Understanding Tax Loss Harvesting with ETFs

As investors begin to plan and assess year-end tax strategies, it’s important to understand the structure of ETFs and the implications for your tax bill.

Tax loss harvesting is a strategy used by investors to minimize their annual tax liability. The basic idea is to sell investments that have lost value to offset capital gains from other investments. Let's say you own a stock that has decreased in value by $10,000 since you purchased it. You can sell the stock and use the $10,000 loss to offset any capital gains you may have realized during the year.

From a planning perspective, this can be an effective way to reduce your tax bill at the end of the year, but it is important to consider the implications of selling an investment that has lost value. Accessing U.S. securities while avoiding capital gains tax may be difficult, especially when investing in individual stocks or bonds, but this is one area that the underlying mechanics of ETFs can come into play.

Understanding the Tax-Efficient Structure of ETFs

When an investment vehicle (e.g. mutual funds, ETFs, etc.) realizes a capital gain from the sale of securities, it must distribute the gains to shareholders. The distribution is typically made at the end of the year, and it is subject to taxation.

Most ETFs are able to minimize the amount of taxable capital gains, because they typically track the performance of an underlying index, which means they generally sell their holdings only when the underlying index changes its constituent stocks. In addition, the structure of ETFs makes them one of the most tax efficient investment vehicles available to investors today.

When an ETF wants to add more shares, it does so by having authorized participants create new shares. To do this, the authorized participant buys a basket of the underlying securities from the market and then exchanges them for new ETF shares. Conversely, when an ETF wants to reduce its number of shares, it has authorized participants redeem existing shares. The authorized participant does this by turning in a specified number of ETF shares and receiving a basket of the underlying securities. This process results in very few taxable events, contributing to lower taxes for investors. As investors start to plan and assess their year-end tax strategies, it is a good time to consider the role of ETFs in their broader portfolio.

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All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.