Tax-loss harvesting (TLH) is a technique used to minimize taxes on your taxable investments – without altering them significantly – by “harvesting” capital losses during market declines. There are many lengthy articles about TLH out there, but Wealthfront recently released a brief video about tax-loss harvesting that is a good intro to the subject:
Wealthfront is now including tax-loss harvesting in their 0.25% advisory fee for clients with taxable accounts of $100,000 or more. (Advisory fee is on top of ETF and/or mutual fund expense ratios.) I think it’s great that they are offering tax-loss harvesting at a reasonable price, but I don’t know about their contention that tax-loss harvesting is “traditionally only available to accounts in excess of $10 million”. Respectable portfolio managers, include low-cost passive portfolio managers, have been providing tax-loss harvesting to all their clients for a long time. It is true that other online portfolio managers like Betterment currently don’t offer this, however.
(I’m also skeptical about their finding that TLH boosted returns by a full percentage point, I’d be worried about data mining. I mean, sure, if you harvested losses perfectly during every little decline, maybe, but 1% is a lot.)
Indeed, if you’re a DIY investor with a portfolio of a 2-6 index ETFs, you can harvest losses on your own. Here’s an tax-loss harvesting example with ETFs from an old blog post. Wealthfront’s materials suggest that their own method is to sell a primary ETF (ex. Vanguard/VEA) when it’s down and buy the low-priced secondary ETF equivalent (ex. Schwab/SCHF) to replace it. Then, you sell the secondary ETF again after 30 days to get your Vanguard ETF back with a lower basis while avoiding IRS wash sale rules. They believe that their pairings satisfy the IRS requirement that the ETFs can’t be “substantially identical”. You’ll have to decide for yourself if you want to do those extra two trades to swap things back (and paying extra commisions) every time you TLH, or if you should just keep holding the secondary ETF until the next time you want to sell for whatever reason.
Update: I received the following message from Wealthfront:
I wanted to point out when reading your post is that we offer continuous tax-loss harvesting as opposed to year end tax-loss harvesting. We agree with you that the expected benefits on year end tax-loss harvesting is not 1% a year but rather that is for continuous tax-loss harvesting where you are continually harvesting throughout the year.
Here is their whitepaper on the subject, although I should note that the 1% alpha is based on the assumption that you are in the highest 35% tax bracket (while long-term gains are at 15% tax rate). The continuous algorithm deciding when to harvest is interesting, being based partially on “each ETF’s volatility parameter estimated over a rolling time window.”
By Jonathan Ping | Investing | 10/22/12, 3:00am