Robo Tax Loss Harvesting

Robo tax-loss harvesting is the automated selling of securities in a portfolio to deliberately incur losses to offset any capital gains or taxable income. Robo tax-loss harvesting is a robo-advisor program that seeks to help investors pay the lowest taxes possible in non-tax sheltered accounts following IRS guidelines.

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. An investor that has a capital gain of say $15,000 and falls in the highest tax bracket will have to pay 20% or $3,000 to the government. But if he sells XYZ security for a loss of $7,000, his net capital gain for tax purposes will be $15,000 - $7,000 = $8,000, which means that he’ll 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 re-purchase the same security due to the algorithm.

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 US 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 re-purchased.

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.

There are two different capital gains tax rates that an investor may be subjected to depending on how long he holds 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% as of 2018, down from the previous highest tax bracket rate of 39.6%. With robo-advisor platforms like Betterment, investors are never exposed to short-term capital gains as 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 as Betterment robo platform provides guidance on using these gains as a charitable donation or as a gift to a relative.

While many traditional financial advisors 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 and Betterment have both stated that their automated robo platforms can create an additional annual return of 0.77% to 1.55% for their investors.