Updated
Tax-Loss Harvesting
Tax-Loss Harvesting is a strategy that takes advantage of movements in the markets to capture investment losses, which can help reduce your tax bill, leaving more money to invest. In fact, Tax-Loss Harvesting typically generates savings worth at least 6x our advisory fee¹.
Financial advisors to the rich have used this strategy to limit their tax burden for decades — and we’re making it available in all Wealthfront taxable Investment Accounts.
How does it work?
When an ETF in your Wealthfront portfolio declines in value, a common occurrence in broadly diversified investment portfolios, we sell that ETF at a loss if the loss meets certain thresholds established by our model. You can use the losses to offset investment gains and any remaining losses can offset up to $3,000 of ordinary income, which can help lower your overall tax bill.
What’s more, when we sell an ETF at a loss, we replace it with another highly correlated ETF. The result is that the risk and return profile of your portfolio is unchanged, even as Tax-Loss Harvesting can generate tax savings. These tax savings can then be reinvested to further grow the value of your portfolio.
Read our Tax-Loss Harvesting White Paper for more details.
What types of accounts qualify?
Tax-Loss Harvesting is only relevant to taxable accounts. It does not apply to retirement accounts such as IRAs or 401(k)s, since gains and losses in those types of accounts are not taxable events. Tax-Loss Harvesting is also not typically suited for 529 accounts.
How do you choose alternate ETFs?
We pick alternate ETFs to purchase if a primary ETF declines in value. These alternate ETFs have highly correlated historical returns, similar volatility, and similar expense ratios to the primary ETFs. To avoid triggering the wash-sale rule, we make sure to select alternate ETFs that track different indices than the primary ETFs.
We receive no additional compensation for recommending any of the ETFs in our client portfolios and have no business relationship with any of the providers.
Note: For Automated Index Investing Accounts with US Direct Indexing enabled, the “US Stocks” position is implemented by directly purchasing up to 1,001 securities – 1,000 stocks from the S&P 1500 index and completion ETFs to provide exposure to small and medium capitalization stocks.
Can I do tax-loss harvesting myself?
Yes, although there are some significant complexities. You will need to track lot-level cost basis, identify alternate securities that are not substantially identical, but that correspond with your investment goals, periodically review your investment portfolio, and carefully observe the wash sale rule (even as it relates to rebalancing). Many high-net-worth investors look to their brokers or investment advisors to harvest tax losses, but typically only at year-end.
Wealthfront has built a sophisticated, software-based Tax-Loss Harvesting service that checks client investment portfolios, during business hours, for opportunities to harvest losses.
Are there any things to keep in mind when filing taxes?
Wealthfront will provide a Form 1099 to be filed with your tax return that will include all the relevant investment transactions in your Wealthfront accounts, including those generated by Tax-Loss Harvesting.
If you hold and trade the same ETFs found in your Wealthfront account in other brokerage accounts, then transactions in your other accounts may generate wash sales and reduce the tax benefit from Tax-Loss Harvesting. If you’re concerned about wash sales, we recommend reviewing the IRS website or consulting your tax advisor.
Doesn’t Tax-Loss Harvesting just defer tax liability?
Yes, however, there are cases where you could come out ahead by not paying these taxes today and only potentially having to pay them years from now.
The tax savings from Tax-Loss Harvesting can be reinvested and compounded over time. $10,000 in tax-savings today, for example, reinvested at a 5% annual return for 20 years comes out to more than $26,000. You’re still left with $8,000 with gains due to tax-loss harvesting even if you pay a 50% tax on those reinvested gains and pay back the original $10,000 tax liability [$26,000 – $10,000 – ($26,000-$10,000) x 50% = $8,000].
Tax-Loss Harvesting also takes advantage of the difference between your current and future tax rates — a practice known as tax-rate arbitrage. Tax-Loss Harvesting realizes losses at a short-term capital loss rate, which optimizes tax deductions. Additionally, if the investment’s alternate ETF is held for at least a year, it can be sold at a long-term capital gains rate, which typically results in lower taxes. You can learn more about tax-rate arbitrage in our Tax-Loss Harvesting White Paper.
What’s more, if you don’t end up selling all of your investments and instead choose to pass them on to your heirs or donate them to a non-profit organization, then you actually never have to pay back the original tax liability. This is because your heirs will receive a step-up in basis for the assets that you pass down, eliminating any capital gain tax liability for those assets. Non-profit organizations will similarly not owe any taxes upon selling the assets you donate.
¹To estimate how much an account’s TLH benefit “covers” its fees, we start by taking our client's state of residence, stated income, and marital status to estimate their combined federal and state tax rates.
We then take the harvested losses and multiply the total short term losses by the client’s estimated marginal tax rate, and the total long term losses by the client’s estimated long term gains rate. For each client, the sum of these two values is our estimated TLH benefit. We then divide by the total Wealthfront management fee paid by the account to estimate the benefit to fee ratio. The median result in this data set is over 6x.
For informational and educational use only. Your actual results may differ due to your unique financial and tax situation. Please consult a tax professional for advice tailored to your specific circumstances.
The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront Advisers and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short-term or long-term).
Wealthfront Advisers’ investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.
Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
The possibility of tax advantages from state municipal bond ETFs is dependent on a client's state of residence and individual tax situation. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront Advisers assumes no responsibility for the tax consequences to any investor of any transaction.
Wealthfront Advisers and its affiliates do not provide legal or tax advice and do not assume any liability for the tax consequences of any client transaction. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances.
The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer or recommendation to buy or sell any security. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.
Investment management and advisory services are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and brokerage related products, including the Cash Account, are provided by Wealthfront Brokerage LLC, a Member of FINRA/SIPC.
The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer or recommendation to buy or sell any security. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.
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