Robo-Advisor Magic: The Easy Way to Cut Your Taxes!

Discover how to leverage your robo-advisor for tax savings through tax-loss harvesting (TLH) within your robo-advisor account. Tax-loss harvesting is a strategic approach to tax planning aimed at reducing your tax liability. If your investment brokerage account contains both taxable gains and losses, you have the opportunity to sell the depreciating securities, utilizing those losses to counterbalance the taxable gains.

Leading robo-advisors streamline tax-loss harvesting, saving you both time and money. The finest low- or no-fee robo-advisors adeptly oversee your investment portfolio, allowing you to retain more of your funds rather than relinquishing them to taxes. We’ll outline tax-loss harvesting guidelines, caution against common pitfalls, and showcase the top robo-advisors offering this feature.

Explaining Tax-Loss Harvesting

Tax-loss harvesting is a financial strategy aimed at reducing taxes to enhance your post-tax earnings legally. In taxable accounts, investors sell assets below their purchase price, generating a taxable loss that can offset taxes on gains from profitable investments. While some robo-advisors automatically conduct tax-loss harvesting, others may not provide this service.

How Does Tax-Loss Harvesting Function?

1. Sell an investment at a value lower than its purchase price.
2. Compute the total loss and categorize it as either a short-term loss (for investments held for less than a year) or a long-term loss.
3. Short-term losses must first offset short-term gains, while long-term losses must first offset long-term gains.

1.Sell an investment at a value lower than its purchase price.

When you invest in stocks, bonds, mutual funds, or other securities, you purchase them at a certain price, often referred to as the “purchase price” or “cost basis.” This is the amount you pay to acquire the investment. Over time, the value of the investment may fluctuate due to various factors such as market conditions, economic trends, company performance, etc.

If the value of your investment decreases below the original purchase price, you may decide to sell it. When you sell the investment at a price lower than what you paid for it, you incur a loss. This loss is calculated by subtracting the selling price from the purchase price.

For example, let’s say you bought shares of a company for $50 each, investing a total of $1,000. If the value of those shares later drops to $40 each, and you decide to sell them, you would incur a loss of $10 per share ($50 purchase price – $40 selling price). If you sold all your shares at this price, your total loss would be calculated by multiplying the loss per share ($10) by the total number of shares sold.

Selling an investment at a value lower than its purchase price is a fundamental aspect of tax-loss harvesting, as it allows investors to realize losses that can be used to offset taxable gains and potentially reduce their overall tax liability.

2. Compute the total loss and categorize it as either a short-term loss (for investments held for less than a year) or a long-term loss.

1. Compute the Total Loss: To calculate the total loss incurred from selling an investment below its purchase price, you simply subtract the selling price from the purchase price. For instance, if you purchased shares of a stock for $1,000 and sold them for $800, the total loss would be $200 ($1,000 – $800).
2. Categorize as Short-Term or Long-Term Loss: Short-Term Loss: This applies to investments that were held for one year or less before being sold. If you sell an investment that you’ve owned for less than a year at a loss, it is considered a short-term loss. Long-Term Loss: Conversely, if you sell an investment that you’ve held for more than one year at a loss, it is categorized as a long-term loss. Investments held for longer than one year are considered long-term investments for tax purposes.It’s important to distinguish between short-term and long-term losses because they are taxed differently:
   • Short-term losses are typically used to offset short-term gains first.
   • Long-term losses are usually used to offset long-term gains first.
3. By categorizing the loss as either short-term or long-term, investors can strategically utilize these losses to offset taxable gains in a way that minimizes their overall tax liability. This process is an essential aspect of tax planning and portfolio management for investors looking to optimize their after-tax returns.

3. Short-term losses must first offset short-term gains, while long-term losses must first offset long-term gains.

1. Short-Term Losses and Gains:
   • Short-term losses are those incurred from investments held for one year or less before being sold.
   • Short-term gains are profits earned from selling investments held for one year or less.
2. Long-Term Losses and Gains:
   • Long-term losses result from selling investments held for more than one year.
   • Long-term gains are profits earned from selling investments held for more than one year.

Now, regarding how these losses can offset gains:

• Short-term Losses Offset Short-term Gains: When you have both short-term losses and short-term gains in your investment portfolio, the IRS requires that you first use your short-term losses to offset any short-term gains. This means that if you have $1,000 in short-term losses and $800 in short-term gains, you can use the losses to offset the gains entirely, resulting in a net taxable gain of $0.
• Long-term Losses Offset Long-term Gains: Similarly, if you have both long-term losses and long-term gains, the IRS mandates that you utilize your long-term losses to offset any long-term gains first. For example, if you have $500 in long-term losses and $600 in long-term gains, you can use the losses to offset the gains entirely, leaving you with a net taxable gain of $100.

If, after offsetting gains with losses, you still have losses remaining or if you don’t have gains to offset, you may be able to use those remaining losses to offset gains of the other type. For example, if you have remaining short-term losses after offsetting short-term gains, you could use them to offset long-term gains, and vice versa.

Understanding these rules is crucial for investors engaged in tax planning, as it allows them to optimize their tax liabilities and potentially reduce their overall tax burden. By strategically utilizing losses to offset gains, investors can maximize their after-tax returns.

Once all short-term gains are balanced out by short-term losses and long-term gains are counteracted by long-term losses, any remaining losses can be applied to offset ordinary income. Single filers and married couples filing jointly can deduct up to $3,000, while married individuals filing separately can deduct up to $1,500. Any unused losses can be carried forward to subsequent tax years for utilization.

A key consideration in tax-loss harvesting is the wash-sale rule, which poses a limitation. According to IRS regulations, investors must refrain from acquiring the same stock, fund, or a substantially identical security that was sold within a 30-day timeframe in order to reap the tax advantages of tax-loss harvesting.

An instance of violating the wash-sale rule would be if a trader sells their Class A shares of Nike and then promptly purchases Class B shares of Nike within the 30-day window. To preserve the benefits of tax-loss harvesting and continue investing in similar securities, it’s advisable to select a replacement asset that is moderately different. For instance, if you sell shares of Procter and Gamble at a loss, you could consider purchasing a consumer products sector fund as a replacement. This approach allows you to maintain a comparable asset mix while sidestepping the wash-sale rule.

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How to Utilize Tax-Loss Harvesting Using a Robo-Advisor

A robo-advisor, which oversees your investments at minimal or no cost, can streamline the process of tax-loss harvesting, ensuring that your portfolio is optimized for maximum returns. By investing through a robo-advisor that offers tax-loss harvesting within a taxable, non-retirement account, you can simply click a button and let the digital investment manager handle the intricacies.

While it’s possible to manage your investments independently and sell underperforming assets to counterbalance capital gains, this approach is time-intensive and demands a certain level of investment and tax knowledge.

Here are the steps you should take:

1. Assess Your Need for Tax-Loss Harvesting: If you have a taxable investment account managed by a robo-advisor, you’ll be subject to taxes on any net capital gains resulting from selling funds or individual assets. To reduce or eliminate this tax liability, consider selecting a robo-advisor that offers tax-loss harvesting. This strategy is particularly beneficial for investors with taxable investment accounts.
2. Choose the Right Robo-Advisor: Not all robo-advisors provide tax-loss harvesting, and some, like Schwab Intelligent Portfolios, may require a minimum investment amount to access this feature. For instance, at Schwab Intelligent Portfolios, tax-loss harvesting is available for accounts with a minimum value of $50,000. If you’re interested in robo-advisory services for a taxable account, ensure that the provider offers tax-loss harvesting. Consider platforms like Betterment, which offer cost-effective services with tax-loss harvesting features.
3. Open the Appropriate Robo-Advisor Account: Many robo-advisors offer individual or joint taxable investment brokerage accounts, which can benefit from tax-loss harvesting. Additionally, most trust accounts are eligible for tax-loss harvesting. Note that tax-loss harvesting doesn’t provide any advantages in traditional or Roth IRAs, as gains and losses in retirement accounts are not subject to taxation.
4. Activate the Tax-Loss Harvesting Feature: Tax-loss harvesting may be either automatic or manually activated. If it’s automatic, all taxable robo-advisor accounts typically receive tax-loss harvesting. Alternatively, for optional tax-loss harvesting, there may be a designated button to indicate your preference. Refer to the FAQ section to learn how to enable this service.
5. Monitor Your Portfolio: Whether you manage your investments independently or with a robo-advisor, it’s essential to regularly review your portfolio. Check several times a year to ensure that your asset allocation aligns with your initial preferences. Confirm that any transfers have been executed and verify that your balance and returns correspond with the movements of portfolio benchmarks. For example, the returns of your S&P 500 ETF should closely resemble those of the S&P 500 benchmark.

