We believe investors should focus on the things they can control – cost, risk, and taxes. At Wealthfront, we help you with all three: we charge one low advisory fee, offer diversified portfolios with automatic rebalancing, and work to lower your tax bill with a suite of tax minimization features. Tax-Loss Harvesting is by far the most valuable of those tax-minimization features, and it’s the most compelling reason to choose a robo-advisor. However, it’s also one of the least understood.
Tax-loss harvesting isn’t a fad – very high-end financial advisors have offered it to wealthy investors for decades, and that’s unlikely to change anytime soon. But you don’t have to be wealthy to use Wealthfront’s Tax-Loss Harvesting service, which is available to all of our investing clients at no additional cost. For the average Wealthfront client, the service covers our annual 0.25% advisory fee many times over.
Because tax-loss harvesting is so valuable, we think it’s important to help our clients understand the basics. Here’s a jargon-free primer on how it works.
What’s in a name
Admittedly, you wouldn’t know from the name that tax-loss harvesting is worth getting excited about. “Tax” probably makes you think of paying taxes, “loss” makes you think of losing money, and “harvesting” just seems like a lot of work. We promise, it’s much better than it sounds.
Tax-loss harvesting means taking advantage of market volatility (those are the “losses”) to lower your tax bill. When an investment declines in value, you can sell it, harvest the loss, and replace the original investment with a similar one so as to maintain the risk and return characteristics of your portfolio. Harvesting losses can be extremely labor-intensive when human advisors do it manually, so they’re highly unlikely to look for opportunities to do it daily. But it’s a task perfectly suited to software, which can take advantage of volatility on a daily basis to automatically save you money on your taxes.
Tax-loss harvesting with ETFs
Let’s look at a simplified example of tax-loss harvesting in action – first, with ETFs. We’ll imagine you have a portfolio with a share of SPY in it (an ETF that tracks the performance of the S&P 500 index). If you bought that share for $350 and one day, the price fell to $349, you could sell your share of SPY, harvest the $1 loss, and purchase a new ETF to replace it.
This new ETF needs to meet several criteria. First, it needs to be different enough that the transaction isn’t considered a “wash sale” (more on that later). This means it needs to track a different index than your original ETF does. Second, it’s important that this ETF is similar enough that your portfolio still maintains the same risk and return characteristics. This means it should be highly correlated with the original ETF so your portfolio’s level of risk doesn’t get out of whack.
In this example, let’s say you decide to replace your share of SPY with VONE, an ETF that tracks the performance of the Russell 1000 index. This index’s performance is highly correlated with the performance of the S&P 500, but it’s different enough that the transaction shouldn’t be considered a wash sale. If you bought VONE to replace the SPY you sold, you’d still have a nicely diversified portfolio with roughly the same level of risk. And, of course, you would have harvested a $1 loss.
Lower your tax bill
Harvesting a $1 loss isn’t that meaningful in itself, but repeating this process for all of the investments in your portfolio many times over the course of the next year can make a big difference. Let’s imagine by the end of the year you’ve harvested $4,000 of losses and realized $500 of capital gains. Come tax time, you could apply those harvested losses to offset those capital gains completely, meaning you’d owe no taxes on those $500 of investment gains.
Of course, you’d still have $3,500 of losses left over. Each year, you’re allowed to use harvested losses to offset up to $3,000 of ordinary income – so you could apply $3,000 of your remaining losses against the money you made at your job, for example. If you would have otherwise paid a marginal federal tax rate of 24%, the amount you’d save would be $3,000 x 0.24, or $720. The higher your tax rate, the greater the value of the harvested losses.
After that, you’d still have $500 of losses left over. The good news is that you can carry those losses into next year, or as long as it takes for you to use them.
Even if you never plan on selling any of your investments, tax-loss harvesting can be incredibly valuable. You might, for example, plan to sell your house one day and realize capital gains in the process. You can use your harvested losses to offset those gains and lower your tax bill.
