a precise definition of what constitutes substantially identical securities, it can be difficult to navigate this rule. Generally, stocks offered by different companies won’t fall into this category. The exception, however, is when you repurchase and sell stock after the company has undergone reorganization.

ETFs for harvesting losses

A stock, a bond, and a commodity may be included in an exchange-traded fund, just as they do in mutual funds. Most ETFs follow a particular index, such as the S&P 500 or NASDAQ (Standard & Poor’s 500). The primary difference between mutual funds and exchange-traded funds lies in the fact that ETFs are actively traded on the stock exchange.

It is easier for investors to avoid the wash-sale rule when selling off securities with exchange-traded funds, which gives them an advantage when it comes to tax-loss harvesting. ETFs can be used to counter losses because they track a broader segment of the market.

When you sell 500 shares of an underperforming biotech stock at a loss, but you want to keep your exposure to the asset class, you can do so at the same time. In order to preserve asset diversity without violating the wash-sale rule, the proceeds of the sale can be invested in an ETF that tracks the larger biotech sector. 

As long as the ETFs aren’t substantially identical, you can use them to replace mutual funds and other ETFs. For guidance on a particular ETF’s similarity to another ETF, refer to its index. If the ETF you’re selling and the ETF you’re thinking of buying both track the same index, the IRS may see the securities as too similar. 

It is not just the fact that ETFs can be used to harvest tax losses that makes them more attractive than stocks and mutual funds when it comes to cost. Generally, exchange-traded funds are cheaper than stocks and mutual funds. Since they don’t make capital gains distributions as often as other securities, they are also more tax-efficient in general. 

Implications for taxes

If you’re avoiding short-term capital gains tax, ETFs are the best way to harvest losses since long-term gains tax rates are lower than those of short-term capital gains tax.

Suppose you were to repurchase the same security later, the tax basis would be lower, which would result in a taxable gain if you sold the security at a higher price.

You will also incur a short-term capital gain if you decide to sell an ETF and use the money to invest in the original security again. This will result in a short-term capital gain. As a result, you will defer your taxes rather than reduce them.

Limitations on tax loss harvesting

First of all, tax-loss harvesting applies only to assets that have been purchased and sold within a taxable account. Investors must follow certain guidelines when attempting to harvest losses for tax purposes. In a Roth or traditional IRA, which provide tax-free or tax-deferred investment opportunities, losses cannot be harvested.

Second, when no capital gains are realized in a single tax year, the amount of ordinary income that can be claimed as a loss is limited to $3,000 (or $1,500 for married taxpayers filing separate returns). A loss exceeding this limit can be carried forward to subsequent years.

If you have more losses than gains, you can apply the difference to another type of gain in that circumstance. If you have more losses than gains, you can apply the difference to a different type of gain.

There are many analyst and tax professional predictions for changes to the tax code in any given year. Many analysts expect these changes to affect the practice of tax-loss harvesting in a significant way. Several new provisions and proposed changes to the highest bracket tax rate may affect the tax year 2021, reducing the benefits of tax-loss harvesting in the near future.

Conclusion

ETFs can be used to minimize or defer taxes on capital gains through tax-loss harvesting. In order to reap the maximum tax benefits from tax-loss harvesting, investors must be careful when choosing exchange-traded funds. They must observe the wash-sale rule when implementing this strategy.