It’s time to set the record straight on automated tax loss harvesting.
Many digital investment advisors tout this strategy as a way to lower your taxes and thus increase your after-tax returns — risk-free. The thinking behind automated tax loss harvesting is simple: Search continuously for investments that have declined in value, sell them, and then use those losses to reduce your taxes. The end result is a lower tax bill that year, and enthusiasts claim the tax savings give you higher after-tax returns. Some even go so far as to claim that it’s practically a surefire way to maximize them.
But tax loss harvesting is only a temporary fix for lowering taxes; you may save some money on taxes now, but you’re just deferring them. In almost every scenario (except certain situations that may only become clear in hindsight), you will still end up paying taxes — possibly higher ones — eventually. Even advisors who offer automated tax loss harvesting admit this, though they tend to bury this important detail at the bottom of a page or in a white paper.
We don’t offer automated tax loss harvesting at Ellevest. Investing is for reaching financial goals, and we don’t believe that taxes alone should dictate how you invest. That’s not to say we ignore them; in fact, we try to minimize taxes as much as possible. This means avoiding pricey short-term capital gains when we can and realizing losses when it makes sense.
Because contrary to how automated tax loss harvesting is often sold, it isn’t a no-brainer for every investment portfolio. A lot can impact how effective or ineffective tax loss harvesting is for an investor. And we believe the potential benefits of automating this process — which doesn’t give much thought to those factors — rely on more “ifs” than are worth it for your financial goals.
The What and Why
Here’s how tax loss harvesting works: You sell a losing investment in order to use that loss to offset capital gains. If your loss is greater than the amount of your capital gains, you can apply the remainder of the loss against up to $3,000 of your ordinary income to reduce your tax bill that year. The loss doesn’t offset your income tax directly; it offsets your gains and/or income, which is used to determine how much you owe in taxes.
After the sale, you replace the losing investment with one that is similar, but not identical, in order to maintain the investment portfolio’s asset allocation.
Tax loss harvesting doesn’t work for tax-advantaged accounts, such as 529 college savings plans and retirement accounts like 401(k)s, 403(b)s, as well as traditional, Roth, and SEP-IRAs. Earnings in these accounts aren’t subject to taxation until the funds are withdrawn, so any losses (or gains) won’t impact your year-to-year tax bill.
Deferring, Not Eliminating
In all the hype around automated tax loss harvesting, there’s a common misperception that this strategy can help you avoid taxes. This is wrong; in most cases, it only defers them.
Let’s say you have a losing investment (ETF A) and you decide to “harvest” that loss by selling it and buying a similar one (ETF B). Should ETF A bounce back, ETF B is expected to rise, too, because the two ETFs are similar.
When you finally sell ETF B — presumably at a higher price — you will be on the hook for any capital gains. Capital gains are calculated by subtracting the purchase price from the sale price, so any gains from ETF B will likely be higher than the gains you would have realized from holding onto ETF A. Make a lot of money from selling ETF B, and the taxes you’ll see on those capital gains could easily cancel out some, possibly all, of the tax savings you realized from tax loss harvesting. There’s also the chance that ETF A outperforms ETF B, which means you’ll miss out on bigger returns.
So not quite as foolproof as the hype suggests. And this strategy really doesn’t lend itself to financial goals with a shorter investment horizon — like a six-year home goal, for example. If your new investment appreciates (like ETF B earlier), by the time you sell everything, your tax bill could be higher than it would have been had you not realized the loss in the first place. Plus, a bigger tax bill means you’ll have less money to put toward that house.
Which begs the question: Is it really worth it to push back taxes to the one point in time when you want all the money you can possibly get?
Sure, there are times where deferring taxes can be beneficial. If you expect to be in a lower tax bracket in the future, deferring taxes could mean a more favorable tax rate down the line. This is a gamble — a political one even — because you don’t know what tax rates will look like. As for the two scenarios where you can eliminate deferred taxes — by donating the replacement investment to charity or passing it down to your heirs — those tax breaks aren’t unique to tax loss harvesting. You can get them simply by donating or passing down your investments anyway.
Better Performance Not Guaranteed
Now we come to another frustrating part of the conversation around automated tax loss harvesting: advisors overstating tax loss harvesting’s role in driving portfolio performance. One digital advisor has even gone so far as to publicly guarantee in a television appearance that its investment portfolios can beat the S&P 500 by 1–2% due to automated tax loss harvesting. (The company’s own white paper, though, suggests an estimated 0.77% boost for a typical customer.)
But even this reduced forecast may be high. These numbers rely on testing the strategy on limited historical data and making assumptions that may or may not apply. The advisor, along with others making similar claims, assumes that an investor will re-invest the savings from not paying taxes to help their portfolio grow. Then there’s the assumption that the portfolio is heavy on equities; this is fine for long-term goals, but less so for short-term goals where you can’t afford as much risk.
And in calculating tax loss harvesting benefits, providers of automated tax loss harvesting services don’t always account for you selling your entire portfolio at the end of your horizon and paying those deferred taxes. Hmmmm, so the stated savings and the eventual cost aren’t really apples-to-apples, are they?
Furthermore, automated daily tax loss harvesting, as offered by some advisors, requires you to continuously sell your investments in a down market. Keep in mind that the federal wash sale rule states that you can only write off your losses if your replacement investment, when purchased within 30 days of the sale, is similar — but not identical — to your original investment.
So if you replace ETF A with ETF B and ETF B continues to go down, you would have to buy ETF C, and so on and forth. And if the market continues to decline, each replacement ETF will become less similar to ETF A, which can throw off your original asset allocation — and financial goals.
The bottom line? The benefits of tax loss harvesting depend on an investor’s goals, tax situation, whether or not she has capital gains to offset now and/or in the future, and the state of tax policy in the coming years. There are a lot of unknowns here, and we believe it’s hard to definitively state that deferring taxes will increase your portfolio’s return, as some advisors guarantee.
That’s why we decided early on we weren’t going to focus on trying on playing around with your taxes through automated tax loss harvesting. Instead, we’re focusing on what we believe matters most: developing a low-cost diversified approach to investing, giving you tools to help you make trade-offs among your goals, minimizing your taxes when we can, and constructing investment portfolios that are the most personalized of any digital advisor.
Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.
The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.
The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.
Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.