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by Alexander Green

With the stock market’s historic drop this year, some investors have fled to cash. Others are cautiously buying. Most, however, are sitting on their hands - but they shouldn’t be.

Even if you lack the cash - or the willpower - to buy into this market, there is still a very smart move you can make: switch.

Switch from your poor-performing, high-cost, tax-inefficient stock and bond mutual funds to index funds or exchange-traded funds [ETFs].

Why Choose Exchange Traded Funds Over Mutual Funds?

Compared to exchange traded funds, most mutual funds are a lousy deal, here’s why:

  • Each year more than three-quarters of them fail to match the performance of their benchmarks.
  • Many are loaded with front-end or back-end loads, 12b-1 fees, high management costs and other expenses.
  • Moreover, even when these actively managed funds fall sharply, they still often distribute annual capital gains to shareholders, in effect handing shareholders a paper loss and a tax bill at the same time.

Don’t stand for it. Now is your chance to fight back.

Switching to Exchange Traded Funds Will Save On Taxes

Switch from your underperforming mutual funds to index funds and exchange-traded funds - and save yourself thousands of dollars in taxes in the process.

The IRS allows you to take losses each year to fully offset any realized capital gains, and also allows you to take capital losses to offset up to $3,000 in earned income.

In a year as nasty as this one, of course, you probably don’t have too many realized capital gains to worry about.

You should make this switch anyway. The IRS allows you to carry forward your losses indefinitely to offset future capital gains.

As bleak as the outlook is today, there will be capital gains in your future and, eventually, the tax on them is going to be higher than it is now.

Aside from the thousands you’ll save in taxes (and expenses) in the years ahead by making this switch to exchange traded funds, there is an important psychological reason to do it.

When you get your statements in 2009 and beyond, instead of looking at a smorgasbord of losing positions you’ll be looking at winners. You may not end up buying at the very bottom - few do - but you will have bought a whole lot closer to it than you did originally.

Exchange Traded Funds - Turning Market Lemons Into Lemonade

So take the lemons the market has handed out so abundantly this year and turn them into lemonade with exchange traded funds. Here’s how:

click to enlarge

Using Identical Exchange Traded Funds As Smart Tax Moves

If you’re already invested in exchange traded funds, incidentally, you can still make the same smart tax move by selling your losers and moving into virtually identical funds.

For example, you can take a loss in one S&P 500 Index Fund and replace it with, say, this S&P 500 Index Fund (AMEX: IVV). Even though these funds have the same benchmark and are virtually identical, they are different funds, so the IRS allows the switch.

(For a complete list of ETFs at Fidelity.com.)

However, you cannot sell a fund and buy back the exact same one and qualify for this deduction (unless you wait at least 30 days). If you do, you run afoul of the wash-sale rule.

Incidentally, if you own individual shares that are down but for which there is no logical replacement - think Apple (NASDAQ:AAPL) or Berkshire Hathaway (NYSE:BRK.A) - and you don’t want to sell and risk that the stock will be substantially higher 30 days from now (always a possibility from these depressed levels) you can double down on your stocks now, then sell your higher-cost shares the last week of December. (You will, of course, be doubling down on your risk for the next 30 days).

If you plan to do this, however, you need to do it by the end of the month. Once November ends, it will be too late to do it for the year.

Bear in mind, you cannot take tax losses in an IRA, 401(k) or other qualified retirement plan. But you should still consider making the switch to ETFs and index funds for the cost advantages and psychological benefits I’ve described.

Source: ETFs: Clearly Better Than Mutual Funds