A Complete Guide to Tax Loss Harvesting With ETFs

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.

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. (For more, see: A Brief History of Exchange-Traded Funds.)

To understand what the benefits of tax loss harvesting are, it’s important first to be aware of how investment gains are taxed.

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 max rate for high-income investors topping out at 39.6%.

The long-term capital gains tax applies to investments held longer than one year. As of 2015, the rate is set at 0%, 15% or 20%, based on the individual investor’s tax bracket.

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 off an asset that’s underperforming and repurchasing it after a 30-day window has passed.

In the meantime, you would use the proceeds from the sale to purchase a similar investment. 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 dictates when a tax loss can be harvested. Specifically, when you sell a security at a loss, you cannot purchase one that is substantially identical to replace it within 30 days before the sale and 30 days after it’s complete. If you attempt to include the loss on your tax filing, the IRS will disallow it, and you won’t receive any tax benefit from the sale.

The IRS does not offer a precise definition of what constitutes a substantially identical security so navigating this rule can be tricky. Generally, stocks offered by different companies wouldn’t fall into this category. There is an exception, however, if you’re selling and repurchasing stock from the same company after it’s been through reorganization.

Similar to mutual funds, exchange-traded funds encompass a range of securities, which may include stocks, bonds, and commodities. ETFs typically track a particular index, such as the NASDAQ or Standard and Poor's 500 Index. 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 to loss harvesting because they make it easier for investors to avoid the wash-sale rule when selling off securities. Because ETFs track a broader segment of the market, it’s possible to use them to counteract losses without venturing into identical territory.

For instance, let’s say you sell off 500 shares of an underperforming biotech stock at a loss, but you want to maintain the same level of exposure to that particular asset class in your portfolio. By using the proceeds from the sale to invest in an ETF that tracks the larger biotech sector, it’s possible to preserve asset diversity without violating the wash-sale rule. 

You can also use ETFs to replace mutual funds or other ETFs as long as they’re not substantially identical. If you’re unsure whether a particular ETF is too similar to another, you can look to its index for guidance. If the ETF you’re selling and the ETF you’re thinking of buying both track the same index, that’s an indication that the IRS may deem the securities too similar. 

Aside from their usefulness in tax loss harvesting, ETFs are more beneficial compared to stocks and mutual funds when it comes to cost. Regarding the fees, 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. (For more, see: How to Reduce Taxes on ETF Gains.)

From a tax perspective, using ETFs to harvest losses works best when you’re trying to avoid short-term capital gains tax since the rates are higher compared to the long-term gains tax.

There is 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 if you were to sell the securities at a higher price down the line, any profits you realize would be considered a taxable gain.

The same is true if the ETF you purchase goes up in value while you’re holding it. If you decide to sell it off and use the money to invest in the original security again, that will generate a short-term capital gain. Ultimately, you’d be deferring your tax liability rather than reducing it.

There are certain guidelines investors must keep 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, which offer 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. As of 2015, the limit is capped at $3,000 or $1,500 for married taxpayers who file separate returns. If a loss exceeds the $3,000 limit, the difference can be carried forward in future tax years.

The IRS also requires you to offset gains with the same type of losses first, i.e., short-term to short-term and long-term to long-term. If you have more losses than gains, you can apply the difference to gains of a different type in that scenario.

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 correctly observing the wash-sale rule. Investors must be careful in choosing exchange-traded funds to ensure that their tax loss harvesting efforts pay off.