3 Things To Know About Tax Loss Harvesting

Many financial advisors say that tax-loss harvesting is a good way to manage taxes on your investments at the end of the year. Exchange-traded funds can help you accomplish that.

Tax-loss harvesting centers on the idea that you can sell securities that have lost value this year in your portfolio to offset any taxes you might have incurred on capital gains from securities that performed well.

There’s a lot of literature on tax-loss harvesting, but Fidelity has done a great job of compiling data on how this works, and what to watch for. The company even offers a tax-loss harvesting tool for its clients, so we will share some of its insights.

Works For All Investors

As the company put it, “Whatever type of investor you are, planning ahead and starting early to evaluate a tax-loss harvesting strategy can help you maximize the potential benefits.”

“The size of the potential benefit from tax-loss harvesting depends on your income level and the amount of your short- and long-term capital gains, minus any current losses that you may have already realized or any losses carried forward from other years,” Fidelity said.

Here are the key points to know:

• Sell losers, but don’t forget to keep your portfolio balanced

At the end of the day, keep sight of your investment goals. If selling a losing stock, bond or fund is a good way to offset capital gains on something else, don’t let a tax-loss harvesting strategy hurt your portfolio diversification.

Here’s where ETFs are particularly helpful. Say you were going to sell a losing security for tax purposes only—meaning, it’s a security you actually wanted to keep. If you proceeded to buy it again within 30 days of the sale, you would run into the IRS “wash sale” rule, which would void the tax benefits you were hoping to capture.

But you can replace a losing security—say, a health care company stock—with a strategy that offers similar exposure such as a health care ETF.

“Here, you would not be subject to the wash sale rule, assuming the IRS does not view it as a ‘substantially identical’ security,” Fidelity said. The 1,800-plus U.S.-listed ETFs provide low-cost access to just about every corner of the market, so it’s easy to do that today.

• Short-term gains are taxed differently than long-term gains

Short-term gains—or capital gains on any investment you’ve owned for less than a year—are taxed at a higher rate than long-term gains, which are those on investment you’ve held longer.

Consider this data from Fidelity: Short-term capital gains, which are taxed at the marginal rate you pay on ordinary income, can top 39.6%. For some high net worth individuals, that rate is even higher, exceeding 43%, plus state and local income taxes.

By comparison, “for the majority of taxpayers,” the long-term capital gains tax rate is 15%.

If you are going to implement a tax-loss harvesting strategy, you might want to apply those assets toward offsetting short-term capital gains first.

• · ETFs are tax-friendly vehicles

It’s rare to see an ETF report capital gains distributions. It happens, but by and large, broad-based passive funds rarely do. It’s a different story with mutual funds, however, which makes ETFs very attractive for tax-aware investors.

Picking investments for tax purposes alone isn’t the right call, but managing taxes wisely can keep more of what you earn in your pocket.

Contact Cinthia Murphy at [email protected].