The Real Value of Tax-Loss Harvesting

We just published the actual results of our daily tax-loss harvesting (TLH) service over the past five years, and even we were surprised at the magnitude of the benefit. According to our analysis, the value of the tax-loss harvesting benefit at Wealthfront far exceeds the advisory fee in terms of the after-tax benefit.

The Basics

As a refresher, tax-loss harvesting works by taking advantage of investments that have declined in value, which is a common occurrence in broadly diversified investment portfolios. By selling investments that have declined below their purchase price, a tax loss is generated, and that loss can be used to offset other taxable items, thus lowering your taxes.

Investments sold in this manner can be replaced with highly correlated alternate investments so that the risk and return profile of your portfolio remains unchanged, even as tax savings are created and reinvested to further grow the value of your portfolio. The more frequently you deposit the more you benefit.

The Value of TLH

Tax-loss harvesting creates value from tax rate arbitrage (trading that takes advantage of a difference in tax rates as the basis for profit) and compounding (letting your money grow over time). The vast majority of the losses we harvest are short term, meaning the securities sold have been held for less than one year. These losses can be credited against your short term capital gains and up to $3,000 of ordinary income each year (both of which are taxed at ordinary income rates).

The lower cost basis  that results from the tax-loss harvesting transaction will ultimately increase your gains when you liquidate your portfolio, but if held for more than a year those gains will be taxed at long term capital gains rates. Taxes paid in the future are not nearly as costly as those paid today due to the time value of money. Therefore, the ultimate value generated from tax-loss harvesting is the difference between the ordinary income taxes saved and the lower long-term taxes paid in the future. As mentioned before,  that TLH benefit generated can be reinvested and compounded over time. The longer you invest the greater the benefit.

Our Analysis 

We quantify the effectiveness of our tax-loss harvesting service by calculating its harvesting yield. Harvesting yield measures the quantity of harvested losses (short or long-term) during a given period, divided by the value of the portfolio at the beginning of the period. Note that the ultimate benefit each client will receive will depend on her particular tax rate.

In order to analyze the results realized by clients over the past five years, we aggregated clients into cohorts based on the year in which they first started using TLH, known as the “client vintage,” and their portfolio risk score. The vintage is a fixed client characteristic, but clients can actually move across risk score groupings based on their risk score on a given day in the sample.

On each day, we computed the aggregate losses harvested within portfolios of clients belonging to a given cohort. We then summed these losses across clients in the cohort, and divided them by the aggregate portfolio balance of clients belonging to the cohort. That formula generates that day’s harvesting yield.

We then computed an annualized “since inception” harvesting yield for each cohort, by summing the daily harvesting yield figures, then dividing by the number of trading days since inception, and finally multiplying by 252 (the number of trading days in a year).

The annualized harvesting yields for each cohort are reported in the table below. The data include all tax losses harvested through October 31, 2017. (Note that the values for the 2017 cohort are not annualized, since a complete year of tax-loss harvesting data is not yet available.)

Source: Wealthfront

The Results

As you can see, harvesting yield generally increases as risk score increases (there are some aberrations due to small sample sizes). That’s because portfolios with higher risk scores should have higher volatility, which in turn creates more tax-loss harvesting opportunities. However, you should not increase your risk score to get more harvested losses because it can lead to a portfolio with more volatility than you might be comfortable with. In that scenario, you could be compelled to withdraw at the worst possible time. (We explain why increasing your risk beyond what is appropriate can lead to very bad outcomes in The Right and Wrong Reasons to Change Your Risk Tolerance).

You will also notice that significant losses were harvested even in years in which the S&P 500 didn’t decline very much (2012, 2013 and 2017), which is represented in the row labeled “max drawdown” (or the maximum amount the S&P 500 declined from the beginning of the year). This speaks to the power of looking for losses daily rather than the traditional approach of only looking to harvest losses at year-end, as you are unlikely to have a benefit if there is no drawdown during that period.

We are most proud of the fact that the incremental value of our daily tax-loss harvesting far exceeds the advisory fee we charge. Even if you were to apply a very low marginal tax rate of 25% to our lowest achieved average annual harvesting yield (located in the column labeled “AVG”) of 2.9% (on a risk score 2 portfolio), the annual after-tax benefit would have been 0.73%, which is almost three times our 0.25% annual advisory fee. On the flip side, applying the highest state plus federal marginal tax rate of 50% to our highest average annual Harvesting Yield of 5.19% (on a risk score 10 portfolio) would have created 2.6% of annual after tax value, which is more than 10 times our fee*.

Final Thoughts

At Wealthfront we choose to publish our tax-loss harvesting results because we believe in being transparent and providing context. If you’re still deciding who should manage your money, you should care deeply about transparency. Odds are if nothing is published or if the results are buried in the fine print it might not be such a great investment benefit after all.

 

*These calculations assume you could use all of the harvesting yield benefit, which is not the case for all our clients, although any unused benefit can be carried forward to future years.

Disclosure

This blog is as of November 15, 2017, and Wealthfront disclaims any undertaking to update this blog after this date, even if in the future Wealthfront’s assumptions would be different or if Wealthfront changes its tax-loss harvesting methodologies described in this blog.

This blog was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront Inc. clients pursuant to a written agreement, which investors are urged to read carefully, that is available at www.wealthfront.com. All securities involve risk and may result in some loss. For more information please visit www.wealthfront.com or see our Full Disclosure. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information.

Wealthfront does not represent in any manner that the tax consequences described herein will be obtained or that Wealthfront’s tax-loss harvesting strategies, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting strategy and other strategies that Wealthfront may pursue are complex and uncertain and may be challenged by the Internal Revenue Service (IRS). This white paper was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.

Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in these tax strategies, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.

The table showing the Harvesting Yield for daily tax-loss harvesting clients is based on Wealthfront’s estimates from existing client data for accounts opened between October 1, 2012 (the launch of asset-class tax loss harvesting) and October 31, 2017. The table was based on the subset of our clients with tax-loss harvesting enabled in their accounts. Past performance is not indicative of future results.

When Wealthfront says it replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Expected returns and risk characteristics are no guarantee of actual performance.

Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that Wealthfront trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time. Wealthfront may lack visibility to certain wash sales, should they occur as a result of external or unlinked accounts, and therefore Wealthfront may not be able to provide notice of such wash sale in advance of the Client’s receipt of the IRS Form 1099.

The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth above, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.

A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at (844) 995-8437. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.


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