Tax advantages with mutual funds and ETFs
Key Insights
- Consider incorporating capital gains and income tax implications into your analysis when evaluating investing strategy and performance.
- Offsetting realized capital gains taxes by harvesting investment losses can offer strategic benefits to clients who need to diversify a concentrated portfolio or plan for a windfall.
- Exchange-traded funds (ETFs) may offer advantages when tax-loss harvesting.
When market volatility spikes, investors turn to their advisors, and so far 2023 has provided plenty of ups and downs. Though broad market indices are still well into positive territory after spending much of 2022 mired in a bear market, much of the bounce-back is attributable to a handful of high-flying tech stocks. That may mean plenty of opportunities for advisors to provide additional value to clients through the strategic implementation of tax-loss harvesting in the year's final quarter.
Many advisors routinely sell stocks, bonds, mutual funds, ETFs, or other investments in taxable accounts that have lost value since purchase to offset realized gains elsewhere in a portfolio. Maintaining a similar risk profile within the portfolio when selling positions for tax-loss harvesting purposes can be tricky, as they must be replaced with similar, but not substantially identical securities. Swapping out individual securities for mutual funds or ETFs may help. Not only can they enhance diversification, they're less likely to run afoul of wash-sale rules, and may provide long-term tax benefits by reducing the amount of taxable distributions incurred by the investor.
Tax-loss harvesting using funds
Many clients may have mutual funds and/or ETFs, along with individual stocks, in their taxable portfolios. One common tax-loss harvesting strategy is to sell an individual stock that has incurred losses and replace it with an ETF or mutual fund that provides exposure to the same asset class, and often a similar segment of that asset class.
Implementing tax-loss harvesting in this way can achieve several goals. Not only are losses generated to offset gains, the overall risk exposure of the portfolio may be reduced by lowering exposure to individual investments. Shifting into an ETF may also offer additional tax efficiencies, as the structure of ETFs means they are less likely to generate capital gains while being held in a portfolio. And importantly, shifting into either a mutual fund or ETF can help avoid running afoul of the wash-sale rule.
The wash-sale rule generally states that a tax-loss will be disallowed if the same security, a contract or option to buy the security, or a substantially identical security, is purchased within 30 days of the sale date of the loss-generating investment. The wash-sale rule encompasses the entire holdings of the investor in question—and those of their spouse if they file a joint tax return.
It's important to be sure you have a full picture of a client's finances before engaging in tax-loss harvesting on their behalf. A purchase of a substantially similar security in their or their spouse's tax-deferred retirement account or personal trading account could run afoul of wash-sale rules.
Assessing tax savings
Short- and long-term losses must be used first to offset gains of the same type. However, if losses of one type exceed gains of the same type, the excess can be applied to the other type. If any losses remain after all gains have been offset, remaining losses may be offset against up to $3,000 of ordinary income. Finally, any losses beyond that can be carried forward to future years.
Tax-loss harvesting example
Suppose a client's portfolio holds a technology stock whose current price is below its cost basis, and while you're not convinced that it will come back over the short term, you still believe in the long-term prospects for all or some part of the technology sector.
Selling the stock and replacing it with a technology ETF can help maintain a similar risk profile while reaping the tax benefits of loss harvesting. You could choose a broad technology sector ETF, or you might opt instead for a more narrowly focused consumer staples industry ETF if you'd like to focus on a particular segment of the technology sector—such as software, semiconductors, or electronic equipment products. You might also consider a comparable mutual fund with exposure to the technology sector.
Obviously, ETFs and mutual funds have their own characteristics and risks that should be carefully considered before making any decision. Even a focused tech ETF provides much broader exposure than any individual security and it may have quite different characteristics.
Similarly, if you bought a dividend-paying stock to generate income for the portfolio, but the stock has an unrealized loss, you may want to sell the stock and replace it with a diversified dividend-focused ETF. In doing so, you may be able to generate the desired tax effect—incurring a loss to offset gains—while improving the diversification of the portfolio and still generating income.
These are just two examples amid a broad range of investment strategies where tax-loss harvesting can be implemented with the help of an ETF or mutual fund. No such swap provides guaranteed gains or loss protection, but replacing individual investments with ETFs and mutual funds may enhance overall portfolio diversification and improve relative risk-return levels.
Replacing funds with another fund
Often the position with unrealized losses in the portfolio may itself be a mutual fund or ETF. Tax-loss harvesting remains a viable strategy in such circ*mstances, though careful consideration must be taken to ensure that the replacement ETF or fund is not substantially identical to the one being sold. One option? Swapping a passive or indexed ETF for an actively managed one. In recent months, the variety of actively managed strategies being offered in ETF wrappers has increased substantially, offering the opportunity to retain the tax advantages of ETFs while still maintaining exposure to a given area of the market.
Active ETFs can rebalance directly on a daily basis in the primary market. The basket of securities exchanged for ETF shares in a redemption is custom and designed to trim low-basis securities, improve portfolio performance, or maintain style purity. This differs from an index or passive ETF where the basket of securities exchanged for shares is predetermined and executed on a set schedule.
Careful analysis of the replacement ETF or mutual fund holdings should be undertaken before making such a switch. Swapping one fund with another, especially a passive one for an active one, can change the risk and return exposures significantly. Always keep the client's investing objectives and risk constraints in mind. Fund expenses, too, may vary significantly, especially between active and passive funds, even within the same sector. Make sure increased expenses don't eat away at the marginal tax alpha obtained by tax-loss harvesting.
Maximizing returns
Tax-loss harvesting may not be beneficial in every instance; depending on a client's investment goals and time horizon, sticking with a particular position through a short downturn may be preferable in order to reduce tracking error and maintain a desired risk profile. And clients should be made aware the lower cost basis of the portfolio post harvest may mean any tax benefits obtained in the present result in higher taxes in the future.
For many clients tax-loss harvesting can be an important tool for adding value to their portfolios. This consultative approach between advisors and clients can strengthen relationships. And it's never too soon to consider implementing it.
