Why is tax loss harvesting helpful for passive investing?

Question

I am considering opening an account with a robo-advisor (e.g. Wealthfront), and in my research I have seen that robo-advisors often advertise tax loss harvesting as a feature of their accounts.

However, my plan is to place money in this account and hold the resulting stocks for the long term (decades), without buying or selling anything (other than additional stock purchases as I invest more money or as my dividends are reinvested).

In this case, what is the benefit of tax loss harvesting to me, given that I will not be issuing any buy/sell orders? Is the problem that the robo-advisor will still buy and sell stocks on my behalf for rebalancing purposes during this time, thus necessitating tax loss harvesting for tax planning purposes?

Answer 1

The harvested losses are capital losses. See this IRS page:

Generally, realized capital losses are first offset against realized capital gains. Any excess losses can be deducted against ordinary income up to $3,000 ($1,500 if married filing separately) on line 13 of Form 1040.

Losses in excess of this limit can be carried forward to later years to reduce capital gains or ordinary income until the balance of these losses is used up.

This means that your harvested losses can be used to offset ordinary income --- up to $3000 in a single year, and with extra losses carried forward to future years. It is pretty close to a free lunch, provided that you have some losses somewhere in your portfolio.

This free lunch is available to anyone, but for a human, it can be quite a chore to decide when to sell what, keep track of the losses, and avoid the wash sale rules. The advantage of robo-advisors is that they eat that kind of bookkeeping for breakfast, so they can take advantage of tax loss harvesting opportunities that would be too cumbersome for a human to bother with.

Answer 2

You also may want to consider how this interacts with the stepped up basis of estates. If you never sell the stock and it passes to your heirs with your estate, under current tax law the basis will increase from the purchase price to the market price at the time of transfer.

In a comment, you proposed:

Thinking more deeply though, I am a little skeptical that it's a free lunch: Say I buy stock A (a computer manufacturer) at $100 which I intend to hold long term. It ends up falling to $80 and the robo-advisor sells it for tax loss harvesting, buying stock B (a similar computer manufacturer) as a replacement. So I benefit from realizing those losses. HOWEVER, say both stocks then rise by 50% over 3 years. At this point, selling B gives me more capital gains tax than if I had held A through the losses, since A's rise from 80 back to 100 would have been free for me since I purchased at 100.

And then later thought

Although thinking even more (sorry, thinking out loud here), I guess I still come out ahead on taxes since I was able to deduct the $20 loss on A against ordinary income, and while I pay extra capital gains on B, that's a lower tax rate. So the free lunch is $20*[number of shares]*([my tax bracket] - [capital gains rates])

That's true. And in addition to that, if you never sell B, which continues to rise to $200 (was last at $120 after a 50% increase from $80), the basis steps up to $200 on transfer to your heirs.

Of course, your estate may have to pay a 40% tax on the $200 before transferring the shares to your heirs. So this isn't exactly a free lunch either. But you have to pay that 40% tax regardless of the form in which the money is held. Cash, real estate, stocks, whatever. Whether you have a large or small capital gain on the stock is irrelevant to the estate tax.

This type of planning may not matter to you personally, but it is another aspect of what wealth management can impact.

Answer 3

Your assertion that you will not be selling anything is at odds with the idea that you will be doing tax loss harvesting. Tax loss harvesting always involves some selling (you sell stocks that have fallen in price and lock in the capital losses, which gives you a break on your taxes). If you absolutely prohibit your advisor from selling, then you will not be able to do tax loss harvesting (in that case, why are you using an advisor at all?).

Tax loss harvesting has nothing to do with your horizon nor the active/passive difference, really. As a practical matter, a good tax loss harvesting plan involves mechanically selling losers and immediately putting the money in another stock with more-or-less similar risk so your portfolio doesn't change much. In this way you get a stable portfolio that performs just like a static portfolio but gives you a tax benefit each year. The IRS officially prohibits this practice via the "wash sale rule" that says you can't buy a substantially identical asset within a short period of time. However, though two stocks have similar risk, they are not generally substantially similar in a legal sense, so the IRS can't really beat you in court and they don't try. Basically you can't just buy the same stock again.

The roboadvisor is advertising that they will perform this service, keeping your portfolio pretty much static in terms of risk, in such a way that your tax benefit is maximized and you don't run afoul of the IRS.

Answer 4

I wrote a detailed article on Tax Loss Harvesting to show the impact on returns.

For my example, I showed a person in the 15% bracket. In years with no loss, they trade to capture gains at 0% long term rate, thus bumping their basis up. In years with losses, they tax harvest for a 15% effective 'rebate' on that loss.

I showed how for the lost decade 2000-2009, a buy and hold would have returned -1% CAGR, but the tax loss harvester would have gained 1% (just 1% for the decade, not CAGR), ending the decade with no loss.

As one's portfolio grows, the math changes. You can only take $3000 capital loss against ordinary income, and my example relies on the difference between taking a gain for free but using a loss to offset income. Note, the higher earner would take gains at 15%, but losses at 25%, but only for the relatively small portfolio. The benefit for them is to use loss harvesting to offset gains, less so for ordinary income.

As the other answer state, Wealthfront can aid you to do this with no math on your part.