Tax-loss harvesting can be a useful tool for managing short and long-term tax liability. Incorporating exchange-traded funds (ETFs) into a tax-loss harvesting strategy offers certain advantages that may prove valuable to investors.
Successfully building a wealth-generating portfolio involves more than just picking the right investments. Smart investors also pay attention to how gains and losses impact their bottom line concerning taxes.
Key Takeaways
- Tax-loss harvesting is the process of selling securities at a loss to offset a capital gains tax liability in a very similar security.
- Using ETFs has made tax-loss harvesting easier because several ETF providers offer similar funds that track the same index but are constructed slightly differently.
- Tax-loss harvesting can be a great strategy to lower tax exposure but traders must be sure to avoid wash sales.
- You can't replace a security that you've sold at a loss by purchasing one that's substantially identical from 30 days before the sale until 30 days after it’s complete.
Understanding Tax-Loss Harvesting
Federal capital gains tax applies when you sell an asset for a profit. The short-term capital gains rate comes into play when you hold an investment for less than one year. Short-term gains are taxed at ordinary income tax rates with the maximum rate for high-income investors topping out at 37%.
The long-term capital gains tax applies to investments you've held for longer than one year. The rates are set at 0%, 15%, or 20% for tax years 2023 and 2024 based on the individual investor’s taxable income. The rate increases with more income.
Tax-loss harvesting is a strategy designed to allow investors to offset gains with losses to minimize the tax impact. Harvesting a loss involves selling an asset that’s underperforming and repurchasing it or a largely similar asset after a 30-day window has passed.
The net result is that you’re able to maintain roughly the same position in your portfolio while generating some tax savings by deducting the loss from your gains for the year.
The Wash Sale Rule
The wash sale rule dictates when a tax loss can be harvested. When you sell a security at a loss, you can't purchase and replace it with one that's substantially identical from 30 days before the sale until 30 days after it’s complete. The Internal Revenue Service (IRS) will disallow it if you attempt to claim the loss on your tax filing and you won’t receive any tax benefit from the sale.
Navigating this rule can be tricky because the IRS doesn't provide a precise definition of what constitutes a substantially identical security. Stocks offered by different companies generally won't fall into this category but there's an exception if you’re selling and repurchasing stock from the same company after it’s been through reorganization.
Harvesting Losses With ETFs
Exchange-traded funds encompass a range of securities, similar to mutual funds. They can include stocks, bonds, and commodities. ETFs typically track a particular index, such as the NASDAQ or S&P 500 (Standard and 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.
Exchange-traded funds offer an advantage when it comes to tax-loss harvesting because they make it easier for investors to avoid the wash sale rule when selling off securities. ETFs track a broader segment of the market so it’s possible to use them to counteract losses without venturing into identical territory.
TheSecurities and Exchange Commission(SEC) has approved 11 new ETFs to be listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges as of Jan. 11, 2024. These are the first spot market bitcoinexchange-traded funds(ETFs) ever to be offered and they'll provide investors with even more trading options.
Let’s say you sell off 500 shares of an underperformingbiotech stock at a loss but you want to maintain the same level of exposure to that particular asset class in your portfolio. It’s possible to preserve asset diversity without violating the wash sale rule by using the proceeds from the sale to invest in an ETF that tracks the largerbiotech sector.
You can also use ETFs to replace mutual funds or other ETFs as long as they’re not substantially identical. You can look to its index for guidance if you’re unsure whether a particular ETF is too similar to another. It's an indication that the IRS may deem the securities too similar if the ETF you’re selling and the ETF you’re thinking of buying both tracks the same index.
Aside from their usefulness in tax-loss harvesting, ETFs are more beneficial compared to stocks and mutual funds when it comes to cost. Exchange-traded funds tend to be a less expensive option. They’re also more tax-efficient in general because they don’t make capital gains distributions as frequently as other securities.
Tax Implications
Using ETFs to harvest losses works best when you’re trying to avoid short-term capital gains tax because these rates are higher compared to the long-term gains tax. There's one caveat, however, if you plan to repurchase the same securities at a later date. Doing so would result in a lower tax basis and any profits you realize would be considered a taxable gain if you were to sell the securities at a higher price down the line.
The same is true if the ETF you purchase goes up in value while you’re holding it. It will generate a short-term capital gain if you decide to sell it off and use the money to invest in the original security again. You'd ultimately be deferring your tax liability rather thanreducingit.
Tax-Loss Harvesting Limitations
Investors must keep certain guidelines in mind when attempting to harvest losses for tax purposes. First, tax-loss harvesting only applies to assets that are purchased and sold within a taxable account. It’s not possible to harvest losses in a Roth or traditional IRA that offers tax-free and tax-deferred avenues for investing.
A second limitation involves the amount of ordinary income that can be claimed as a loss in a single tax year when no capital gains are realized. The limit is $3,000 or $1,500 for married taxpayers who file separate returns. The difference can be carried forward in future tax years if a loss exceeds the $3,000 limit.
The IRS also requires that you offset gains with the same type of losses, such as short-term to short-term and long-term to long-term. You can apply the difference to gains of a different type if you have more losses than gains.
Tax codes are subject to change in any given year. Many analysts and tax professionals expected changes to the tax code that could impact tax-loss harvesting after President Biden took office in 2021 but no such changes have taken place as of the end of 2023.
The Inflation Reduction Act and SECURE 2.0 Act brought only modest tax changes that didn't impact tax-loss harvesting. U.S. federal tax rates will hold steady until at least 2025 as a result of the Tax Cuts and Jobs Act of 2017 but rates may change at that time.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the process of countering gains with losses to limit tax liability. The strategy involves selling off an investment that has lost money and then buying it back after 30 days have passed. An investor would buy a similar product in the 30-day window before repurchasing the sold asset to make sure that the diversity of their portfolio wasn't compromised by the selling of the asset.
What Is the Advantage of Tax-Loss Harvesting?
Tax-loss harvesting allows market participants to lower their tax bills if they follow the rules and execute the strategy correctly. They can also rebalance their portfolios and keep more of their money invested.
How Much Money Can You Save With Tax-Loss Harvesting?
You can save up to $3,000 per year under IRS rules. That's the amount of ordinary income that can be claimed as a loss in a single tax yearwhen no capital gains are realized. The amount is $1,500 for married taxpayers who file separate returns.
The Bottom Line
Tax-loss harvesting with ETFs can be an effective way to minimize or defer tax liability on capital gains. The most important thing to keep in mind with this strategy is the wash sale rule. Investors must be careful in choosing exchange-traded funds to ensure that their tax-loss harvesting efforts pay off.
