How to Use ETFs for Tax-Loss Harvesting

Investing can be tricky to master and one thing it’s important to do is balance your profits against your losses. Selling off stocks or other securities for a profit can actually cost you money if you have to pay a substantial amount of taxes on your capital gains. Tax-loss harvesting and investing in exchange-traded funds (ETFs) can help shrink your tax bill.

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What Is Tax-Loss Harvesting?

Tax-loss harvesting isn’t as complicated as it sounds. It just involves selling off securities at a loss to offset gains you’ve realized with other investments. For instance, let’s say you bought $5,000 worth of Stock A a year ago but now it’s only worth $3,000. If you sell it off, you’ll realize a capital loss of $2,000.

At the same time, you sold shares of Stock B for $4,000 more than the original purchase price. Normally, that $4,000 would be subject to capital gains tax but because you’ve racked up a $2,000 loss, you can reduce the amount of money that’s subject to taxes.

Tax-Loss Harvesting Rules

One important thing to keep in mind about tax-loss harvesting is that you can only use this strategy if you’re investing in a taxable account. If you’ve got all of your money tied up in a 401(k) or an IRA, this won’t be an option.

You’ll also need to remember the wash sale rule. If you sell a stock or a mutual fund at a loss, you have to wait 30 days before buying another security that’s substantially similar. If you don’t wait, you won’t be able to claim the loss on your taxes.

Why ETFs Can Be a Good Choice

Exchange-traded funds are appealing to investors for a couple of reasons. For one thing, they’re usually a better bargain because they tend to carry lower administrative fees. What’s more, they can give you broad market exposure. ETFs typically track indices like the Nasdaq or the S&P 500.

For tax-loss harvesting purposes, ETFs make sense because they can help you sidestep the wash sale rule. If you sell off a tech stock at a loss, you won’t be able to replace it with another tech stock until 30 days have passed. You can, however, use the money from the sale to invest in a tech ETF.

Under the IRS rules that govern these transactions, your purchase won’t count toward the 30-day time limit because it’s not considered to be the same type of security. By going with an ETF, you can add some diversity to your portfolio without having to sacrifice your capital loss.

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Think Long-Term

One caveat to keep in mind is that ETFs have the potential to generate some sizable returns over time. That’s good news since you’ll be making money, but it does bring the capital gains tax back into play once you decide to sell. Before you use an ETF to harvest tax losses, it’s important to take a look at your capital gains and see how you can balance the equation.

This article originally appeared on SmartAsset.com.