The fourth quarter often heralds a flurry of tax-loss harvesting activity as advisors and investors look to offset capital gains and losses. Given their tax efficiency, ETFs may prove an attractive replacement for both single securities and other funds.
In a year of ongoing volatility and change, investors may find themselves with tax-loss harvesting opportunities in the final quarter. This arises when an advisor or investor sells an investment that lost value. The action captures the previously unrealized loss to offset capital gains made either in the same type of exposure or elsewhere. Should losses exceed the amount of capital gains offset, they may be carried into future tax years, Fidelity explained in a paper. Tax-loss harvesting may help with overall portfolio tax efficiency come tax season.
When selling out of a position to capture unrealized losses, it’s common practice to replace it with similar exposures. What advisors and investors must be mindful of, however, is the wash-sale rule. This rule prevents an investor from selling at a loss and purchasing the same security. It also prevents using options to buy that security or a substantially identical security within 30 days. Should an investor buy a substantially identical security within the 30-day period, the tax-loss capture is not allowed. This also applies to investments spouses make if they file jointly.
Look to ETFs When Tax-Loss Harvesting
ETFs may offer a potential solution for reinvesting a loss. Their structure and unique mechanisms create the potential for reduced capital gain generation within portfolios compared to other fund types. This makes ETFs a replacement worth considering when optimizing portfolio tax efficiency.
They essentially offer a double tax benefit. That’s first with their tax-efficient structure and, second, as a use case for avoiding triggering a wash sale.
For those individuals who sold out of a single security, replacing it with an ETF with exposure to the same asset class may be a solution. This may also reduce the risk profile of the portfolio by putting a damper on single-security risk. However, as ETFs offer a variety of types of exposures, you should understand each one’s risks, strategy, and portfolio holdings.
See also: “Fidelity Offers Core Equity Exposure With Active Benefits”
To capture unrealized losses, individuals selling out of a fund, whether a mutual fund or an ETF, could also consider an ETF replacement. However, remember the wash-sale rule and don’t use a substantially identical ETF.
“One option? Swapping a passive or indexed ETF for an actively managed one,” the Fidelity article explained. Active ETFs may offer benefits beyond passive firms in their ability to be more discretionary about security selection. It’s important to have a firm grasp on the risks, return exposure, and costs when investing, particularly when moving from a passive exposure to an active one, cautioned Fidelity: “Always keep the client’s investing objectives and risk constraints in mind.”
While selling out of a position at a loss isn’t always beneficial, tax-loss harvesting can create potential added value for a portfolio. Consider replacing existing positions with ETFs when looking to tax-loss harvest this quarter.
For investors seeking active ETF replacements, Fidelity offers several strategies across core allocations. These include the Fidelity Investment Grade Bond ETF (FIGB), the Fidelity Fundamental Small-Mid Cap ETF (FFSM), the Fidelity Enhanced Large Cap Growth ETF (FELG), and more.
For more news, information, and strategy, visit the ETF Investing Channel.
Fidelity Investments® is an independent company unaffiliated with VettaFi LLC (“VettaFi”). These articles do not form any kind of legal partnership, agency affiliation, or similar relationship between VettaFi and Fidelity Investments, nor is such a relationship created or implied by the articles herein. VettaFi LLC is the author and owner of these articles.
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