What is Tax Loss Harvesting (And Should You Care?)

What is Tax Loss Harvesting?If you’ve spent any time at all looking at automated investment services (aka “robo advisors”) like Betterment and Wealthfront, you’ve probably noticed they often tout that their services feature tax loss harvesting. And if you’re anything like the average new investor, your response is probably something like, “Cool, uh…by the way, what is tax loss harvesting?” Good question.

Before I go full-on geek mode and launch into a complete explanation of tax loss harvesting, let me give you the simplest answer. Tax loss harvesting is basically a way to reduce the amount of taxes you have to pay on your investments. The money you save on taxes can be reinvested, and over time, those savings can help you build more wealth through years of compound interest.

Up until recently, this was a service that was reserved for the wealthy, as in those with a $5 million+ portfolio, but not any more. Robo advisors like Betterment and Wealthfront (review) have developed software that automates tax loss harvesting, so your account is continuously monitored to maximize its tax efficiency. There’s no work on your end at all. Pretty cool, right?

If you’re still with me, raise your hand. Okay, good. Now, are you ready to delve a little deeper into this? Let’s do it.

 

First Things First…

Before I can answer the question of “What is tax loss harvesting,” first there’s another term you need to understand. Portfolio rebalancing. I know, I know, more jargon. But don’t worry, this one’s pretty simple.

When you start an investment portfolio, an advisor takes you through a survey that asks a lot of personal questions ranging from, “How old are you?” to “If your investments dropped 30% tomorrow, would you sell them all off?” The goal is to figure out three things:

  1. What’s your current financial situation?
  2. What are your financial goals?
  3. How much risk can you stomach?

Basically, they want to help you with your financial goals, while making sure you can remain sane through market fluctuations. So once they figure this out, they set you up with a mix of investments that matches the results of your survey. This is called your asset allocation.

Once your portfolio is set up, it’s time to let your money ride (and add to it). Along the way, different investments will rise and fall in value. This screws up that original asset allocation target set to match your goals and risk tolerance. But never fear. By buying and selling different portions of your portfolio, balance can be restored, and your portfolio will return to normal. This is what we call portfolio rebalancing.

Traditionally, financial advisors handle this process for clients with lots of money. If you were an average person just starting out, well, it’s likely you were on your own. However, now robo advisors like Betterment have created this super sweet software that handles it all for you on a daily basis. You can sit back and twiddle your thumbs, play video games, whatever. And if you get the itch to check in on the process, you can just login to the app on your phone.

 

Okay, But What Does All of That Have to Do with Tax Loss Harvesting?

Ah, good question. That’s where I’m going next. While portfolio rebalancing is necessary to maximize gains and keep your investments in order, it can create a small problem along the way.

Taxes. Ugh, seems like Uncle Sam’s gotta put his hands in everything, right?

The problem with rebalancing is that when your advisor is buying and selling to get your portfolio back on track, he’s also creating (necessary) taxable events because:

  1. When you sell investments that went up, you make money. Cha-ching! We call these gains.
  2. When you make gains, you have to pay taxes on them. Booooo! I know, but it’s just like when you make money at work.
  3. When you sell investments that have gone down in value, you lose money. Booooo! We call these losses. Everyone experiences them, but tax loss harvesting can turn them into a positive.
  4. When you experience losses, you lower your taxable liability. Cha-ching! Paying Uncle Sam less means more money in your pocket.

Following me so far? Good. Now that we understand that, let’s answer the real question, because here’s where tax loss harvesting can save your butt.

 

Tax Loss Harvesting Explained in Plain English

tax loss harvesting memeSo you want your portfolio to build wealth, but you don’t want to pay a fortune in taxes. Yet your portfolio has to be rebalanced. It’s a conundrum.

Well, tax loss harvesting allows you to have your cake and eat it too.

How does it work? Obviously, you don’t want to cut into your gains. So instead, losses are “harvested” by selling off investments that have dropped in value. This creates a loss that will then offset some of the gains you are experiencing in other parts of your portfolio.

But remember, we have to keep the balance (it’s a common theme). So the funds that were sold are then replaced with similar funds to restore your portfolio’s target allocation. That’s it, tax loss harvesting in a nutshell.

 

Are Robo Advisors Better at Tax Loss Harvesting Than Traditional Advisors?

