As 2023 winds down, strategies for reducing the tax bite come to mind. And exchange-traded funds can play a vital role in helping with this all-important task.
Tax-loss harvesting is a common method for using investment losses to offset taxable gains or earned income.
Under current U.S. tax laws, realized losses can be used dollar for dollar to offset capital gains. Alternatively, investors can also choose to offset up to $3,000 per year of income with capital losses.
“We speak to a lot of financial advisors, and if there’s a chance to reposition an investment portfolio to counteract higher inflation or elevated market volatility—and at the same time realize some capital losses to carry forward—it makes a lot of sense,” said Lance McGray, head of ETFs at Advisors Asset Management.
He cites the preferred securities ETF market, with around $30 billion in assets, as a ripe candidate for tax-loss harvesting. Certain funds with longer duration maturities, like the iShares Preferred and Income Securities ETF (PFF) and Invesco Preferred ETF (PGX), have fallen 12% to 16% over the past two years in response to rapidly rising interest rates.
Instead of sitting around waiting for a recovery, one strategy could be to swap the iShares fund for an alternative preferred ETF that’s been less hurt by rising rates, like the AAM Low Duration Preferred & Income Securities ETF (or PFLD; “AAM” stands for Advisors Asset Management). The investor can receive the tax benefits associated with losses while maintaining an income approach in a different ETF with little overlap.
If the same investor wants to bail on preferred securities altogether, an alternative approach could be to replace the iShares fund with a higher yielding bond ETF that offers tax benefits, for example, the VanEck High Yield Muni ETF (HYD). If tax rates aren’t much of a concern, a dividend equity ETF strategy like the NEOS S&P 500 High Income ETF (SPYI) could be another dividend income replacement solution.
Advisors should aim to make sure that the replacement investments are as dissimilar as possible to the tax-loss holdings that are sold. Specifically, the prospective return paths and fund holdings for the new investments should have minimal similarities with the old ones. This will help investors avoid running afoul of the IRS’s 30-day wash-sale rule, which, if breached, could prevent the tax loss from being claimed.
While tax-loss harvesting applies only to investments held inside a taxable brokerage account, the strategy can be applied to individual stocks and bonds along with mutual funds.
Suppose an investor has a losing technology stock position he or she decides to sell for a loss. That position can be replaced with a diversified technology fund or ETF. Besides getting a tax benefit from the loss, the investor can maintain exposure to the technology sector but with greater diversification than what one would get concentrated in a single stock.
While tax-loss harvesting is fairly straightforward, it’s always a good idea for clients to consult their advisors and tax professionals to ensure successful execution.