We’ve studied the results of our Tax-Loss Harvesting and found that 96% of our clients save enough on their taxes to completely offset their Wealthfront 0.25% annual advisory fee. But Tax-Loss Harvesting doesn’t just cover most clients’ advisory fee – on average, clients receive a tax benefit from Tax-Loss Harvesting worth as much as 13x that fee, meaning the service more than pays for itself.
Tax-loss harvesting within an index
Tax-loss harvesting with ETFs is great already, but conducting tax-loss harvesting using the stocks within an index gives you even more opportunities to harvest losses. Wealthfront is the only robo-advisor that offers both to everyday investors.
Let’s look at a simplified example of how tax-loss harvesting works within an index. Imagine you have a well-diversified portfolio that includes a share of Coca-Cola, which you bought for $50. One day, the value of Coca-Cola drops to $49 a share.
To harvest this loss, you would sell that share of Coca-Cola for $49 and “harvest” the $1 decline in Coca-Cola’s value. You could then buy a share of PepsiCo, which is correlated and similar. Your portfolio would still be nicely diversified and it would have roughly the same level of risk. Again, you’d end up with a $1 loss to use against your taxable income. Except now, if you’re harvesting losses within an index, you should be able to harvest far more losses. Individual stocks are generally much more volatile than index funds, and on a day when an index is up, individual stocks may still be down. As a result, you can boost your tax savings even further.
A word on wash sales
The wash sale rule is an important consideration when you’re using tax-loss harvesting, and unfortunately, many people get it wrong. A wash sale happens if you sell an investment at a loss and then repurchase it (or, in the case of ETFs, one that tracks the same index) within 30 days.
Wash sales aren’t illegal. But if you make a wash sale, you can’t use that loss to lower your taxes that year – you have to wait until the following year.
It’s also important to know that the wash sale rule applies to all of your investment accounts and, if you’re married, your spouse’s as well. This includes taxable accounts and tax-advantaged accounts across all investment services you use. If you sell SPY at a loss in your taxable account at Wealthfront and then your spouse buys it a few days later in their 401(k) at Fidelity, that’s a wash sale.
An easy way to avoid problems with wash sales is to keep all of your investments with one provider – particularly if that provider will avoid wash sales across account types (as Wealthfront does), not just within an account. Some people mistakenly believe they are achieving diversification by opening investment accounts using similar ETFs with different robo-advisors, but they’re actually just negating the most important benefit a robo-advisor can provide by ending up with a bunch of wash sales. This is one of the worst mistakes you can make if you want to use a robo-advisor.
Not just tax deferral
Naysayers (or traditional advisors who can’t compete with a robo-advisor’s tax-loss harvesting) might tell you that tax-loss harvesting isn’t valuable because it’s just pushing your taxes down the road. But this argument ignores the time value of money and the difference between short- and long-term capital gains tax rates.
The time value of money means that paying taxes today is more expensive than paying taxes in the future because of the effect of compounding. Money you save on taxes today can be invested and, as a result, should be worth more in the future.
You can also benefit from the difference between short-term capital gains rates and long-term capital gains rates, which means tax-loss harvesting is a form of tax-rate arbitrage. As of early 2021, long-term capital gains are taxed at a maximum federal rate of 20%, while ordinary income and short-term gains are taxed at a maximum federal rate of 37%. Our service primarily harvests short-term losses, which can be used to offset short-term capital gains and ordinary income. When our software sells one of your investments and harvests a loss, you are lowering your cost basis – which increases your gains when you sell your portfolio down the road. But as long as you hold the investment for at least a year, those gains will be taxed at the much lower capital gains rate.
Keep more of what you earn
As we’ve written before, most robo-advisors and investing services using Modern Portfolio Theory to determine asset allocation will generate pretty similar pre-tax returns. But at Wealthfront, we’re focused on using software to maximize our clients’ after-tax returns – and that sets us apart. Review sites might have you believe that software is a commodity, and any robo-advisor with tax-loss harvesting will offer you the same result. This simply isn’t true. Not all software is created equal, and Wealthfront is the only robo-advisor to publish the results of its Tax-Loss Harvesting service, which should tell you something about how it might compare to our competitors’.