Tax-saving ETF strategies to use before end of 2011

October 20, 2011

The final quarter marks the traditional time of year when kids dive into leaf piles, heating bills rise and investors with taxable accounts sell underwater stocks to help lower their tax bills.

They shouldn’t have too much trouble finding candidates this year. Despite a recent uptick, most major indexes remain in negative territory for 2011, and with market volatility in high gear more dips could be on the way.

Tax loss harvesting helps ease the pain of a down market by allowing investors to use the losses to offset gains and up to $3,000 of ordinary income on their tax returns. But you have to wait at least 30 days after the sale of a losing stock to buy back the same security. Otherwise, the IRS calls it a “wash sale” and you can’t deduct the loss.

While someone might use a similar stock as a placeholder in case the market bounces back, that option isn’t ideal because performance can vary significantly among stocks in the same industry. Mutual funds covering similar investment turf don’t always move in sync either.

Exchange-traded funds adapt to the strategy more easily. Since there are more than 1,300 of them, it’s fairly easy to find one that has the look, feel and performance of another security but is different enough to use as a substitute, either temporarily or for the long-term, without drawing IRS scrutiny.

“ETFs have made tax loss harvesting a lot simpler than it used to be,” says Charles Zhang of Zhang Financial in Kalamazoo, Michigan. “It’s not that hard to find one that’s a good stand-in.”

Zhang and some other advisers say using two ETFs or mutual funds based on the same index would probably violate the wash sale rule. To be sure, you might not want to sell iShares S&P 500 or a mutual fund based on the index, for example, and immediately replace it with SPDR S&P 500.

But you could go with a pretty close match. A number of broad-market ETFs, such as SPDR Dow Jones and Vanguard Large Cap follow the S&P 500 fairly closely even though they’re based on different indexes. (The Securities and Exchange Commission has launched a review of some more arcane types of ETFs, but is not expected to have concerns about these mainstream types of ETFs.)

Zhang recently used the strategy by substituting Vanguard Emerging Markets ETF for an emerging markets mutual fund that had lost money, and has switched out a position in on oil industry ETF with another in the same industry. “Even though they’re based on different indexes their performance is almost identical,” he says.

He might go back to the investment he sold after the 30-day blackout period or simply hold on to the new ETF, depending on which one he likes better.

Eric Johnson, principal at Signature, a wealth advisory firm in Norfolk, Virginia, has used sector ETFs when clients have large stock holdings in banks such as Bank of America or Morgan Stanley. Usually, the stock blocks come from previous employers or inter-generational family holdings.

To harvest the loss Johnson sells the individual stock and then buys Financial Select Sector SPDR. “It’s not unusual for us to get back into the original stock later on, particularly if the client has a sentimental attachment to granddaddy’s bank,” he says.

ETFs can also be used to diversify out of large single stock positions that have lost money. Someone who wants to maintain exposure to a particular sector without courting issue-specific risk might sell the losing stock, harvest the loss, and stay in the substitute ETF.

Frank Armstrong, President of Investor Solutions in Coconut Grove, Florida, uses ETFs as part of a strategy to avoid annual mutual fund dividend and capital gains distributions. At the end of the year, he explains, many mutual funds pay out such distributions, which are taxable, as new fund shares, and the share price falls by the same amount. So shareholders don’t really make any money on that transaction, even though they will owe taxes on those payouts.

If the sale of the fund shares results in a tax loss, Armstrong’s firm will sell the shares before the dividend payout date and buy an ETF with a similar investment mission as a placeholder. By doing so, he harvests the loss and avoids the dividend distribution. (This strategy won’t work for investors who have gains in the fund.)

After the payout is made, he’ll move back into the fund shares if more than 30 days have passed since the original sale.

“Avoiding the dividend and moving into an ETF has saved some of our clients a ton of money,” he says.

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