Robo-Advisors Offering Tax-Loss Harvesting Given the complicated nature of tax-loss harvesting, many investors find it advantageous to enlist the services of a robo-advisor to optimize the tax efficiency of their investment strategies. The top robo-advisors typically include tax-loss harvesting as part of their offerings without any additional fees. Here are some options for investors to consider:

Wealthfront: Wealthfront, one of the oldest robo-advisors, automatically enrolls clients in its tax-loss harvesting program when they open a taxable investment account. They claim that the benefits of tax-loss harvesting usually outweigh the low 0.25% investment management fee.

Betterment: Similar to Wealthfront, Betterment provides automatic tax-loss harvesting for its clients. All proceeds from tax-loss harvesting are reinvested into the investment portfolio to enhance investment returns and growth. There’s no minimum investment required, and new investors can start with just $10.

Schwab Intelligent Portfolios: With Schwab Intelligent Portfolios, investors need a minimum investment of $5,000 for the fee-free digital portfolio or $25,000 for the Premium service. Tax-loss harvesting is available for accounts with a value exceeding $50,000 of investable assets.

Wells Fargo Intuitive Investor: Account holders at Wells Fargo Intuitive Investor can activate tax-loss harvesting for all taxable accounts. This feature can be easily toggled on or off in the account settings.

Vanguard Digital Advisor: Both Vanguard Digital Advisor and Vanguard Personal Advisor offer tax-loss harvesting, although activation is required. Investors must request activation, and for the Personal Advisor option, discussion with a financial advisor is necessary. Once approved, investors need to sign documents authorizing Vanguard to commence tax-loss harvesting.

Pros:

1.Tax-loss harvesting provides investors with the opportunity to decrease their tax liability on the capital gains generated within their investment portfolios.

2.Reinvesting the proceeds from tax-loss harvesting can lead to higher compounded long-term investment returns.

3.Tax-loss harvesting allows investors to capitalize on market volatility by selling underperforming assets during market downturns and reinvesting the proceeds in similar assets at lower prices, potentially yielding higher long-term returns.

Cons:

1.High fees paid to investment managers can offset the benefits of tax-loss harvesting.

2.The effectiveness of tax-loss harvesting depends on current tax rates compared to uncertain future tax rates.

3.For individuals, managing their own tax-loss harvesting requires a certain level of investment management expertise and oversight.

Is Tax-Loss Harvesting Beneficial?

In many instances, the advantages of tax-loss harvesting within a taxable investment account outweigh the drawbacks. Reinvesting the proceeds into the investment markets often leads to an enhancement in overall returns through compounding and growth. However, novice self-directed investors may find the tax-loss harvesting process challenging and complex to execute.

When Is the Optimal Time for Tax-Loss Harvesting?

The prime time for tax-loss harvesting usually falls in the autumn or towards the end of the year. During this period, investors can evaluate both short- and long-term gains from funds and individual assets they intend to sell. Armed with this information, they can strategically choose assets with losses to sell in order to counterbalance the gains.

Nevertheless, investors can explore tax-loss harvesting opportunities at any point during the year. It’s essential, however, not to allow tax considerations alone to dictate investment decisions. Prioritize your overall strategy before selling assets solely to leverage tax-saving benefits.

Can Tax-Loss Harvesting Offset Regular Income?

Yes, tax-loss harvesting has the ability to offset regular income once losses have initially offset both short- and long-term taxable gains. In a single year, the maximum limit for utilizing tax-loss harvesting to offset regular income is $3,000. Any additional losses beyond this amount can be carried over to future years for deduction.

In Summary Studies have indicated that consistent and well-executed tax-loss harvesting can potentially enhance long-term investment returns. Given the expertise and time required for this process, entrusting tax-loss harvesting to a low-cost robo-advisor like Wealthfront or Betterment may be a prudent decision. Wealthfront asserts that the benefits of tax-loss harvesting often outweigh the minimal investment management fee.

While utilizing tax-loss harvesting with a robo-advisor in a brokerage or non-retirement account is typically advisable, self-directed investors may encounter challenges. Individual investors must actively monitor their investments to identify harvestable tax losses. Additionally, expertise is necessary to select suitable replacements for sold assets and avoid violating the wash-sale rule. Furthermore, there’s a risk of selling an asset after a short-term decline, only to witness its value increase afterward, potentially nullifying the short-term benefits of tax-loss harvesting. Before initiating a tax-loss harvesting program, consulting with an accountant is recommended.

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