In a testament to the complexity of taxes, the late humorist Will Rogers quipped, “The only difference between death and taxes is that death doesn’t get worse every time Congress meets.”

As 2018 heads toward the finish line, financial advisors can help their clients reduce the tax pinch with a few savvy year-end tax strategies. Let’s examine three strategies.   

Harvesting Tax Losses

Although diversified U.S. stock indices like the S&P 500 are modestly up, many individual stocks are not. “This year is the first year in a while that you have a market which has given some gains and some losses," said Dan Dolan, director of wealth management strategies at the Select Sector SPDRs. "As you move into November and December, you should be realizing some of those losses to offset gains."

General Electric, for example, is the perfect tax-loss selling candidate. The company has cratered almost 46 percent since the start of the year while its peer ETF, the Industrial Select Sector SPDR Fund (XLI), has a modest decline of almost 2 percent. By selling GE and re-deploying the sale proceeds into XLI, an investor can realize the capital loss while maintaining exposure to GE’s peer sector group.

Moreover, using this tax-loss strategy with ETFs as the placeholder keeps a person from running afoul of the IRS’ 30-day wash sale rule. The rule defines a wash sale as one that occurs when a person sells a security at a loss, and within 30 days before or after the sale, buys a nearly identical investment.

Avoiding A Capital Gains Tax Hit

The majority of mutual fund capital gains distributions typically happen in the final two months of the year. And for investors who own mutual funds in a taxable account, making new deposits into a mutual fund right before a year-end distribution is a big no-no.

Rather than attempting to estimate a fund’s capital gain distribution for 2018, one possible strategy is to switch part or all of an investor’s holdings away from a potential tax bomb into a tax-friendly ETF. To locate a qualified ETF substitute, simply identify the asset class or investment category of the fund you’re replacing. From there, you will find a bountiful menu of viable ETF choices. Sources like XTF.com and Morningstar.com can help you in your research.

Making Index ETFs The Core

ETFs that use an indexing strategy are very tax-friendly in that they produce little year-to-year tax liabilities to their shareholders. This is a particularly significant matter for people who hold their investments in a taxable account. When, besides never, does it make sense for a long-term shareholder to get nabbed with yearly capital gains?

Building a portfolio of index ETFs and making it a portfolio’s core or foundation enables investors to avoid unnecessary taxes.

One final tip is to check a fund’s tax-cost ratio at Morningstar and compare it against a similar ETF. The tax-cost ratio measures how much of a fund’s annualized return is reduced by the taxes investors pay on distributions. For example, if a fund has a 1 percent tax-cost ratio over a three-year period that means investors in that fund lost 1 percent of their assets to taxes on an annualized basis. 

Conclusion

ETFs are great tax planning tools, but it’s important to remember they don't avoid taxation on dividends or income. Rather, an ETFs’ tax advantage is due to their “in-kind redemptions.” After an ETF receives investor redemptions, the fund can deliver a basket of the fund’s underlying securities instead of cash. The fund can also pick and choose which shares to distribute, removing securities with the highest embedded capital gains. Because the trade conducted by the ETF is “in-kind,” no capital gains are realized, thereby averting taxes.

In the end, ETF shareholders are the winners.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.