Tax Loss Harvesting – What You Need to Know
According to the automated financial advisors, frequently referred to as robo-advisors, like Betterment or Wealthfront claim that tax loss harvesting is good way to increase your returns. However, research done on this subject suggests that tax loss harvesting may not be as lucrative a technique are investors are led to believe.
Understanding Tax Loss Harvesting?
Simply put, Tax-loss Harvesting is a strategy used by investors where they sell off securities that are at a loss so that the capital gains tax liabilities can be mitigated. The basic premise is that if you sell an investment that is down at a loss this year, you can offset that against gains you may have made through another investment in your portfolio. If you were unable to book gains this year, then you can use that loss to counterbalance your regular income. In theory, if you declare the maximum permitted capital loss of $3,000 against your income, you could end up saving hundreds of dollars on your taxes.
What does Tax Loss Harvesting Actually do?
In reality, all you would be doing is postponing the taxes you need to pay off. Basically, you could end up raising taxes for yourself in the future since all tax-loss harvesting really does is defer your taxes. The method doesn’t eliminate your taxes. The reason why investors still look at this option is because robo-advisors extol the advantages of tax loss harvesting. According to Michael Edesess, chief investment strategist and mathematician from Compendium Finance, these robo-advisors are ignoring two key factors in their calculations of returns on tax loss harvesting.
- Today’s tax savings have to be paid off sometime. The exception to this rule is if the investor never plans to realize capital gains on that asset. This can be done if the investor donates that asset to charity.
- Robo-advisors also assume that investors can take the full value of their losses on taxes. However, the maximum capital loss that can be realized is $3,000.
These robo-advisors claim that they can increase annual performance to around 0.77%. However, Edesess says that if you are to actually compute the value of tax loss harvesting correctly, you need to do a long-run calculation, usually across a person’s lifetime. And based on this calculation, the actual increase in annual performance is about 0.15% to 0.25%.
Tax Loss Harvesting Can Still Benefit You
Just because the numbers touted by robo-advisors may not be correct doesn’t mean that tax loss harvesting is a waste of time. This method of deferring taxes can still provide benefits if used correctly. For example, if you live in a high-tax state such as California or New York, then the tax benefit you can get from tax loss harvesting can be quite beneficial. And if you just defer your tax break and never sell your investments, then you can really win with this strategy. This can be done in two ways – donating to charity or leaving your investments in a will to your heirs. If, however, you are planning to use your investments to pay for your retirement, then deferring your taxes is not a good idea.