Tax-loss harvesting is the practice of selling an investment at a loss in order to reduce your taxable income or to offset current (or future) gains. For example, if you invested $50,000 in stock ABC and it has declined 10% since you bought it, you have a $5,000 unrealized loss. By selling ABC, you now have a $5,000 realized loss you can use to your advantage from a tax perspective. You can deduct up to $3,000 in losses against ordinary income (like W2 wages) and offset any gains from the stock market dollar for dollar.
How tax-loss harvesting works
Sticking with our $5,000 ABC loss example… let’s say you make $100,000 in income for 2021. By taking the $5,000 loss you’ll lower your taxable income to $97,000 ($3,000 offset) leaving you with $2,000 that you can use against investment capital gains. So if you then had a $2,000 profit in stock DEF, and decided to take the gain, you wouldn’t be triggering any tax. That’s because the $2,000 left over from the original $5,000 loss in stock ABC (of which $3,000 was used to offset income), would zero out the $2,000 profit you realized in stock DEF.
What’s more, there’s no rule that says you have to use the $2,000 loss in tax-year 2021. If you wanted to hold stock DEF, the $2,000 in losses from stock ABC will carry forward to 2022. Therefore, there is clear value in optimizing tax-loss harvesting strategies. And in 2021 there are a number of tax-loss harvesting strategies we’ve identified that we are currently executing on behalf of clients.
Tax-loss harvesting in 2021
While the headline numbers will show that the stock market has enjoyed a strong year, the performance is highly concentrated in the S&P 500 and to the first half of the year. VT, a total market ETF from Vanguard, is up 14.80% year-to-date. However, since July 1st (the second half of the year), VT is up less than 2%. IJR and IWM, two index ETFs that track small-cap benchmarks, are up 21% and 10% year-to-date, respectively. Yet, since July 1st, they are each down 1.75% and 5.63%. VEA, an index ETF tracking international stocks (mainly Europe & Japan) is up 8.50% year-to-date. Since July 1st? VEA is down 1.82% and recently fell 5% from a high.
All of those are simply index fund examples. If you start looking at sector ETFs, or actively managed ETFs like those of popular fund manager, Cathie Wood, the performance is much worse. ICLN, a popular ETF that focuses on investments in the clean energy sector is down 24% year-to-date. Ms. Wood’s flagship ARKK ETF, which invests in “disruptive and innovative companies,” is down 22% year-to-date. IBB, a biotechnology ETF that rode vaccine optimism to a 15% gain through the first six weeks of the year, is down 10% since mid-February.
3 index funds to tax-loss harvest
So, without further ado, here are five tax-loss harvesting ideas to execute before the end of the year:
Sell VEA to buy IEFA: Both of these ETFs track international stocks. The ETFs have 76% fund overlap, so you’re keeping your targeted exposure in place. This one may not be applicable depending on your purchase history of international stocks. However, if you’ve bought them anytime in the last six months then you are probably sitting on losses.
Sell IJR to buy SPSM: These ETFs track the exact same index: the S&P 600, which is an index of small-cap stocks. They have over 97% fund overlap. This area of the market is down almost 2% since July 1st but recently fell 10% from a November high. Depending on your timing or any previous rebalancing, there’s a chance you have losses in the small cap space.
Sell VWO to buy IEMG: Both of these ETFs track an index of emerging market stocks, like those in China. This particular area of the market has been hit hard. VWO is down 9% since July 1st and is flat on the year (while most every other index category is higher). These funds share 76% overlap between their holdings.
2 popular ETFs to tax-loss harvest
Sell ICLN to buy CTEC: These passively managed ETFs own stocks related to the clean energy sector. A standout group in 2020, 2021 has not been kind to the sector. ICLN and CTEC are each down 24% and 21% year-to-date. They share 41% of the same holdings and have a high correlation to each other. Two stocks, ENPH & PLUG, make up roughly 15% of each fund and are top holdings.
Sell ARKK to buy KOMP: These ETFs have the same objective: invest in companies that are in “disruptive” areas of economy; such as electric vehicles, gene editing, artificial intelligence, etc. The main difference between them is that ARKK is actively managed and KOMP follows a passive benchmark. In addition, ARKK’s mandate allows for much higher concentration in its investments whereas KOMP is much more diversified due to its benchmark. Importantly though, both provide exposure to the theme of “disruptors.”
Any one of these ideas can be flipped around (i.e. sell KOMP to buy ARKK or sell CTEC to buy ICLN). It just depends on what you own personally. What’s great about ETFs is there are so many of them and you can usually find a duplicate of what you already own. So when it comes to tax-loss harvesting, you can easily replace an ETF you own for the purposes of tax-loss harvesting, without losing your desired exposure.
An extra 1% per year
Make sure when you execute tax-loss harvesting ideas you are mindful of any wash-sale implications. You should note that most brokers classify wash sales by CUSIP numbers, so selling one S&P 500 ETF to buy a different one won’t typically trigger a wash sale. But be sure to check with your broker that such a trade won’t trigger a wash sale in their system. Lastly, if you want to be able to use losses in 2021 make sure you complete the transactions in the 2021 year. If you wait until the new year, you won’t be able to apply the loss on your 2021 taxes.
If you’re a client, you can assume we are executing these strategies on your behalf right now. There is real value in tax-loss harvesting. A study by researchers out of MIT estimated that effective use of tax-loss harvesting strategies would have generated an additional 1% in annual return from 1928-2018. That’s an extra $1,000 per year on a $100 thousand portfolio, or an extra $10,000 per year on a $1 million portfolio. Email us if you would like a comprehensive list of ETFs that can easily be swapped out for the other.
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