Tax-Loss Harvesting (original) (raw)

Tax-Loss Harvesting is a strategy that takes advantage of movements in the markets to capture investment losses, which can reduce your tax bill, leaving more money to invest. In fact, Tax-Loss Harvesting typically generates savings worth at least 6x our advisory fee¹.

Financial advisors to the rich have used this strategy to limit their tax burden for decades — and we’re making it available in all Wealthfront taxable Investment Accounts.

How does it work?

When an ETF in your Wealthfront portfolio declines in value, a common occurrence in broadly diversified investment portfolios, we sell that ETF at a loss if the loss meets certain thresholds established by our model. You can use the losses to offset ordinary income or investment gains, which can lower your overall tax bill.

What’s more, when we sell an ETF at a loss, we replace it with another highly correlated ETF. The result is that the risk and return profile of your portfolio is unchanged, even as Tax-Loss Harvesting can generate tax savings. These tax savings can then be reinvested to further grow the value of your portfolio.

Read our Tax-Loss Harvesting White Paper for more details.

What types of accounts qualify?

Tax-Loss Harvesting is only relevant to taxable accounts. It does not apply to retirement accounts such as IRAs or 401(k)s, since gains and losses in those types of accounts are not taxable events. Tax-Loss Harvesting is also not typically suited for 529 accounts.

How do you choose alternate ETFs?

We pick alternate ETFs to purchase if a primary ETF declines in value. These alternate ETFs have highly correlated historical returns, similar volatility, and similar expense ratios to the primary ETFs. To avoid triggering the wash-sale rule, we make sure to select alternate ETFs that track different indices than the primary ETFs.
We receive no additional compensation for recommending any of the ETFs in our client portfolios and have no business relationship with any of the providers.
Note: For accounts with US Direct Indexing, the “US Stocks” position is implemented by directly purchasing up to 1,001 securities – 1,000 stocks from the S&P 1500 index and the Vanguard VXF or Vanguard VB ETFs to provide exposure to small and medium capitalization stocks.

Can I do tax-loss harvesting myself?

Yes, although there are some significant complexities. You will need to track lot-level cost basis, identify alternate securities that are not substantially identical, but that correspond with your investment goals, periodically review your investment portfolio, and carefully observe the wash sale rule (even as it relates to rebalancing). Many high-net-worth investors look to their brokers or investment advisors to harvest tax losses, but typically only at year-end.

Wealthfront has built a sophisticated, software-based Tax-Loss Harvesting service that checks client investment portfolios, during business hours, for opportunities to harvest losses.

Are there any things to keep in mind when filing taxes?

Wealthfront will provide a Form 1099 to be filed with your tax return that will include all the relevant investment transactions in your Wealthfront accounts, including those generated by Tax-Loss Harvesting.

If you hold and trade the same ETFs found in your Wealthfront account in other brokerage accounts, then transactions in your other accounts may generate wash sales and reduce the tax benefit from Tax-Loss Harvesting. If you’re concerned about wash sales, we recommend reviewing the IRS website or consulting your tax advisor.

Doesn’t Tax-Loss Harvesting just defer tax liability?

Yes, however, there are cases where you could come out ahead by not paying these taxes today and only potentially having to pay them years from now.

The tax savings from Tax-Loss Harvesting can be reinvested and compounded over time. 10,000intax−savingstoday,forexample,reinvestedata510,000 in tax-savings today, for example, reinvested at a 5% annual return for 20 years comes out to more than 10,000intax−savingstoday,forexample,reinvestedata526,000. You’re still left with 8,000withgainsduetotax−lossharvestingevenifyoupaya508,000 with gains due to tax-loss harvesting even if you pay a 50% tax on those reinvested gains and pay back the original 8,000withgainsduetotax−lossharvestingevenifyoupaya5010,000 tax liability [$26,000 – 10,000–(10,000 – (10,000–(26,000-$10,000) x 50% = $8,000].

Tax-Loss Harvesting also takes advantage of the difference between your current and future tax rates — a practice known as tax-rate arbitrage. Tax-Loss Harvesting realizes losses at a short-term capital loss rate, which optimizes tax deductions. Additionally, if the investment’s alternate ETF is held for at least a year, it can be sold at a long-term capital gains rate, which typically results in lower taxes. You can learn more about tax-rate arbitrage in our Tax-Loss Harvesting White Paper.

What’s more, if you don’t end up selling all of your investments and instead choose to pass them on to your heirs or donate them to a non-profit organization, then you actually never have to pay back the original tax liability. This is because your heirs will receive a step-up in basis for the assets that you pass down, eliminating any capital gain tax liability for those assets. Non-profit organizations will similarly not owe any taxes upon selling the assets you donate.

¹To estimate how much an account’s TLH benefit “covers” its fees, we start by taking our client's state of residence, stated income, and marital status to estimate their combined federal and state tax rates. We then take the harvested losses and multiply the total short term losses by the client’s estimated marginal tax rate, and the total long term losses by the client’s estimated long term gains rate. For each client, the sum of these two values is our estimated TLH benefit. We then divide by the total Wealthfront management fee paid by the account to estimate the benefit to fee ratio. The median result in this data set is over 6x. For informational and educational use only. Your actual results may differ due to your unique financial and tax situation. Please consult a tax professional for advice tailored to your specific circumstances.

Was this article helpful?

This communication has been prepared solely for informational purposes only. Nothing in this communication should be construed as an offer, recommendation, or solicitation to buy or sell any security or a financial product. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.

Wealthfront offers a free software-based financial advice engine that delivers automated financial planning tools to help users achieve better outcomes. Investment management and advisory services are provided by Wealthfront Advisers LLC, an SEC registered investment adviser, and brokerage related products are provided by Wealthfront Brokerage LLC, a member of FINRA/SIPC.

Wealthfront, Wealthfront Advisers and Wealthfront Brokerage are wholly owned subsidiaries of Wealthfront Corporation.

PassivePlus® is Wealthfront’s signature suite of investment features. Designed by Wealthfront’s Research Team to optimize for efficiency and deliver additional risk-adjusted returns, each strategy is based on rigorous, time-tested academic research.