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Is Automated Tax-Loss Harvesting a Good Idea?

By MP Dunleavey · February 28, 2022 · 7 minute read

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Is Automated Tax-Loss Harvesting a Good Idea?

Automated tax-loss harvesting is often considered a valuable tool for tax-efficient investing because it involves using an algorithm — rather than a human advisor — to sell securities at a loss so as to offset capital gains and potentially lower an investor’s tax bill.

Ordinary tax-loss harvesting uses the same principle, but the process is complicated and an advisor might only harvest losses once or twice a year versus automated tax-loss harvesting which can be done more frequently.

Tax-loss harvesting is the strategy of selling certain investments at a loss in order to offset the taxable gains of other investments.

That said, automated tax-loss harvesting — which is typically a feature of robo-advisor accounts — may give investors only limited (or possibly no) tax benefits. Here’s a breakdown of whether an automated tax-loss strategy makes sense.

Tax-Loss Harvesting: The Basics

First, a quick recap of how standard tax-loss harvesting works. Tax-loss harvesting is a way of selling securities at a loss, and then “harvesting” that loss to offset capital gains or other taxable income, thereby reducing federal tax owed.

The reason to consider this strategy is that capital gains are taxed at two different federal tax rates: long-term (when you’ve held an asset for a year or more) and short-term (when you’ve held an asset for under a year).

•   Long-term capital gains are taxed at 0%, 15%, or 20%, depending on the investor’s tax bracket.

•   Short-term capital gains are taxed at a typically much higher rate based on the investor’s ordinary income tax rate — the top rate being 37%.

For example, consider an investor in the highest tax bracket who sells security ABC and realizes a long-term capital gain of $10,000. They would owe 20%, or $2,000.

But if the investor sells XYZ security and harvests a loss of $3,000, their net capital gain will be $7,000 ($10,000 – $3,000). This means that they would owe $1,400 in capital gains tax.

The differences can be even greater when investors can harvest short-term losses to offset short-term gains, because these are typically taxed at a higher rate. In this case, using the losses to offset the gains can make a big difference in terms of taxes owed.

What Is Automated Tax-Loss Harvesting?

Until the advent of robo-advisor services 10 or 15 years ago, tax-loss harvesting was typically carried out by qualified financial advisors or tax professionals in taxable accounts. But as robo-advisors and their automated investment portfolios became more widely accepted, many of these services began to offer automated tax-loss harvesting as well, though the strategy was executed by a computer program.

Just as the algorithm that underlies an automated portfolio can perform certain basic functions like asset allocation and portfolio rebalancing, some automated programs can execute a tax-loss harvesting strategy as well (along with a suite of services that robo-advisors offer, such as dividend reinvestment plans (DRIP investing), where dividend payouts get reinvested).

So whereas tax-loss harvesting once made sense only for higher net worth investors, owing to the complexity, automation has enabled retail investors to reap the benefits of tax-loss harvesting as well. The idea has been that automated tax-loss harvesting can be conducted more often and with less room for error, thanks to the precision of the underlying algorithm — which can also take into account the effects of the wash-sale rule.

The Wash-Sale Rule

It’s important that investors understand the “wash-sale rule” as it applies to tax-loss harvesting.

What Is the Wash-Sale Rule?

The wash-sale rule prevents investors from selling a security at a loss and buying back the same security, or one that is “substantially identical”, within 30 days. If you sell a security in order to harvest a loss and then replace it with the same or a substantially similar security, the IRS will disallow the loss and you won’t reap the desired tax benefit.

In the example above, the investor who sells security XYZ in order to apply the loss to the gain from selling security ABC may then want to replace security XYZ because it gives them exposure to a certain market sector. While the investor can’t turn around and buy XYZ again until 30 days have passed, they could buy a similar, but not substantially identical security, to maintain that exposure.

That said, it can be tricky to follow this guidance because the IRS hasn’t established a precise definition or description of what a “substantially identical security” is. This is another reason why automated tax-loss harvesting may be more efficient: It may be simpler for a computer algorithm to make these choices based on preset parameters.

