ETF Trends
ETF Trends

In my last post, I confided in you my feelings on paying taxes, shared a tip for how to potentially pay less this year, and promised another word to the wise. So here’s tip #2: take advantage of tax loss harvesting.

What is tax loss harvesting?

Tax loss harvesting is purposefully selling an investment at a loss.

How on earth could that help? Because the government taxes you on your total gains for the year, you can use losses in one part of your portfolio to offset gains in another, and reduce your total tax bill.

This technique can make a difference in your tax bill and on your long-term returns. The federal government currently taxes long term capital gains (from the sale of investments held more than 1 year) at a rate up to 23.8%, and short term capital gains at an individual’s ordinary income tax rate. This year, the highest income tax bracket is a whopping 43.4%*.

According to the IRS, you can also carry your losses forward indefinitely. So make sure you’ve used up all of your losses from prior years (2008 is a good place to start!) to make sure you’re not leaving some losses on the table.

Where should I look in my portfolio this year?

Check your monthly statements to see where you’re at a loss or gain. US stocks have had a good run this year, but this list of the Six Worst S&P 500 Stocks of 2013 proves that not all stocks are winners.

How can I stay invested during the meantime?

If you’re looking to sell individual stocks to offset gains, diversified ETFs and mutual funds can help you stay invested during what’s known as the “wash sale” period.

The “wash sale” rule says that an investor can’t claim a loss on the sale of an investment and then buy a “substantially identical” security for the period beginning 30 days before and ending 30 days after the sale. (Think of it as the government’s insurance policy—they want to make sure that investors don’t get a tax break and then instantly buy back their original investment.)

Because ETFs and mutual funds hold many stocks or bonds, (and so look very different from an individual stock), they can be great candidates for reinvesting your money during the 60-day period.

Bottom line: there’s still hope to reduce your tax bill this year. In between trips to the mall and grocery store, take a quick look at your investments to see where you can save this year—I promise you won’t regret it.

Jessie Szymanski writes about personal finance for iShares. You can find more of her posts here.

* The Patient Protection and Affordable Care Act was enacted in 2010 and imposed a 3.8 percent net investment income tax (“NIIT”) on higher income taxpayers for tax years beginning in 2013. For individuals, the tax is assessed on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (AGI) over a threshold amount, generally $250,000 for married taxpayers filing joint returns and $200,000 for single taxpayers. Net investment income includes, but is not limited to interest, dividends, royalties, rental income, and net gain from the disposition of property. Such investment income is reduced by properly allocable deductions to arrive at net investment income. Tax exempt interest (e.g., Interest from municipal bonds) is not subject to the NIIT. The NIIT does not apply to nonresidents of the U.S. and will not affect income tax returns for the 2012 taxable year that will be filed in 2013. The information provided is neither tax nor legal advice. Tax laws and regulations governing the NIIT are complex. Investors should speak to their tax professional for specific information regarding their tax situation.

The Internal Revenue Service has not released a definitive opinion regarding the definition of “substantially identical” securities and its application to the wash sale rule and ETFs. The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy.