What clients do understand and love about tax-loss harvesting is its simple value proposition: it can lower the taxes you pay. But too many people are getting something important wrong about this popular feature.
Tax-loss harvesting is one of the biggest reasons why people choose Wealthfront’s automated investment service, and yet it is our least-understood feature. We’ve gone to great lengths to educate our clients on how tax-loss harvesting works. Our whitepaper is an incredible deep dive into the topic, from the basics to a granular exploration of the details. We publish our actual tax-loss harvesting results year over year. We even ran an experiment to compare the tax-loss harvesting benefits offered by Charles Schwab and Wealthfront in 2016. Even still, we see behavior that suggests people don’t fully grasp how to make the best use of it. So I’d like to go about this topic a different way: addressing the misunderstandings themselves.
Let’s start with what most people get right.
What clients do understand and love about tax-loss harvesting is its simple value proposition. Most people hate paying taxes, and tax-loss harvesting can lower the taxes you pay. The inherent value is easily evident, even amidst misunderstandings. Unfortunately, a number of our competitors would like you to believe that tax-loss harvesting is a commodity feature — either it works or it doesn’t. To them, offering tax-loss harvesting “checks the box.” But nothing could be further from the truth. If you open accounts at a number of automated investment services with comparable risk levels (i.e. similar investment mixes), you will notice a wide variance in the amount of losses harvested. More losses harvested means greater tax savings for you. Based on our testing, we are confident we will harvest the most.
But despite all of the information and testing we provide, we still see people open accounts with multiple automated investment services, thinking that type of diversification is a good thing. In this case, it’s not. By spreading your money among more than one automated investment service, you could kill all the potential benefit you’d get from tax-loss harvesting. It’s important to ask yourself why you want to open accounts with multiple automated investment services. If it’s a higher return you’re seeking, this is a fool’s errand. The portfolios offered by automated investment services are largely commoditized, applying only a slightly different asset allocation for a particular level of risk tolerance to their respective portfolios. This means over the long run you will see approximately the same (pre-fee) return. Only luck will lead one portfolio to generate a higher return in a particular period like one quarter or one year. However, the benefits of tax-loss harvesting can vary significantly based on quality of implementation, and it should take no more than six months to see the differences among vendors.
Aside from being ineffectual, there’s another significant downside to opening multiple automated investment accounts: wash sales.
Should you decide to run the tax-loss harvesting test among multiple automated service providers, you need to keep in mind that you will not be able to receive the full benefit of all the losses you harvest when it comes time to file your taxes due to the “wash sale rule.” A wash sale occurs when you sell and buy a substantially identical security (regardless of what investment portfolio it’s held in) within 30 days. It defers your ability to recognize the loss on that security (which results in taxes saved) until the following tax year. Minimizing wash sales is therefore critical to maximizing taxes saved. Unfortunately, it is highly likely that most of the losses you generate will be characterized as wash sales if you use multiple automated investment services because most use similar ETFs. That’s why we don’t recommend keeping multiple automated investment services, since it can wipe out most of the benefit you would otherwise derive from tax-loss harvesting. (That said, we love a good experiment and data-based decisions, so we understand if you decide to do this test anyway. Just please consolidate as soon as you have your answer.)
It’s also worth noting that the wash sale rule applies to all of your investments (taxable and IRAs), as well as your spouse’s investments. That means you cannot get maximum benefit from tax-loss harvesting if you keep your taxable account at one service and your IRA account at another, or if you keep your spouse’s accounts somewhere else. You have the tax code to thank for this. In order to get the maximum after tax benefit of tax-loss harvesting (which, as we pointed out in 2016, could represent 3x to 11x our advisory cost), you need to make sure all your portfolios in which you own ETFs are managed by the same company to avoid wash sales.
I hope the message is clear after reading this: if you’re going to commit to passive investing, overwhelmingly your best bet is to choose one automated investment service. Most automated investment services are highly diversified and insured by the SIPC, so there is no need to diversify across multiple automated investment services in the long run. If you opened accounts with multiple services at some point to test them and still have money sitting in a forgotten investment account, consolidating as soon as possible will maximize your tax savings. While we’d love for you to consolidate with us, the important thing is that you consolidate somewhere, so as not to wipe out the benefit tax-loss harvesting could give you.
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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).
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.
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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