Tax loss harvesting is the strategy of purposely selling some holdings at a loss in order to offset the taxable profits of another investment. Investors “harvest” a loss from one asset and can then use the remaining money to buy a different but similar asset.
Tax loss harvesting is used in taxable accounts and not in tax-sheltered ones, like 401(k)s and individual retirement accounts (IRAs). In automated tax loss harvesting, robo-advisors automate the strategy for clients in order to perform it continuously.
The strategy can be a helpful tool for saving on taxes for stocks or other assets. But it’s important to understand that tax loss harvesting is a way of deferring taxes, not eliminating them. It’s also not foolproof. There’s a risk that investors end up being on the hook for a bigger tax bill or missing out on gains in the market.
Here’s a breakdown of how tax loss harvesting works.
What Is Automated Tax Loss Harvesting?
Tax loss harvesting operates on the assumption that it’s valuable for individuals to delay paying taxes so that they could potentially earn an income in the meantime. It’s a strategy that takes into account the “time value of money,” the concept that money held now is worth more than the same sum in the future because of that money’s earnings potential.
This is why after investors book a loss when an asset or market is down, they often put money into a different investment rather than hold onto cash. It allows investors to continue to benefit from any potential gains in the market and maintain their asset allocation.
Robo-advisors, digital financial-advice platforms that have become popular in recent years, can perform automated tax loss harvesting for clients. It can be part of a suite of services that robo-advisors offer, such as dividend reinvestment plans (DRIP investing), where dividend payouts get reinvested.
In automated tax loss harvesting, robo-advisors create computer algorithms that strategically swap one similar asset for another with the aim of lowering tax bills for their customers.
So How Much Does Tax Loss Harvesting Save?
It’s hard to say whether tax loss harvesting definitively and consistently delivers a reduced tax bill to investors. A myriad of variables–such as the fluctuating nature of both federal tax rates and market price moves–make it difficult to calculate precise figures. An investor’s financial goals may also be an unknown factor, such as how long he or she can defer taxes for.
However, one evaluation of tax loss harvesting that was published in 2020 found that between 1926 to 2018, a tax-loss-harvesting strategy delivered an average annual outperformance of 1.08% versus a passive buy-and-hold portfolio. Taking into account transaction costs however, the outperformance or “alpha” fell to 0.95%.
The study found the strategy did better when the stock market was volatile, such as between 1926 and 1949, which includes the Great Depression. The average outperformance was 2.13% a year during that period, as investors found more opportunities to harvest losses. Meanwhile, between 1949 and 1972–a quieter period in the market as the U.S. underwent economic expansion–tax loss harvesting only delivered an alpha of 0.51%.
The Wash-Sale Rule
It’s important that investors understand the “wash-sale rule” when tax loss harvesting.
In a wash sale, an investor sells or trades a security at a loss, and then within 30 days before or after this sale, buys another one that is “substantially identical.” Internal Revenue Service regulation prevents wash sales from happening. However, they do allow investments that are “substantially similar.”
This is how the proliferation of exchange-traded funds (ETFs) has benefited the strategy of tax loss harvesting. ETFs are baskets of securities that track an index of stocks, bonds or other markets. Trading ETFs that are similar tends to be easy to do.
So for instance, if an investor harvests a loss from an emerging-market stocks ETF, he or she can soon after buy a “similar” but non-identical emerging-market stocks ETF.
Other Important Tax Rules to Know
Tax losses don’t expire. So an investor can apply a portion of losses to offset profits or income in one year and then “save” the remaining losses to offset in another tax year. Investors tend to practice tax loss harvesting at the end of a calendar year, but it can really be done all year.
Another potential perk from tax loss harvesting is that if the losses from an investment exceed any taxable profits from trades, the losses can actually be used to offset up to $3,000 of ordinary income.
Investors will likely have to pay the IRS eventually. And the tax breaks where they can potentially eliminate deferred taxes–by donating investments or bequeathing them –don’t apply just to tax loss harvesting.
It’s also important for investors to calculate their stock profits and understand the difference between short-term and long-term capital gains taxes. Short-term in the tax code is one year or less, and long-term is anything longer. In 2020, the federal tax rate on short-term gains, or the marginal rate, ranges from 10% to 37%. Meanwhile, the federal tax rate on long-term gains is substantially lower and is bracketed into three tiers : 0%, 15% or 20%.
Using short-term losses to offset short-term gains is the best way to take advantage of tax loss harvesting, since short-term gains are taxed at the higher federal marginal rate. According to IRS rules, short-term or long-term losses must be used first to offset gains of the same type, unless the losses exceed the gains from the same type.
Pros of Automated Tax Loss Harvesting
1. Because of the concept of “time value of money,” some tax specialists and robo-advisors argue that deferring taxes and potentially offsetting income taxed at a higher rate is a valuable tool for investors. A 2020 evaluation showed a version of the strategy can deliver outperformance.
2. Tax loss harvesting tends to be beneficial for investors who are in higher tax brackets. Investors can also strategically use the strategy if they expect to be in a lower tax bracket in the future.
3. Because of the practice of selling one asset and buying a similar but non-identical one, tax loss harvesting can also be a way to get more diversification in an investment portfolio.
4. One academic study has also pointed out that the practice may be more beneficial when the stock market posts a particularly strong performance. When markets are up more than 20% year-to-date, it may help to study the effects that tax-loss harvesting has on a portfolio, according to the study.
Cons of Automated Tax Loss Harvesting
1. In 2018, the Securities and Exchange Commission charged a robo-advisor for making misleading claims about the benefits of tax loss harvesting. It’s crucial for investors to know that there could be no tax savings or even a bigger tax bill. Say for instance, an investor harvests a loss from one ETF and switches to a second one in order to perform tax loss harvesting. When the investor finally sells the second ETF, the gains realized from this second sale could be so high that they cancel out or be greater than the tax benefits from selling the first fund.
2. There’s a potential political risk from tax loss harvesting. By deferring their taxes to a later date, investors could be putting themselves at the risk of tax policy changes after a government political transition.
3. Individuals with shorter-term financial goals, such as buying a home, tend to benefit less from tax loss harvesting since they may not be able to defer their tax payments for as long. These folks may benefit from other tax-efficient investing strategies.
4. In automated tax loss harvesting, by continuously buying into similar but non-identical assets, an investor may be unintentionally distorting their asset allocation.
5. Continuously trading assets in automated tax loss harvesting also means an investor may incur additional costs, such as more transaction fees.
Tax loss harvesting is the practice of strategically taking money-losing bets to offset income from taxable profits from other investments. In order to comply with IRS rules and still maintain their asset allocations, investors then put the money leftover after the loss into a “substantially similar” asset.
Automated tax-loss harvesting can be a valuable way of deferring taxes so that investors can earn an income. But there’s no guarantee for tax savings. Consumers should aim to be mindful of the potential benefits of tax loss harvesting are being overstated by their financial planner or robo-advisor.
There may be too many unknowns and variables to definitively pinpoint how much an investor has saved from tax loss harvesting. Individuals in high-tax states or higher-income tax brackets may benefit more from the strategy. Consumers can weigh their individual investment goals and tax situation to decide whether tax loss harvesting can be beneficial to them.
If an investor is ready to start investing, he or she can open an active brokerage account or automated investment account with SoFi. Active investing may work best for those who like to take a hands-on approach, while automated accounts may be good for investors who want a more passive approach.
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