Investors constantly seek ways to enhance their portfolio performance. While diversification and risk management are essential, there’s another powerful tool often overlooked: tax-loss harvesting. This strategy transforms paper losses into real tax advantages, potentially boosting after-tax returns without altering your investment strategy or increasing risk.
Betterment, a pioneer in automated investing, offers a sophisticated tax-loss harvesting (TLH) service. This feature scans portfolios for opportunities to realize losses that can be used to offset gains, potentially reducing your tax bill. Unlike traditional approaches, Betterment’s TLH takes a holistic view of tax efficiency, optimizing both automated activities and user-initiated transactions.
Understanding tax-loss harvesting
Tax-loss harvesting involves selling securities at a loss and replacing them with correlated assets that provide similar market exposure. This strategy offers two key benefits: it allows investors to “harvest” valuable losses for tax purposes while maintaining their desired portfolio allocation.
The primary advantage of tax-loss harvesting is its ability to lower your tax bill. Capital losses can offset capital gains realized in other transactions throughout the year. If losses exceed gains, you can offset up to $3,000 of ordinary income annually. Any remaining losses can be carried forward indefinitely.
Over the long term, tax-loss harvesting can add value through several mechanisms. It defers taxes on gains, potentially allowing savings to grow at a conservative rate of 5% over a 10-year period. It can also help push capital gains into lower tax brackets and convert ordinary income into long-term capital gains, which are typically taxed at lower rates. In certain circumstances, such as charitable donations or bequests to heirs, tax-loss harvesting can even lead to permanent tax avoidance.
Navigating the wash sale rule
One of the most critical aspects of tax-loss harvesting is managing the wash sale rule. This IRS regulation disallows a loss from selling a security if a “substantially identical” security is purchased within 30 days before or after the sale. The rule applies across all accounts, including IRAs and 401(k)s, and even to spousal accounts.
A wash sale involving an IRA or 401(k) is particularly unfavorable, as the loss can be permanently disallowed. To minimize wash sales, Betterment employs advanced strategies that repurchase assets with similar exposure but are not “substantially identical” for purposes of the wash sale rule. This approach helps preserve the value of harvested losses and maintains portfolio balance.
Betterment’s TLH feature also uses a tertiary ticker system to prevent losses realized in taxable accounts from being washed by subsequent deposits into an IRA or 401(k). This system automatically allocates inflows into a third option for the asset class, preserving valuable realized losses and maintaining desired allocation.
Betterment’s innovative approach
Betterment’s tax-loss harvesting stands out due to its comprehensive and automated approach. The service features a Parallel Position Management (PPM) system that allows each asset class to contain primary and alternate securities. This dual-security approach enforces preference for one security without triggering capital gains unnecessarily, all while maintaining market exposure.
The PPM system minimizes unnecessary gains, reduces potential wash sales, and protects both harvested and user-realized losses. It also directs the proceeds of every harvest to rebalance the entire portfolio, further reducing the need for additional selling during volatile markets and minimizing tax liability.
Betterment’s TLH feature is calibrated using rigorous Monte Carlo simulations, optimizing around multiple inputs to make harvesting decisions. The service considers trading costs, execution expenses, and increased cost of ownership for replacement assets, ensuring that the cost of harvesting approaches negligible.
To help investors understand the potential benefits of tax-loss harvesting, Betterment provides a personalized Estimated Tax Savings tool. This tool quantifies the tax-saving potential of the TLH feature by leveraging transactional data and client financial profile information. It generates dynamic estimates of realized and potential tax savings, providing both current-year and cumulative “all-time” tax savings estimates.
The Estimated Tax Savings tool takes into account client financial profile information, such as annual pre-tax income, state of residence, tax filing status, and number of dependents. It analyzes tax-lot level trading data and applies the IRS offset order to calculate potential tax benefits. The tool provides a clear and actionable view of how tax-smart investing can add value over time.
Betterment’s automated and sophisticated approach to TLH makes this valuable tool accessible to all investors, helping them maximize their investment performance while minimizing tax liability.
