Now that 2022 is almost over, advisors have a tight December 31 deadline to help their clients maximize the tax savings from their investments. And it’s better to look into strategies sooner rather than later.
This is usually the time many investors start thinking about tax-loss harvesting, which allows them to log the investment losses inside a taxable account to offset capital gains or ordinary income elsewhere. Under current U.S. tax law, an investor’s capital losses can be used to reduce ordinary taxable income up to a $3,000 annual limit. For market losses that exceed $3,000 in a calendar year, the losses can be carried forward indefinitely until the full amount is exhausted.
Exchange-traded funds come in handy here because they give investors a place to redeploy their investment sale proceeds. As long as the ETFs being used are different from the holdings recently sold, the investor won’t run afoul of wash-sale rules, which say that if an investment is sold for a loss and then rebought within 30 days, the original loss can’t be counted for tax purposes.
Let’s examine three reasons ETFs are great tools for tax-loss harvesting.
ETFs Help Clients Reduce Risk
People don’t usually realize they have taken on too much investment risk until a bear market strikes—and the recent coordinated fall in stocks, bonds and real estate took many investors by surprise.
It’s been a particularly painful experience for investors holding bond funds or individual bonds with longer maturities of 10 or more years. Consider the iShares 20+ Year Treasury Bond ETF (TLT), which has cratered this year, falling by more than 35%. Investors who reached for yield by going with longer-duration bonds are paying dearly for that choice.
Using this example, how can advisors use ETFs to help reduce risk?
For investors with longer maturity bond funds and individual bonds, a shift into bond ETFs with shorter durations—for example, the Federated Hermes Short Duration Corporate ETF (FCSH)—can lessen interest rate risk. Also, the rapid rise in interest rates has made shorter-term bond ETFs a more attractive alternative.
ETFs Help Clients Reduce Fees
Some investors might be stuck in expensive, underperforming funds. How can advisors help them? One way is by identifying the losers inside a client’s portfolio and helping them understand why now could be a good time to trim them.
After that, advisors can help clients reinvest the money into lower cost ETFs with better investment potential. By using less expensive ETFs, the investor is paying less in fees, which puts less pressure on the advisor to deliver performance by taking more risk.
ETFs Help Clients Stay Disciplined
When financial markets get rough, the immediate human tendency is to bail out. Nobody wants to lose money. However, ups and downs are part of the investment process and investors need to understand this.
But if somebody wants to sell a losing investment and seeks to rebuy it later on, an ETF gives them a temporary place to park money while helping them avoid the wash-sale rule (so long as the ETFs are different from the original investment). For instance, an investor could swap a losing growth stock for a diversified growth equity ETF. Such moves could also keep the investor disciplined. How? By helping them stay fully invested when the eventual rebound comes.
Summary
This year’s broad decline in stocks, bonds and equity real estate has provided many opportunities for tax-loss harvesting.
Advisors should be working closely with clients to help them maximize the tax savings. Moreover, using ETFs as replacements can go a long way toward cutting fees, reducing risk and keeping investors disciplined.