ETFs Can Be a Part of Your Tax Strategy

Tax day has come and gone, but it's never too soon to start planning for next year. And for those investors determined to manage their portfolios in the most tax-savvy way this year, exchange traded funds can be important tools for avoiding a nasty tax hangover in April 2005.

Unlike actively managed mutual funds, which report their holdings on a quarterly or twice-annual basis, exchange traded funds update their portfolio components and weightings on a daily basis on most ETF Web sites. This transparency gives investors the ability to shop around until they find an ETF that will enable them to perform a basic tax-planning strategy called a tax swap, which entails the sale of one security and the simultaneous purchase of a similar, but not identical, one.

For example, say you sell drug stock ABC for a loss, and buy a drug-stock-based ETF called XYZ to replace it. You can use the loss from selling ABC to offset gains realized elsewhere in this portfolio. This may help reduce taxes due for the current year while allowing you to maintain your exposure to the drug sector even after selling ABC.

The main requirement of tax swaps is that they must be done in compliance with the wash-sale rule. Under the wash-sale rule, the IRS prohibits a taxpayer from claiming a loss on the sale of an investment if that same investment was purchased within 30 days before or after the sale date.

In terms of our example, that means the investor cannot claim ABC as a tax loss unless he waits 30 days before buying it back. But you need not kick yourself if ABC happens to rally during the 30-day wash-sale period because you can enjoy part of the gain via your holding in the XYZ ETF.