Tax-Loss Harvesting is not an Integrated Income Tax Plan
Incorporating taxes with an investment plan is one area most investors want assistance with from a financial advisor. Lately, there has been a pitch from online investment firms (sometimes referred to as “robo-advisors”), which claim their technology automates a plan for maximizing tax-efficient investing. What they have to offer though, tax-loss harvesting, may really not be a benefit to the majority of their clientele.
Tax-loss harvesting is the practice of selling investments within a taxable account at a loss, thereby generating a loss that can be used against current and future income. The primary benefit comes from recognizing a paper loss today rather than letting it stay on the books as a loss, and placing the proceeds in a similar but different investment. Online investment advisors have invested in technology to automate transactions to increase the capture of losses generated in an investor’s taxable brokerage account holdings, and they claim this technology can add between an additional 0.7% to 1% annualized to your bottom line.
While there are certainly benefits to harvesting tax losses, there are a number of critics who question the actual impact of those benefits, and whether there are any at all. Below are a few reasons why the loss harvesting proponents may be off on their benefit claims.
Tax-loss harvesting won’t benefit most savers. If you are like the majority of savers and have been using tax-qualified retirement plans like 401(k)’s, 403(b)’s, IRAs, and Roth IRAs as your sole investment vehicles, tax-loss harvesting won’t benefit you. You need a taxable account to generate losses. Given the target clients of most online advisors are the mass affluent rather than the super-rich, many don’t have taxable accounts to worry about this added portfolio management concern.
Tax-loss harvesting just doesn’t generate the claimed gains. To the extent tax-loss harvesting only benefits an investors taxable account balance, it will only be providing a benefit to that money. When robo-advisors claim to generate additional percentage points for you, that’s not actually the case across the entirety of your accounts, and as we noted it may not matter to the majority of your tax-qualified savings.
They market gains that may only benefit the top 1% of investors. My biggest complaint with the tax-loss harvesting sales pitch from some online firms is that they don’t even attempt to show the benefits to their target clientele.
One provider bases their calculation of the benefits of tax-loss harvesting using the top income tax bracket (for single people earning $400,000 or more, or married filing jointly earning $450,000 in 2014) alongside an assumption that the investor lives in the state with the highest tax rate on that income.
Clearly, if you are in this income tax bracket (and you live in California and own a substantial taxable brokerage account) tax-loss harvesting provides the maximum benefits to you. However, blatantly marketing a service to the mass affluent while showing benefits to the top 1% of income earners is deceptive.
And while I admit tax-loss harvesting is likely to have some benefit to many who can take advantage of losses, how much that is can be debated, however, we should also consider the downsides.
You are out of an investment you preferred. In order to take a loss, you must sell and not own that (or a substantially similar) investment. What if the loss is due to an exaggerated market move, and there is a recovery? In order to participate in the market you must either purchase an investment you don’t prefer, or you stay out of the market entirely for a period of 30 days to capture the loss.
Exchange-traded funds (ETFs) have downsides. Most of these programs use ETFs as the investment vehicle of choice. One proponent of tax-loss harvesting states that they can trade in and out of exchange-traded funds with “no harm” to the customer.
However that simply is not true. Since ETFs trade on the market, there is a market premium or discount factor that must be considered with each purchase.
What’s even more frightening is this provider states “when you are thinking about buying an ETF, the Expense Ratio is pretty much all you need to know.”
No. It absolutely is not all you need to know.
What are the ways robo-advisors should (but likely don’t) talk to clients about tax-efficient investing?
Structure of accounts. Where you save is important. Having a plan to make withdrawals or conversions while in a relatively low tax year adds value. You won’t get that advice from a robo-advisor. The order in which you withdraw funds from in retirement can extend the life of your portfolio by several years.
Asset location. Many robo-advisors do not pay attention to asset location, or placing assets that are inefficient from a tax standpoint into tax-preferenced account.
Managing holistically over employer accounts. If you have a 401(k) plan with good bond options, perhaps you should have your bond allocation in your 401(k), and your growth assets in various managed accounts.
Gifting gains. Getting into discussions on tax strategies for high income earners is more than I can cover here, but you can be sure robo-advisors are not discussing gifting appreciated securities out of their managed portfolios in order to not generate taxable gains.
Robo-advisors likely will tell you that investors should work with a CPA for advice on the above, but since they are already wading into providing tax-efficient investing services and marketing the ‘benefits’ of those services, it needs to be noted that no matter how impressive the technology may be it still isn’t as beneficial to the mass affluent investor they claim to want to work with, or the high income earner who likely requires a far more personalized plan. Likely from a human holistic financial advisor like those of NAPFA.