Also, 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. In that case, losses of up to $3,000 per year can be used to offset ordinary income or carried over to the following year.

How ETFs Help With the Wash-Sale Rule

This is how the proliferation of exchange-traded funds (ETFs) has benefited the strategy of tax-loss harvesting. Exchange-traded funds, or ETFs, are baskets of securities that typically track an index of stocks, bonds, commodities or other assets, similar to a mutual fund. Unlike mutual funds, though, ETFs trade on exchanges like stocks.

In some ways, ETFs may make tax-loss harvesting a little easier. 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 because the fund may have slightly different constituents.

Because most robo-advisors generate automated portfolios comprised of low-cost ETFs, this can also support the process of automated tax-loss harvesting.

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.

How Much Does Automated Tax-Loss Harvesting Save?

It’s hard to say whether automated 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.

The Upside of Automated Tax-Loss Harvesting

However, one evaluation of standard (not automated) tax-loss harvesting that was published by the CFA Institute in 2020 found that from 1926 to 2018, a simulated tax-loss harvesting strategy delivered an average annual outperformance of 1.08% versus a passive buy-and-hold portfolio. Taking into account transaction costs and the wash-sale rule (more on that set of restrictions below), 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, a period 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 after World War II — tax-loss harvesting only delivered an alpha of 0.51%.

The Downside of Automated Tax-Loss Harvesting

While the research cited above identifies some benefits of tax-loss harvesting, like many investment studies it’s based on historical data and simulations of a portfolio, not real-world investments.

Another fact to bear in mind: This study does not factor in the impact of automated tax-loss harvesting, which is typically conducted more frequently.

Indeed, in 2018 the Securities and Exchange Commission (SEC) charged a robo-advisor for making misleading claims about the benefits of automated tax-loss harvesting in terms of higher portfolio returns. Investors should know that there could be no or little tax savings or even a bigger tax bill, depending on how different securities perform after they’re sold (or bought back).

For instance, if an investor harvests a loss from one ETF (to offset the gains from a sale of another ETF), they might then buy a replacement ETF that’s not substantially identical, per the wash-sale rule. But it’s possible that 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 to harvest the loss.

In that case, although the investor had harvested a loss to offset gains in the present, they could end up paying more taxes down the road — effectively deferring, not eliminating, the tax burden.

Also, by using automated tax-loss harvesting and continuously buying into similar but non-identical assets, an investor may be unintentionally distorting their asset allocation. Continuously trading assets in automated tax-loss harvesting also means an investor may incur additional costs, such as more transaction fees.

Pros of Automated Tax-Loss Harvesting

1.    Standard tax-loss harvesting is complex and time-consuming, but the benefits are well established. Therefore using automated tax-loss harvesting may be an efficient way to reap the benefits of this strategy because it can be done more consistently.

2.    To realize the benefits of tax-loss harvesting investors must obey the IRS wash-sale rule, which imposes restrictions that can be tricky to follow. In this way, an automated strategy may limit the potential for human error and may increase the tax benefits for investors.

3.    Some robo-advisors claim that using an automated strategy may increase portfolio returns over time.

Cons of Automated Tax-Loss Harvesting

1.    Because an algorithm performs tax-loss harvesting on an automated cadence, it may be difficult to make more nuanced choices about which investments to sell and when.

2.    An automated tax-loss program may not be able to anticipate a security’s future gains that could reduce or eliminate the tax benefit of harvested losses.

3.    Automated tax loss harvesting could increase the amount an investor pays in transaction fees, which can lower portfolio returns.

The Takeaway

Automated tax-loss harvesting is a feature primarily offered by robo-advisors, which use a computer algorithm to automatically sell securities at a loss in order to reduce the tax impact of capital gains realized from the sale of other securities. While this practice can offer real tax benefits in some cases, and academic studies have used portfolio simulations to gauge the potential for outperformance, it’s unclear whether automated tax-loss harvesting offers the same benefits. Because the strategy is carried out by an underlying algorithm, a computer program may not be capable of making more nuanced choices about which assets to sell and when. Investors could potentially end up still owing capital gains taxes or paying more in transaction fees.

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