As you can imagine, this would be difficult to do on your own. You’d have to watch your portfolio like a hawk, and in reality it’s more complex than my barebones explanation. For that reason, people have historically depended on their financial advisor to handle it for them. But now with robo advisors arriving on the scene and offering this service, many people are wondering: who does it better?

According to data from research firm Morningstar, the answer is clear. Robo advisors.

I won’t bore you with the details, but here’s the gist of it. According to the article linked above, the majority of human advisors miss 80% or more of tax loss harvesting opportunities each year. Over the last 15 years, the market has produced positive returns at the end of the year 78% of the time. Yet about a third of quarterly returns were negative. Of those, only 20% occurred in the fourth quarter.

Why does that matter? Financial advisors typically use tax loss harvesting as an end-of-year strategy. In other words, they do it during the last quarter. Think the positive fourth quarter returns are a coincidence? Unlikely.

On the other hand, top robo advisors offer this service on a continual basis. The automated system watches your portfolio day-in and day-out, looking for opportunities to harvest losses. There’s just no way a human advisor could do this without an automated program (and why pay them extra to do it when you can get the service straight from the source?). The result? According to research from Betterment, this can boost your yearly return by .77% or more. That more than makes up for their low fees that range from .15%-.35%.

Percentages are nice, but let’s put this in terms of cold hard cash. In a white paper on their site, Betterment looks back at data from 2000-2013. Check out the savings.

tax loss harvesting historically

Assuming you deposited $50,000 in 2000, added $750 twice a month, and increased contributions by 5% each year in a moderate portfolio of 70% stocks and 30% bonds, by the start of 2014 you’d be ahead about an extra $45,000.

So when you scratch your head and ask, “What is tax loss harvesting?” the truth is that it’s not as important that you understand the term as it is that you have the right service handling the process for you.

 

Why Should Millennials Care About Tax Loss Harvesting?

As a millennial, your whole life is ahead of you. Places to go, people to see. That being said, you have plenty of years ahead to build wealth. So you, more than anyone, should be focused on investing for the long-term. And it just so happens that tax loss harvesting is a strategy built for the long-term investor. Here’s why: as you harvest losses through sales, you lower your taxes in the short-term. Those tax savings are kept in your portfolio, invested, and are compounded each year. That’s money you keep. Money you can spend later on vacations, cars, coffee, philanthropy…whatever you choose.

Or would you rather hand it over to Uncle Sam? It’s not much of a choice, is it?

Will you eventually have to pay taxes on your overall gains? Sure. But these gains get pushed into the long-term (more than one year), which is a good thing because long-term capital gains are taxed at a lower rate.

So in the short-term, you save money, which you’ll reinvest to build more wealth. In the long-term, you pay less on your gains. And with 30-40 investment years in front of you, tax loss harvesting can end up paying off big for you.

 

Does Tax Loss Harvesting Help My IRA?

Nope. IRAs and Roth IRAs already have tax advantages of their own (they’re either tax-free or tax-deferred). So essentially, there are no taxes to harvest in your IRA. Tax loss harvesting is specifically for taxable accounts.

But say you hold both taxable and IRA accounts with Betterment. They are the only service who will coordinate tax loss harvesting with your IRA to keep you safe against IRA wash sales. I’m sure I’ve rambled on long enough, so I won’t detail that here. But just know that helps ensure that your harvested losses don’t end up permanently disallowed.

 

Betterment Makes Tax Loss Harvesting Available to All

Now that I’ve answered the question of, “What is tax loss harvesting?” the new question you probably have is, “How can I take advantage of tax loss harvesting?” Another great question.

Traditionally, this was a technique that was only available to the wealthy. But now, Betterment is making it available to anyone with their automated Tax Loss Harvesting+ service. Whether you’re 23 starting out depositing $100 a month, or a 40-year-old making $100,000 a year who’s depositing $1,000 a month, Betterment will automatically rebalance your portfolio and harvest tax losses on a continual basis. There is no account minimum.

Don’t want to lose out on the savings tax loss harvesting can create for you? Click here now to find out how easy it is to sign up for a Betterment account and get up to 6 months managed for free!

Want to learn more about investing online? Click here to read my simple 3-step guide! And as always, if you have any questions, simply leave a comment, and I’ll get back to you!

The People's Advisor

The People's Advisor

The People's Advisor is the champion for the common investor. Ask for help on how to get started investing online!
The People's Advisor

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The People's Advisor
The People's Advisor is the champion for the common investor. Ask for help on how to get started investing online!

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