I am often asked by people unfamiliar with our service, “Why should I use Wealthfront to buy a portfolio of Vanguard index funds, when I could buy the same funds directly from Vanguard without paying any advisory fee?”
It’s a perfectly reasonable question, but it has a very simple answer. Wealthfront can save you significantly more money in taxes than the 0.25% a year you’ll pay us in advisory fees — up to eight times as much, in fact. There’s also the comfort of knowing that you can take a “set it and forget it” attitude towards your investment, confident that professionals will be looking after the routine housekeeping tasks that are crucial for any investing strategy. Even Vanguard’s management team has told me we offer a superior service for taxable accounts.
Some investors prefer to manage their portfolios themselves, just like some people like to build their own furniture. If this describes you, then we’re not here to convert you. In fact, we give you our recommended portfolio allocation for free. You’re welcome to tweak it and implement it yourself, at Vanguard or anywhere else.
Many of our customers, though, are attracted by simple convenience, not to mention up to approximately 2% of annual tax saving Wealthfront is capable of generating1.
How does Wealthfront provide this extra value? Through three services we pioneered: dividend-based rebalancing, daily tax-loss harvesting and direct indexing.
Rebalancing is the process of maintaining the risk profile of your portfolio by selling asset classes that have performed relatively well and buying ones that performed relatively poorly. Every portfolio should be rebalanced on a periodic basis to make sure it hasn’t, without you realizing it, taken on more (or less) risk than you’re comfortable with.
Because it appears to be quite simple, many people believe they can do rebalancing themselves. In fact, since the process turns out to be far more complicated than many investors believe, investors too often have much less success than they expected to.
Not only does Wealthfront rebalance your portfolio, but it does so in a much more tax-efficient way than simply buying and selling securities. Specifically, we use the dividends generated by each of your index based ETFs to buy more of your under-allocated asset classes. That cuts down on the sale of over-allocated assets. Fewer sales means fewer gains, which means lower taxes.
Our research found dividend based rebalancing could save up to 0.11% of your portfolio value per year in taxes versus classic rebalancing.
Tax-loss harvesting is a way of reducing your taxes by taking advantage of investments that have declined in value. These holdings are sold, and replaced with highly-correlated, but not identical, investments, allowing you to maintain the risk and return characteristics of your portfolio while generating a loss that can be applied to lower your taxes.
It is possible to do tax-loss harvesting yourself. But the enormous complexity of keeping track of all your different tax lots limits you, for all practical purposes, to doing it once a year at year-end. In contrast, Wealthfront’s software looks for losses on a daily basis.
Our research shows that daily harvesting can save up to 1.55% of your portfolio value per year, compared to just 0.6% when done annually.
Many people assume that tax-loss harvesting is a generic function, like the compounding of interest, and that all investment companies do it as well as any other. But Wealthfront research has demonstrated that not all tax-loss harvesting from automated investment services are alike.
Wealthfront’s direct indexing service allows you to own all the stocks in a major index (like the S&P 500), while also harvesting losses they might generate. That means you can take advantage of the times individual stocks trade down, even when the overall index rises. Index funds and ETFs, like the ones you can buy from Vanguard, cannot provide this service, because investments that are structured as funds are prohibited by the Internal Revenue Code applicable to funds registered under Investment Company Act of 1940 from distributing tax losses to their shareholders.
Depending on your portfolio size, tax rate and amount of annual short term capital losses, direct indexing could add an additional 0.20% to 0.48% to your annual after-tax return. That’s over and above the benefit you could receive from daily tax-loss harvesting on ETFs only.
The table below compares the after-tax benefits of the three value-added services we’ve discussed for a $100,000 account at Wealthfront, with the same portfolio invested with Vanguard:
As you can see, for a $225 annual advisory fee2, Wealthfront could deliver an additional $1,635 of net-of-fee, after-tax value per year. Even if our tax savings on tax-loss harvesting and direct indexing could only be applied to your annual $3,000 ordinary income limit, as is the case with some taxpayers, your annual net benefit would be $1,1663. Clearly, your small Wealthfront annual fee is money well-spent, for both convenience as well as for direct, dollars-in-your-pocket savings.
What about retirement accounts?
