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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.

Here are two strategies using ETFs for investors who are resolute and smart enough to do their tax planning year-round -- although you should always check with your tax advisor before making any moves:

Strategy 1: Taking Individual Stock Losses While Maintaining Sector Exposure

In this case, let's use a real, but somewhat arbitrary, example. Let's say you are holding too large a position in


(WMT) - Get Walmart Inc. Report

and your portfolio is dangerously out of balance. Furthermore, the Wal-Mart shares you purchased happen to be trading below your purchase prices. Since Wal-Mart accounts for more than 21% of the

Consumer Staples Select SPDR

(XLP) - Get Consumer Staples Select Sector SPDR Fund Report

, an ETF that contains the 37 consumer staples listed in the

S&P 500

, you can: (1) sell your Wal-Mart stock; (2) realize the loss; and (3) buy the Wal-Mart-heavy ETF to maintain your exposure to Wal-Mart and to that sector in general.

And after 30 days, you can choose to buy back some or all of your Wal-Mart position and sell the ETF.

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Dan Dolan, an ETF specialist at S&P, says investors can also use this strategy to take a loss in a mutual or closed-end fund while maintaining exposure to a particular sector. For example, if you are holding a technology fund that is currently under water from where you purchased it, you can sell the fund, realize the loss and buy a tech ETF like the

Technology Select SPDR ETF

(XLK) - Get Technology Select Sector SPDR Fund Report

to stay exposed to the sector.

Strategy 2: Swapping One ETF for Another

Paul Mazzilli, an ETF strategist at Morgan Stanley, says investors can also swap sector ETFs "if they have similar -- but not exactly the same --- holdings, and are based on different indexes."

Again, let's use actual securities for a hypothetical example. This means that investors staring at unrealized losses in

iShares Dow Jones US Healthcare ETF

(IYH) - Get iShares U.S. Healthcare ETF Report

can switch into the

Vanguard Healthcare VIPER ETF

(VHT) - Get Vanguard Health Care ETF Report

or the

Healthcare Select SPDR ETF

(XLV) - Get Health Care Select Sector SPDR Fund Report

for 30 days and still comply with the wash-sale rule.

Mazzilli says the swap is kosher under the wash-sale rule because each ETF corresponds to a different index. The Dow Jones Healthcare ETF tracks the performance of the Dow Jones U.S. Healthcare Sector Index; the Vanguard ETF follows the MSCI U.S. Investable Market Health Care Index; and the Select Spider tracks the healthcare components of the S&P 500.