Year-End Tax-Loss Harvesting: Tips and Tricks with ETFs

As we approach December 2023, it's that time of the year when both advisors and investors start to focus on tax-loss harvesting. Despite 2023 being a bull market, particularly for large-cap U.S. indices, not everyone might be basking in the warmth of unrealized gains.

Some investors are still likely licking their wounds from the losses of 2022, while others might be facing fresh setbacks, especially in the bond market, where long-duration Treasuries have been particularly hard hit.

If you're in the camp looking to minimize your tax bill and are curious about how ETFs can be leveraged in this process, you've come to the right place. Consider this your quick guide to using ETFs for tax-loss harvesting.

But, before diving in, a word of caution: I am not a tax professional. So, do your own research (DYOR) and, for the best results, consult with a tax expert to tailor a strategy that best fits your specific financial situation.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy employed to minimize capital gains tax, which can be a significant drag on investment portfolios in non-tax-advantaged accounts.

Capital gains tax applies when you sell an investment at a profit, with the rate depending on the holding period of the investment.

For investments held over a year and a day, the long-term capital gains rate (0%, 15%, or 20%, depending on your tax bracket) applies. For those held for less than a year, the short-term rate, which aligns with your ordinary income tax rate of up to 37%, is used.

The goal here is to legally minimize capital gains tax. Tax-loss harvesting enables you to do this by using investment losses to offset gains. If you sell an investment at a loss, that loss can be claimed as a tax credit to counterbalance future gains.

It's important to understand how the type of capital gain – short-term or long-term – plays a role in this strategy. Losses incurred on investments held for less than a year (short-term losses) are first used to offset short-term gains.

Similarly, losses on investments held for more than a year (long-term losses) are applied against long-term gains. This distinction matters because short-term and long-term gains are taxed at different rates, as previously mentioned.

Moreover, if your investment losses exceed your gains in a given tax year, you can carry over the excess to apply against taxable income. The IRS allows you to use up to $3,000 of excess losses each year to offset ordinary income. Any remaining losses beyond that can be carried forward to future tax years, providing an ongoing opportunity to reduce taxable income and potentially lower your overall tax liability.

However, there are rules to follow, notably the wash-sale rule. This rule prevents you from selling a security at a loss and then buying a “substantially identical” security within a 30-day window before or after the sale.

The IRS's definition of “substantially identical” can be vague, but for ETFs, it generally means those tracking the same index - say, two competing S&P 500 index ETFs from different providers. Still, there are (legal) ways to circumvent this, as we will explore below.

Tax-loss harvesting examples using ETFs

Let's consider a practical and timely example using the iShares 20 Plus Year Treasury Bond ETF (TLT), which, as of 2023, has seen a significant loss of 12.75% year to date.

If you're holding TLT and experiencing a loss, a tax-loss harvesting strategy could involve selling TLT to realize a capital loss and then immediately purchasing a similar but not "substantially identical" ETF, like the SPDR Portfolio Long Term Treasury ETF (SPTL).

This move likely wouldn't violate the wash-sale rule. Why? While TLT and SPTL are similar in many aspects, they track different indices. TLT follows the ICE (NYSE:ICE) US Treasury 20+ Year Index, whereas SPTL is pegged to the Bloomberg Long U.S. Treasury Index.

Despite their differences in tracking indices, both ETFs have comparable portfolio compositions, with similar overall credit ratings, durations (16.48 years for TLT versus 15.36 years for SPTL), and yields to maturity (4.75% for TLT versus 4.76% for SPTL).

This is just one instance of how you can employ tax-loss harvesting with ETFs. To explore more options suitable for your specific tax-loss harvesting needs, a tool like the ETF Central Screener can be invaluable. It allows you to sift through the vast universe of over 3,300 current ETFs, helping you find those that align with the exposures and characteristics you're looking for.

Finally, keep in mind that the above-noted example is hypothetical. To determine whether two ETFs qualify as “substantially identical,” ensure you always consult a tax attorney or accountant. The information presented above is for general purposes only and should not be construed as legal or investment advice.

This content was originally published by our partners at ETF Central.