By now, I hope you’re persuaded that Wealthfront’s service is far superior to managing a taxable portfolio on your own. But how about your IRA? Well, if your only investment account is an IRA, and you don’t mind rebalancing yourself, then Vanguard is likely a better option than Wealthfront. But if you have taxable and IRA accounts, then once again you will come out ahead with Wealthfront.
Unless the vast majority of your money is held in your IRA accounts, the tax benefits we generate just on your taxable account(s) should still be far greater than our advisory fee on all your accounts, not to mention how much more convenient it is to have all your investment accounts in the same place. Please keep in mind that because of the Wash Sale Rule, which comes into play if you don’t allow our software to manage all your accounts with similar securities, it is not possible to guarantee all your harvested losses can be applied to your taxes. That’s why it‘s advisable to keep all your accounts (other than your company 401(k)) at Wealthfront.
We think the evidence of Wealthfront’s value is overwhelming, and we hope you give us a try. Because if you like Vanguard, you’ll love Wealthfront.
1. Based on our research for each value-added service we provide. See details, summary table and disclosures below.
2. Clients don’t pay a fee for their first $10,000, so the fee for a $100,000 account is ($100,000 – $10,000) x 0.25% = $225.
3. This estimate assumes a 42.7% combined federal plus state tax rate (equivalent to a joint income of $250-400K in California) applied to the annual ordinary income cap of $3,000 plus the $110 benefit of dividend based rebalancing minus the $225 fee.
This blog was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This blog is not intended as tax advice, and 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 IRS. This blog was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.
Monte Carlo Simulations are a risk and decision analysis technique used to evaluate the outcome of portfolios over time using a large number of simulated variables to generate possible future returns. For our Monte Carlo analysis to arrive at an average of 0.11% of savings per year in taxes, Wealthfront simulated the returns based on accounts with an $100,000 value, with a risk score of 7, and used dividends to rebalance the portfolio. For more information on this methodology, please see https://blog.wealthfront.com/unexpected-impact-of-commissions/.
For our Monte Carlo analysis to arrive at 1.55% annual tax alpha generated by daily tax loss harvesting, we simulated the future returns of two portfolios: the Wealthfront diversified risk level 7 portfolio with daily tax-loss harvesting and the Wealthfront diversified risk level 7 portfolio with no tax-loss harvesting. We evaluated the performance of our daily tax-loss harvesting algorithms across a 10 year investment period, and assumed no withdrawals during the investment period and full withdrawal at the end of the investment period. In our Monte Carlo simulation, we first sample asset class returns from the asset class return joint distribution model and transform them into ETF prices. For the daily tax-loss harvesting portfolio, any tax savings generated by tax-loss harvesting are reinvested into the portfolio at the beginning of the next tax year. We assume an initial deposit of $100,000 and follow on deposits of $10,000 at the beginning of every quarter.
Wealthfront determined the additional average benefit of between 0.20% and 0.48% from direct indexing based on a simulation of the 10 year differential internal rate of return (IRR) of Direct Indexing from Wealthfront WF100 portfolio. The simulations compared the potential additional return achieved through six (6) distinct 10 year periods from 2000 through 2014 using IRR (Internal Rate of Return). These results are historical simulated returns based on backtesting and do not rely on actual trading using client assets.
These results are based on a study Wealthfront conducted for the years between January 2000 and December 2014, assuming a Wealthfront account with a risk score of 7, an initial deposit of $100,000 and additional quarterly deposits of $10,000 for the WF100. For WF100 Clients, Wealthfront assumed a 42.7% combined federal and state short-term capital gain tax rate and assumed a 24.7% combined federal and state long-term capital gain tax rate. For the asset class composition of the assumed Wealthfront account with a risk score of 7, please see Wealthfront’s Tax-Optimized Direct Indexing white paper.
The information regarding the likelihood of various investment outcomes using Monte Carlo Simulations are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the results shown will be achieved or sustained. Actual results will vary, and such results may be better or worse than the simulated scenarios. Hypothetical results have inherent limitations. Specifically, hypothetical results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from backtested performance. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations. The results are not predictions, but they should be viewed as reasonable estimates. Hypothetical results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.
Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. The results of the historical simulations are intended to be used to help explain possible benefits of the tax-loss harvesting strategy and should not be relied upon for predicting future performance.
While the data used for its simulations are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources, including independent market quotations and index information. Wealthfront believes the third-party information comes from reliable sources, but Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third-party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.
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. When Wealthfront 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. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.
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. 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.