Robo-Advisor Tax-Loss Harvesting

What Is Robo-Advisor Tax-Loss Harvesting?

Robo-advisor tax-loss harvesting is the automated selling of securities in a portfolio to deliberately incur losses to offset any capital gains or taxable income within many robo-advisor platforms. A robo-advisor is an automated investment platform that features very low costs and low minimums due to the use of algorithms so that there is minimal human involvement. Tax-loss harvesting is a program that seeks to help investors pay the lowest taxes possible in non-tax sheltered accounts following IRS guidelines.

Understanding Robo-Advisor Tax-Loss Harvesting

Emergent technology in the financial industry, popularly called fintech, has made it possible for financial services and products to be easily assessed at low costs through investment platforms using smart technology. These platforms, known as robo-advisors, build customized portfolios for users and then monitor and rebalance the portfolios periodically for low and affordable management fees. One of the numerous services that some robo-advisors offer through their systems is tax-loss harvesting.

Tax-loss harvesting is a deliberate strategy whereby any loss from the sale of a security in a taxable account is used to offset a capital gain or taxable income, thereby reducing the tax paid. For example, an investor that has a capital gain of $15,000 and falls in the highest tax bracket will have to pay 20%, or $3,000, to the government. But if they sell XYZ security for a loss of $7,000, their net capital gain for tax purposes will be $15,000 – $7,000 = $8,000, which means that they will have to pay only $1,600 in capital gains tax. (The IRS wash-sale rule prevents the investor from re-purchasing XYZ or a security that is substantially identical to XYZ within 30 days from its sell date, though the definition of "substantially identical" seems to be vague.) An investor who wants to maintain exposure to XYZ may be better off purchasing a mutual fund or ETF that tracks the sector in which XYZ operates.

Performing a tax loss harvest can be tedious, complicated, and expensive for the average investor, which is why a couple of robo-advisors have included this value-added strategy as part of their services. Robo-advisors typically create and manage personalized asset portfolios using ETFs. Robo-investment platforms have an algorithm in place that incorporates computational rules like the 30-day IRS wash-sale rule. When a realized gain is made, the system will sell a losing investment to counteract the gain but will not be able to repurchase the same security due to the algorithm.

Rebalancing Example

Robo-investment platforms have automated metrics in place to ensure that an investor's portfolio always remains balanced. After a sale is made, in order to keep the portfolio balanced or maintain exposure to the same industry, the system will purchase another ETF to replace the sold one. For example, Wealthfront, a robo-advisor that offers tax-loss harvesting services, would sell the Vanguard Total Stock Market ETF to harvest a loss and then purchase the Dow Jones Broad U.S. Market ETF. Since both are positively correlated and provide the same exposure, Wealthfront is able to maintain the optimal risk-return allocation of the portfolio without violating the IRS rules on substantially similar investments. After the 30-day wash sale period, the original ETF may be repurchased.

In our XYZ security example above, let's consider a scenario in which the gains and loss values are switched. If the investor has a capital gain of $7,000 and a capital loss of $15,000, $7,000 from the capital loss can be used to completely offset the capital gain to $0. The remaining $8,000 of the capital loss value can be used to reduce the investor's ordinary income for tax purposes. The IRS stipulates that only a maximum capital loss of $3,000 can be claimed against ordinary income in any given year. So $68,000 – $3,000 = $65,000 is the value that the investor will be taxed as ordinary income. The remaining $5,000 can be rolled forward and applied against an individual's ordinary income in subsequent years.

Tax-Loss Harvesting and Capital Gains

There are two different capital gains tax rates that an investor may be subjected to depending on how long they hold the investment for. A long-term investment (i.e., an investment that is held for more than 365 days), will have a maximum rate of 20% applied to any capital gain if the investor falls in the highest tax bracket. For this same investor, the capital gains tax on a short-term investment that was sold in less than 365 days will be the same as the investor's income tax rate of 37%. With robo-advisor platforms like Betterment, investors are never exposed to short-term capital gains since all capital gains are pushed into a lower tax rate. It is also possible for a robo-investor to permanently avoid taxes on their gains; for instance, the Betterment robo platform provides guidance on using these gains as a charitable donation or as a gift to a relative.

Robo-Advisor Tax-Loss Harvesting vs. Financial Advisor Tax-Loss Harvesting

While many traditional financial advisors only run a tax-loss harvest once a year due to the time-consuming and labor-intensive process, robo-advisors can run these processes daily without human intervention. A financial advisor cannot identify the numerous tax-loss harvesting opportunities that are available in multiple portfolios. A robo-advisor on the other hand is usually on the alert during a market downturn to capitalize and execute on tax-loss harvesting opportunities that come up. Wealthfront has stated that their automated robo platforms can create an additional annual return of 1.11% to 1.98%, depending on the tax burden of the investor. Betterment has stated that 0.77% is what a typical investor can expect for an additional annual return.