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How to Use ETFs for Tax Loss Harvesting

Investing can be tricky to master and one thing it’s important to do is balance your profits against your losses. Selling off stocks or other securities for a profit can actually cost you money if you have to pay a substantial amount of taxes on your capital gains. Tax-loss harvesting and investing in exchange-traded funds (ETFs) can help shrink your tax bill.

Check out our capital gains tax calculator.

What Is Tax-Loss Harvesting?

Tax-loss harvesting isn’t as complicated as it sounds. It just involves selling off securities at a loss to offset gains you’ve realized with other investments. For instance, let’s say you bought $5,000 worth of Stock A a year ago but now it’s only worth $3,000. If you sell it off, you’ll realize a capital loss of $2,000.

At the same time, you sold shares of Stock B for $4,000 more than the original purchase price. Normally, that $4,000 would be subject to capital gains tax but because you’ve racked up a $2,000 loss, you can reduce the amount of money that’s subject to taxes.

Tax-Loss Harvesting Rules

How to Use ETFs for Tax Loss Harvesting

One important thing to keep in mind about tax-loss harvesting is that you can only use this strategy if you’re investing in a taxable account. If you’ve got all of your money tied up in a 401(k) or an IRA, this won’t be an option.

You’ll also need to remember the wash sale rule. If you sell a stock or a mutual fund at a loss, you have to wait 30 days before buying another security that’s substantially similar. If you don’t wait, you won’t be able to claim the loss on your taxes.

Why ETFs Can Be a Good Choice

Exchange-traded funds are appealing to investors for a couple of reasons. For one thing, they’re usually a better bargain because they tend to carry lower administrative fees. What’s more, they can give you broad market exposure. ETFs typically track indices like the Nasdaq or the S&P 500.

For tax-loss harvesting purposes, ETFs make sense because they can help you sidestep the wash sale rule. If you sell off a tech stock at a loss, you won’t be able to replace it with another tech stock until 30 days have passed. You can, however, use the money from the sale to invest in a tech ETF.

Under the IRS rules that govern these transactions, your purchase won’t trigger the wash sale rule because it’s not considered to be the same type of security. By going with an ETF, you can add some diversity to your portfolio without having to sacrifice your capital loss. Just keep in mind that you could end up breaking the wash sale rule if you sell one ETF and buy another that tracks an identical index.

Think Long-Term

How to Use ETFs for Tax Loss Harvesting

One caveat to keep in mind is that ETFs have the potential to generate some sizable returns over time. That’s good news since you’ll be making money, but it does bring the capital gains tax back into play once you decide to sell. Before you use an ETF to harvest tax losses, it’s important to take a look at your capital gains and see how you can balance the equation.

If this is a lot to wrap your head around, you can always turn to a financial advisor for guidance. A matching tool like SmartAsset’s can help you find a financial advisor to work with to meet your needs. First you’ll answer a series of questions about your financial situation and goals. Then the program will narrow down your options to up to three suitable advisors in your area. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: ©iStock.com/Susan Chiang, ©iStock.com/Minerva Studio, ©iStock.com/larkyphoto

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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