Many investors know the key benefits of exchange-traded funds (ETFs): lower costs, trading flexibility, transparency and tax efficiency. Fewer people are aware that ETFs also may help reduce tax bills through a strategy called tax-loss harvesting. It’s a strategy with taxable accounts that can be employed throughout the year—and useful whenever volatility strikes—to sell losing positions to offset capital gains.
Here’s how ETFs have the potential to save you money at tax time.
Market turbulence can be an opportunity to reassess your portfolio. Capitalizing on losses can help offset future gains while also giving you the ability to rebalance your portfolio. Taxes alone shouldn't drive investment decisions. But harvesting losses made in concert with an overall investment plan may ease the future tax-bill sting.
Turning Your Loss Into A Potential Win
Investment losses can be hard to swallow, but tax-loss harvesting lets you take the losses of one investment to offset the gains of another.* According to the IRS, if your net capital loss exceeds your capital gains, the amount of the excess that you can claim to lower your income is $3,000. If your net capital loss is more than $3,000, you can carry the loss forward to later years to help lighten your future tax burden. The IRS provides guidance on the amount you can carry forward or consult with a professional tax consultant.
We all get satisfaction when we make money on the sale of a stock, yet these gains can come with the surprise of hefty tax bills. Losses, on the other hand, can be hard to swallow. The good news is that losses may come with a silver lining in the form of potential tax benefits.
“Tax-loss harvesting,” as it is known, allows investors to offset gains realized in one investment with losses incurred in another.* The following hypothetical example illustrates how this technique can help reduce an investor’s tax liability.
- The hypothetical long-term loss from the sale of XYZ partially offsets the long-term gain from the sale of ABC.
- This example assumes a capital gains tax rate of 15 percent. This rate varies by filing status and income.
- The offsetting loss results in a tax savings of $600.
Some Dos and Don'ts of Tax-Loss Harvesting
Following a few general guidelines could help you take advantage of this opportunity and may help avoid running afoul of the IRS’s wash sale rule. Remember everyone’s situations is different. Please consult a tax advisor for your individual situation. Continue reading to learn more about this rule.
Do | Don't |
|---|---|
Use the strategy for taxable accounts only, as there is no tax benefit to harvesting losses in a tax-deferred account | Sell a security for a loss and then repurchase it within 30 days |
Replace a security sold for a loss with another similar (but not substantially identical) security in order to maintain desired exposure | Purchase a “substantially identical” security to replace one sold for a loss |
Consider the relative advantages and disadvantages of using ETFs, active mutual funds, or indexed mutual funds to replace a security sold for a loss | Sell a security for a loss from a taxable account and then repurchase it within 30 days in a tax-deferred account |
If losses exceed gains in any one year, carry over any unused losses to apply against gains in future years | Let taxes alone drive investment decisions – the decision to harvest losses should be made in concert with the overall investment plan |
Tax-loss harvesting is a year-round strategy where you sell investments to reduce capital gains taxes in your portfolio. See other examples of how it works.
Consider investments that no longer fit your overall portfolio strategy or can be replaced by other investments that fill a similar role when looking for losses to harvest. After you have decided which investments to sell off or replace, you have to be aware of the specific rules about wash sales.
Time to Review
Now could be a good time to review each portfolio’s capital gains tax exposure as part of your holistic approach to financial planning.
Following is an overview of some recent changes in tax law that you should keep in mind in tax planning:
Tax Cuts and Jobs Act (TCJA)
Many provisions of the TCJA are set to expire in 2025 unless Congress acts, many of which will result in higher taxes for corporations and individuals over current levels. Congress is debating resolutions but a divided government may slow progress.
The Long and Short of It
- There’s a significant tax advantage to holding onto assets for longer than a year, since long-term cap gains tax rates (0%, 15%, 20%) are much lower than short-term cap gains tax rates (taxed as ordinary income).
- Qualified dividends are taxed at the long-term capital gains rate and ordinary dividends and income paid on bonds is taxed at the standard federal income tax rates.
- If losses exceed gains in a given year, they can be carried forward until gains are depleted.
- Investors may also deduct up to $3,000 in losses from their income each year.
- Taxes apply on gains from the sale of a residence (net of improvements and exclusions), yet losses on their sale cannot be deducted.
Tax Year 2024
The Internal Revenue Service announced the tax year 2024 annual inflation adjustments for more than 60 tax provisions for 2024, including the tax rate schedules and other tax changes. Revenue Procedure 2023-34 provides details about these annual adjustments.
The IRS has increased the standard deductions for tax year 2024 that will generally apply to income tax returns filed in 2025. For more details on the IRS tax inflation adjustments for 2024, please consult your tax advisor.
Watch Out for Wash Sales
The IRS’s wash sale rule is designed to keep investors from claiming artificial losses, so it’s critical to understand it if you’re planning to harvest losses.
The rule prohibits the sale of a security in order to claim a loss if the investor repurchases it—or a “substantially identical” security—within 30 days before or after the sale. Violating this rule could negate any potential tax benefits from the transaction.
How does the IRS define “substantially identical” security? Unfortunately, they have not identified specific criteria.** Nevertheless, to determine the potential for a wash sale violation, there are some factors that investors may want to consider, including the degree of holdings overlap and the difference in prospective returns. The greater the holdings overlap and the more similar the prospective returns, the greater the possibility of a wash sale classification by the IRS.
Many investors consider Exchange Traded Funds (ETFs) as well as active and indexed mutual funds as effective tools to gain desired portfolio exposures. Yet it’s important to exercise caution to avoid violating the wash sale rule. The
following framework provides an overview of the extent to which ETFs, active mutual funds, and index mutual funds may feature low portfolio overlap as well as differences in prospective returns under various scenarios.
Many ETFs are available on no-transaction-fee (NTF) platforms. Investors who buy an ETF on a NTF platform do not pay a ticket charge. Additional cost savings is yet one more reason to consider using ETFs when replacing a security sold at a loss.
Note: You should consider the replacement fund’s investment objectives, risks and charges and expenses carefully before you invest.
Tax-Loss Harvesting Do's and Don'ts
Use our framework as a starting point for year-end tax planning discussions.
Long- and short-term capital gains are taxed at different rates. Long-term gains may only be offset by longer-term losses. Likewise, short-term gains may only be offset by short-term losses.
As of April 30, 2024, 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 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.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.