Robo-Advisor Tax-Loss Harvesting

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Robo-Advisor Tax-Loss Harvesting

What Is Robo-Advisor Tax-Loss Harvesting?

Robo-advisor tax-loss harvesting refers to the automatic sale of assets in a portfolio to intentionally suffer losses in order to offset any capital gains or taxable income inside numerous robo-advisor platforms. A robo-advisor is an automated investing platform with extremely cheap expenses and low minimums owing to the use of algorithms that need little human intervention. Tax-loss harvesting is a method that aims to assist investors in paying the least amount of taxes feasible in non-tax protected accounts while adhering to IRS standards.

Wealthfront stated on Wednesday, January 26, 2022, that it has agreed to be bought by UBS, one of the world’s leading wealth management firms, in a $1.4 billion deal. Wealthfront’s Chief Executive Officer, David Fortunato, addressed current and prospective customers’ concerns in a blog post on the company’s website, stating, “You will notice no difference in your experience and can continue to benefit from UBS’s breadth of products, services, and intellectual capital. Rest assured that neither your account nor the pricing of our service will change. We will continue to provide you with excellent goods and services, but at a much quicker rate. You’ll also have access to additional information and insights that can help you as an investor.”

Key Takeaways

  • Today, many robo-advisers provide tax-loss harvesting as a regular service.
  • Tax-loss harvesting is the practice of selling shares at a loss in order to reduce a capital gains tax bill.
  • Because robo-advisors are low-cost automated technologies, they can do this task significantly more efficiently and accurately than a person attempting to extract tax losses.

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Understanding Robo-Advisor Tax-Loss Harvesting

Emerging financial technology, often known as fintech, has enabled financial services and products to be readily appraised at cheap prices through investment platforms that use smart technology. These systems, known as robo-advisors, create tailored portfolios for consumers and then monitor and rebalance the portfolios on a regular basis to keep management costs low and cheap. Tax-loss harvesting is one of the many services that certain robo-advisors provide via their systems.

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Tax-loss harvesting is a purposeful approach in which any loss from the sale of an investment in a taxable account is utilized to offset a capital gain or taxable income, minimizing the amount of tax paid. For example, an investor with a $15,000 capital gain who is in the highest tax rate must pay the government 20%, or $3,000, in taxes. However, if they sell XYZ investment for a $7,000 loss, their net capital gain for tax purposes would be $15,000 – $7,000 = $8,000, resulting in a $1,600 capital gains tax bill. (The IRS wash-sale rule prohibits the investor from repurchasing XYZ or a security that is substantially similar to XYZ within 30 days of the sale date, however the meaning of “substantially same” seems to be ambiguous.) If an investor wishes to keep exposure to XYZ, he or she may be better off buying a mutual fund or ETF that tracks the sector in which XYZ operates.

Tax-loss harvesting will not benefit every investor. Before selecting it on your robo-advisor, be sure to analyze your income and tax status.

For the ordinary investor, doing a tax loss harvest may be time-consuming, difficult, and costly, which is why a few of robo-advisors have incorporated this value-added technique as part of their services. Robo-advisors often use ETFs to develop and manage customised asset portfolios. Robo-investment platforms use an algorithm that integrates computational rules such as the IRS’s 30-day wash-sale requirement. When a realized gain is achieved, the system will sell a losing investment to offset the gain, but owing to the algorithm, it will be unable to buy the identical asset.

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Rebalancing Example

Robo-investment platforms use automatic criteria to guarantee that an investor’s portfolio is balanced at all times. After a sale, the system will acquire another ETF to replace the sold one in order to keep the portfolio balanced or to retain exposure to the same sector. Wealthfront, a robo-advisor that provides tax-loss harvesting services, might, for example, sell the Vanguard Total Stock Market ETF to harvest a loss and then buy the Dow Jones Broad U.S. Market ETF. Wealthfront is able to maintain the optimum risk-return allocation of the portfolio without breaching the IRS limits on substantially comparable assets since both are positively linked and give the same exposure. The original ETF may be repurchased after the 30-day wash sale period.

Consider the following situation in our XYZ security example: the profits and losses are flipped. If an investor has a $7,000 capital gain and a $15,000 capital loss, the $7,000 capital loss may be utilized to entirely offset the capital gain to $0. The remaining $8,000 in capital loss value may be utilized to decrease the investor’s taxable ordinary income. The IRS limits the amount of capital loss that may be deducted from ordinary income to $3,000 in any one year. So the value that the investor will be taxed as regular income is $68,000 – $3,000 = $65,000. The leftover $5,000 may be carried forward and deducted from an individual’s regular income in future years.

Tax-Loss Harvesting andCapital Gains

An investor may be liable to two separate capital gains tax rates depending on how long they keep the investment. If the investor is in the highest tax band, a long-term investment (one held for more than 365 days) will have a maximum rate of 20% applied to any capital gain. The capital gains tax on a short-term investment sold in fewer than 365 days will be the same as the investor’s income tax rate of 37% for this same investor. Investors who use robo-advisor systems like Betterment are never exposed to short-term capital gains since all capital gains are taxed at a lower rate. It is also feasible for a robo-investor to dodge taxes on their profits indefinitely; for example, the Betterment robo platform gives assistance on how to use these earnings as a charity contribution or a gift to a relative.

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Robo-AdvisorTax-Loss Harvesting vs. Financial Advisor Tax-Loss Harvesting

While many conventional financial advisers only perform a tax-loss harvest once a year owing to the time-consuming and labor-intensive nature of the procedure, robo-advisors may execute these processes on a daily basis without the need for human interaction. A financial adviser will not be able to detect the various tax-loss harvesting possibilities that exist across several portfolios. A robo-advisor, on the other hand, is frequently on the lookout for and executing on tax-loss harvesting opportunities that arise during a market slump. Wealthfront claims that its automated robo platforms may provide an extra yearly return of 1.11% to 1.98%, depending on the investor’s tax burden. Betterment claims that a typical investor may anticipate an extra yearly return of 0.77%.

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