Tax Planning Tips For Investors

Here’s a few important tax planning tips (and an important warning) if you’re an investor…especially if you own ETFs or mutual funds.

After you master the basic tax deductions that most people overlook, it’s time to take it up a notch.  First, you probably already know about tax loss harvesting. This is a well-known, year-end tax planning tip. If you’ve never heard about this, it’s a simple yet really important little tool you should be aware of. Basically, look through your holdings. If you are sitting on an ETF or mutual fund that is worth less than what you paid for it, you might consider selling it. This way, you’ll lock in a taxable loss and it will help reduce your taxes and possibly help with some capital gains tax relief.

But what if you want to hold on to it? You might like the fund even though you’re sitting on a loss. If you like the holdings, you may not want to flush the fund just for those tax benefits. No problem there either. You have two choices.

1. Sell the fund and buy it back later.

As long as you wait 31 days before you repurchase, you can claim the tax loss and own the fund. Happy Days! This requirement not to repurchase within 31 days is known as the Wash Rule. For tax purposes, any tax loss you claim for funds you sell is wiped out if you repurchase the same or identical fund within 30 days. That’s why you wait 31 days…capiche?

But wait, what if you’re a smart investor and know a thing or two about financial tax planning? You realize that it might be really risky to be out of that fund during that period. After all, nobody knows when your fund is going to do really well. With your luck, it might take off exactly during that 31 day period.

2. Buy a similar fund.

This is a simple and elegant solution, but this is exactly where you have to be careful.

You see, if you buy a fund that’s identical to what you just sold, the pretty boys up at the IRS aren’t likely to be too happy with you. They’ll consider it a Wash Rule violation and disallow the tax loss. Of course, if they find out about it, it’ll take them a few years. Long enough to tack on some nice penalties and fines. You don’t want to accrue any IRS tax debt.

Now, for people who buy actively managed funds, this is rarely a problem because actively managed funds are all so very different from each other. But for ETF investors, it’s a big landmine you need to avoid. If you sell your XYZ Gold ETF and immediately buy an ABC Gold ETF, you might be falling into this trap. Many ETFs buy exactly the same securities, so tread lightly. This is an ETF tax problem that actively managed fund investors don’t have.

If you are an ETF investor, the best way to avoid this problem is to sell your ETF and then buy an actively managed fund (no load of course) and hold it for at least 31 days.

Just to be on the safe side, I also suggest that you check the holdings of each fund and make sure they’re not identical. Usually the listings of these holdings are not exactly current, but it’s probably just a good safeguard in case the IRS boys get spicy with you.