Basics of ETF Tax Loss Harvesting

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.”

Comments

  1. This year I have been doing to opposite: tax gain harvesting. Since my income is low (15% tax bracket), but I have some investments that have long term gains, I can sell and re-buy them and pay the current 0% long term capital gains tax for low income brackets. I recently learned that there is no wash sale rule for gains.

    One thing to keep in mind with tax loss harvesting (that that video fails to mention) is that you are decreasing your cost basis, so you are potentially increasing future taxes. Of course you get to invest those delayed tax moneys in the interim–now that I think of it it sounds like an interest-free loan–so you can come out ahead. The question is, do you come out far enough ahead to justify paying someone to do it for you?

  2. Jay @ effumoney says:

    Harvesting tax losses now might make as much sense if the fiscal cliff is not averted next year taxes on capital gains and dividends can go up, the losses will be worth more next year then they are this year.

    On the opposite side, selling gains now locks in the current tax rate which is less then it could benext year.

    Of course this is all just a guess and trying to hedge taxes, if the fiscal cliff is averted, taxes might remain the same next year. There is no chance of them going to down however this is as good as it gets.

  3. To add on to what Adam said about tax gain harvesting – as he says, there is no wash sale rules for gains. If you are in a higher tax bracket than Adam, many charities will accept stock donations. If you have stock that has appreciated, and you have held it for more than a year, you can donate the stock instead of cash to a charity, and deduct the fair market value at the time of donation – and you don’t have to pay capital gains on the gains you made on the stock.

    Then, if you still want to keep the stock, you can repurchase it, and have a new higher basis in the stock.

  4. “They believe that their pairings satisfy the IRS requirement that the ETFs can’t be “substantially identical”.”

    The IRS is not stupid. If these guys are purposefully trying to skate around the IRS, either the IRS will stop them under current law (since it sounds like a gray area) or get the laws changed to stop them in the future.

  5. Jay @ effumoney says:

    @Scott

    The Vanguards EFA tracks the MSCI EAFE Index, Schwabs SCHF tracks the FTSE Developed ex U.S. Index, the IRS considers ETF’s that track different indices to not be substantial identical. Both of these indices generaly cover the same market Ex-US stocks, but they are derived on different critiria.

    If you were to replace SPDR’s SPY with iShares IVV which both track the S&P 500 those are substantial identical and would trigger a washsale.

    What Wealthfront is doing is well within the IRS’s published requirements on avoiding a washsale and fully takes advantage of taxlot harvesting while not being over/under allocated for the 30 day window while a washsale could be triggered.

  6. Ditto what Adam said.

    Here’s a really simple example:
    If you buy one share of stock for $10 now, then sell it for $15 in 2022, you’ve made $5. You pay capital gains taxes on that $5.

    Now say you buy one share of stock for $10 now, sell if for $5 in 2017, immediately buy one share of a second near-identical stock for $5, and then sell that share for $15 in 2022.

    Assume you’re paying 10% on captial gains taxes so we can make the math easy. In the first example you’ll pay $.50 in taxes on your capital gains in 2022. In the second example you get $.50 refunded to you from “capital losses” in 2017, and then pay $1.00 in capital gains taxes in 2022. Total amount paid in taxes: still $.50.

    So this tax-loss-harvesting business is more of a game of moving around what years you pay taxes (or get refunds), hoping that tax laws change or your financial situation changes in a way where you benefit. If those things stay constant, however, you only gain or lose a negligible amount by playing this game.

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