Few realize what a powerful impact taxes have on realized returns. Unfortunately, financial media gives a disproportionate attention to investment metrics like pre-tax returns, benchmark returns etc that in reality are not too important for an investor’s financial goals. Tax loss harvesting is a way to boost after-tax returns and needs to be understood by all investors.
Tax loss harvesting is essentially tax deferral until sometime in the future. When one of your investments undergoes a decline in value, you can sell it and harvest a loss to offset any gains you may have realized on other investments or your ordinary income and use the receipts to buy into investments that have similar risk/return characteristics as the one you just sold to stay on your target asset allocation. You will still owe taxes to the IRS in future but if the new investments made are held onto for a long time, the gains achieved through compounded tax savings will outweigh what you will have to pay in taxes, hopefully.
IRS allows short term losses to be first applied against short term gains and long term losses against long term gains. If net losses still remain, up to $3,000 can be used to offset taxes on ordinary income for that year. Rest can either be carried forward or backward.
But to unleash the full impact of tax savings, a buy-and-hold strategy should be implemented in its truest sense. The goal with tax loss harvesting is to benefit from harvested losses to offset equal or larger gains over the course of a year and leave the tax savings to compound in your portfolio over a number of years so that eventually when you do have to pay taxes to the IRS, you still stand to gain rather give back all your tax savings. The longer you keep tax savings invested, the larger will be the compounded gains.
There are few things, however, that you need to be careful about when implementing tax loss harvesting. First is that IRS discourages harvesting losses just to reduce short term taxes by means of a rule called “wash sales,” which is the selling of a security at a loss and repurchase of the same or an identical security 30 days before or after the sale. A few ways wash sales rule could be triggered are:
- Purchase of the same or an identical security by the taxpayer, his/her spouse, or by an IRA account. Therefore it is best to have all your accounts linked, so there is no inadvertent prompting of the rule.
- Dividend reinvestments may also violate this rule. If you sell even a portion of a dividend paying security within 30 days of a distribution and there is a dividend reinvestment plan in place, wash sales rule will be triggered.
Using tax loss harvesting practice for the sole purpose of tax avoidance is counter to prudent long term portfolio management, as it will lead you to make sub-optimal investment choices. The goal with tax loss harvesting should be to use losses to offset gains elsewhere in the portfolio(s) while staying on your target allocation and making your portfolio(s) tax efficient at the same time.
That said, the importance of using a professional service for your investment purposes, especially as it relates to tax loss harvesting, can’t be stressed enough. Besides providing low cost index based investment solutions, most robo advisors also offer tax loss harvesting services at no additional cost to the investor. That is a huge value adding feature for relatively younger investors who are in the wealth accumulation phase. By making regular contributions to their investment accounts, they have more cost lots to harvest losses from. As a result, robo advisors can seek loss harvesting opportunities on a daily basis rather annually as is the case with many actively managed funds. In a dynamic investment environment where asset prices are constantly changing, robo advisors can harvest losses frequently while rebalancing portfolios to maintain target asset allocations.
Some of the robo advisors providing tax loss harvesting (TLH) are:
- Wealthfront – performs TLH on a daily basis with no account minimums. Because it invests in ETFs, TLH is done on an asset class level meaning the algorithm looks to harvest losses on ETFs and uses a bifurcated asset investing approach for each of the asset class.
Wealthfront favors daily TLH on the back of this study that found an average annual tax alpha of 1.29% for a portfolio with daily TLH versus once a year TLH which yielded a mere tax alpha of 0.52%. The company uses cost benefit analysis and Maximum Tax Alpha (MTA) ratio to check for the efficacy of a certain tax loss harvesting strategy before applying it.
- Betterment – similar to Wealthfront, Betterment also offers daily TLH service at no extra cost to the investor. The investor only needs to opt into the service. The way Betterment uses TLH to provide tax alpha is also quite similar to Wealthfront in that within each asset class, it uses a primary and an alternative ETF tracking similar indices. When one suffers a loss, Betterment sells it and harvests loss and increases allocation to the alternative ETF within that asset class to maintain the target allocation mix. Betterment believes its daily TLH service provides an annual average tax offset of 1.94% versus others in the industry that provide TLH services with a 30-day switchback (meaning selling the substitute security and buying back the original security after the 30 days wash sale rule is over, which could essentially lead to short term capital gains greater than the losses harvested.
There are others in the robo advisory space offering TLH service as well. Improving after-tax returns by generating tax alpha is prudent investment management. Tax deference resulting from tax loss harvesting has been a practice only available to the ultra rich until a few years ago, but robo advisors have changed all that. While caution and professional consultations are required when employing such complex strategies, tax loss harvesting can play an important role in your portfolio.
 For more on how bifurcated asset classes work, please refer to article “Looking at Alpha through Betterment’s Lens”