One of the many benefits of exchange traded funds (ETFs) is that they can be used for tax-loss harvesting. This is a popular strategy investors use in order to offset capital gains, now or in the future. But how do you do it?
Each year, investors have a dilemma facing them: should they sell their losing positions to offset any gains they made in others or do they hang on and let them slide further? The risk in selling, of course, is that the position could reverse course and begin to gain again. (What are capital gains?).
By tax-loss harvesting, an investor can sell a losing position but buy an ETF that holds that same position, thereby avoiding losing your stake if things take a turn for the better. (More reasons to choose ETFs).
The Motley Fool has a good example of how it works: If one wants to gain exposure to large-cap stocks and owns the SPDR S&P 500 (NYSEArca: SPY) but has a higher cost basis in the ETF than what the fair market value of it is, the investor can sell SPY, picking up a capital loss, and then simultaneously buy another large-cap index like the Vanguard Large Cap ETF (NYSEArca: VV). This can also be done by using stocks: if you took a loss on a large financial stock, you could sell it and by a financial sector ETF that holds the stock, such as the Financial Select Sector SPDR (NYSEArca: XLF). (Precious metals and taxes).
ETFs are one of the best vehicles for this strategy because of the transparency they offer, along with low fees and intraday liquidity. (What higher tax rates mean).
By doing this, the investor keeps his exposure to large-caps and picks up a capital loss for tax purposes. Although this strategy could be beneficial, a major drawback of it is the accumulation of transaction costs that go with buying and selling shares frequently. Secondly, you may find it hard to find good ETFs that enable you to successfully implement this strategy while maintaining the exposure to a desired asset class. (How ETFs are taxed).
For more stories on taxes, visit our tax category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.