Tax-Harvesting Rule in Senate Tax Proposal Could Change How Robo-Advisors Move Money

Charles Schwab, TD Ameritrade, E*TRADE and other online brokerages that have a robo-advisory service may have to change how they move money for customers if a proposal in the Senate tax reform bill gets passed.

The new rule would change how investors can unload stocks that are sitting in taxable brokerage accounts. As it stands, investors can choose which lots to sell when they have more than one position in a stock, mutual fund or exchange-traded fund (ETF), but with the proposed rule dubbed first-in-first-out, investors would be required to sell the shares they purchase first, which often is the lot that has the most gains and thus generates the bigger tax hit.

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If the rule goes into effect, it would likely require robo-advisors to change their algorithms that are designed to help investors choose the right lot to sell with an eye toward reducing taxes. It could also prevent tax-loss harvesting when an investor sells a winning and a losing stock at the same time to offset any capital gains if the investor owns different lots of the stock. Mutual funds are excluded from the rule after backlash from the investment industry, which argued that clients would have to pay more taxes and would likely be more inclined to hold the stock for longer as a result.

"It basically means higher taxes for investors because they have less control," Alex Benke, vice president of advice and investing at robo-advisor Betterment, recently told CNBC. The executive said that Betterment would have to change its algorithm if the rule passes.

Whether or not that part of the tax bill actually passes is up in the air as Republicans are still debating what should be included in the final proposal that crosses President Donald Trump's desk. The goal is to have something signed by the end of 2017. The potential new rule comes as online brokerages, particularly TD Ameritrade, are highlighting a new tax-loss harvesting tool as a way to stand out from rivals.

Earlier this month, TD Ameritrade rolled out a new tax-loss harvesting service for ETF investors who hold their investments outside of tax-advantaged retirement savings accounts. While it can be easy to spot winners and losers in stock portfolios, it can get tougher to identify those opportunities for ETF investors. To help with this process, TD Ameritrade rolled out the free service for those with taxable accounts invested in its TD Ameritrade Investment Management's Essential Portfolios and Selective Portfolios.

Customers enrolled in the tax-loss harvesting service receive a review of their portfolio from the online brokerage each day to identify tax-loss harvesting opportunities. If there aren't any capital gains or if losses exceed the gains, investors can use the losses to offset $3,000 of other taxable income each year. After offsetting capital gains, investors can carry the extra losses into future years as well.