In addition to asset location, tax optimization (also known as tax-loss harvesting) can help maximize a portfolio's after-tax returns.
One way is to sell an investment held in a taxable account at a loss to offset capital gains from another source. In the illustration, a large-cap fund is sold to offset the capital gains distribution from a small-cap fund. To retain large-cap exposure, the investor then buys an investment that has high correlation to the original investment—in this case, a large-cap ETF.
An investor can achieve three goals with this approach:
Harvest losses to lower tax liabilities.
Remain fully invested within the chosen investment strategy.
Potentially improve the portfolio's future tax efficiency by using ETFs.
Remember that capital losses can only be deducted against capital gains, not income. Capital losses that cannot be deducted in a year can be used to offset capital gains realized in any of the three prior years or in any future year.
Also, you don't have to wait until year end to use a tax-loss-harvesting strategy. Opportunities may arise any time the market declines.
Points to consider
Be sure that if you sell an investment to realize a loss that it doesn't constitute a "superficial loss." A superficial loss generally occurs when you buy the same or an identical investment 30 days before or after the sale of an investment at a loss and you still own the substituted investment 30 days after the sale. Superficial losses are disallowed and cannot be applied against capital gains. You'll want to consult a tax advisor about what constitutes the same or an identical investment.
Your replacement investment could underperform your original investment.
Transaction costs could be greater than the tax benefit.