Please explain the mathematical benefit of tax loss harvesting

[Alex321]

This has probably been asked already, but I'm having a hard time getting my head around an answer. Is there a long-term benefit to tax loss harvesting for the index fund investor who is not selling any appreciated shares? If so, could you explain it?

Actually, could you please explain why my thinking is wrong here: If I have Widgetcorp that has gone from $10k to $20k, and I sell that, I owe 15% of the difference, so $1500. Now TLH is going to say that if I also own Megapharm that's dropped from $10k to $5k, I can sell that (presumably buy its competitor, Worldpharm, for the same value) and bring my net gain from $10k down to $5k so instead of owing $1500, I owe $750.

That's all fine and good, BUT I also just lowered my cost basis on the losing side from $10k down to $5k. So in a way, I didn't make any money, I just deferred a tax liability.  Is the argument in favor of this that it's a "free loan from the government"?

And furthermore, to my original question, if I'm not really looking to sell either, what good is any of this? I'm really trying to fundamentally understand the Betterment argument.

[Tremeroy]

... So in a way, I didn't make any money, I just deferred a tax liability.  Is the argument in favor of this that it's a "free loan from the government"?

And furthermore, to my original question, if I'm not really looking to sell either, what good is any of this? I'm really trying to fundamentally understand the Betterment argument.

There are a few reasons that tax-loss harvesting could be beneficial.

• Each year, a person may deduct up to $3,000 ofnet capital losses from one's AGI.
• As you know, there are a fair number of tax-code provisions that phase out as AGI increases.
• Tax-loss harvesting negates taxable income.
• First, any capital gains are excluded from income (often a 15% savings)
• Next, ordinary income, which is usually taxed at a higher rater than capital gains, is offset (up to the $3,000 maximum)
• These benefits generally carry down to state-level income taxation as well

I will say, your way of thinking is somewhat correct—it is trading non-taxation today for more taxation tomorrow, which is effectively a government loan. But, more importantly, you can trade 15%-39% taxation today for 15% taxation tomorrow.

[Chuck]

But, more importantly, you can trade 15%-39% taxation today for 15% taxation tomorrow.

This is the key portion right here.

Just like Trad IRAs and 401ks, the presumption is that you will be taxed at a lower rate later (with less income) than you are now. For most people (particularly people with enough taxable assets to ask) this is absolutely true and can save you quite a bit of money.

[Interest Compound]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

[seattlecyclone]

Good points have been made so far. If you have a net capital loss, that can be good for your current year taxes in a number of ways: this loss (up to $3,000) is deducted from your regular income at your regular tax rate (likely higher than your capital gains rate). It also lowers your AGI, which may improve your ability to qualify for certain deductions and tax credits (traditional IRA deduction, ACA premium reimbursement, child tax credit, saver's credit, student loan deduction, and more). Aim for a net loss of $3,000 each year (including amounts carried over from previous years) to maximize your benefit here.

There are some other long-term reasons why you might want to trade a tax break now for a deferred tax liability later. If you die while still owning the shares, your heirs will receive them with a cost basis equal to the fair market value on the date of your death. If you harvested losses along the way and invested the tax savings, your heirs will receive those shares resulting from the tax savings, and nobody will ever have to pay taxes on the gains in the intervening years. If you plan to do some charitable giving, you get to deduct the full current value of any long-term shares you donate. Your cost basis doesn't matter here. Harvesting losses and reinvesting the tax savings means you will have more shares in your account and will not be paying tax on any of the gains for the shares you donate.

Even if the tax rate is exactly the same for the capital loss as it is for the future capital gain, harvesting your losses and reinvesting the tax savings can be quite beneficial.

Assume you're in the 15% tax bracket now and forever, for all types of income. Suppose you bought 100 shares of a particular fund at $20/share ($2,000 total investment), but the share price has since gone down to $10. If you do nothing now, waiting to sell until you're retired and need to withdraw some of your money, If you harvest your losses, you'll get $1,000 from the sale of your shares and will also lower your tax burden by $150 (15% of the $1,000 loss). Invest that $1,150 in a very similar but slightly different fund to avoid wash sales. If the price goes up to $40 by the time you retire and want to get your money out, the gross value of your shares will have risen to $4,600. Your cost basis is now $1,150, giving you a $3,450 capital gain. You pay 15% of this gain ($517.50), leaving you with $4,082.50 after taxes. What if you didn't harvest losses and just held on to your original shares? You would have shares worth $4,000 gross, with a $2,000 capital gain. After paying your $300 in tax, you're left with $3,700. Harvesting losses leaves you with about 10% more money in this scenario, with constant tax rates. You do much better than this when your tax rate goes down during retirement.

[Tyler]

Also, don't forget that (at least on a federal level) tax losses can be carried over indefinitely.  So you can use losses this year to offset $3k in income, and save the rest to offset capital gains years from now.  If you have multiple uncorrelated assets, you have a decent opportunity to harvest losses pretty regularly and avoid capital gains taxes for quite a long time.  It requires diligent tracking, but Turbotax does this pretty seamlessly. 

[mr_orange]

Making money is good.  Your goal is to maximize your after-tax profits; not minimize your taxes.  Selling investments to offset gains elsewhere in your portfolio seems like biting off your nose to spit the IRS to me. 

The best investors are interested in holding their investments forever and thus would not worry about a temporary dip in what the market is willing to pay for small pieces of the company.  I'm not sure how applying taxation principles to this philosophy would change it any. 

[tj]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

So the optimal thing would be to transfer specific lots out of Betterment after 3 years or so.

[seattlecyclone]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

So the optimal thing would be to transfer specific lots out of Betterment after 3 years or so.

The optimal thing would be to harvest losses yourself. It really isn't hard.

[tj]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

So the optimal thing would be to transfer specific lots out of Betterment after 3 years or so.

The optimal thing would be to harvest losses yourself. It really isn't hard.

I would have missed the losses that Betterment harvested for me this year, but also may have booked larger losses on my own. Impossible to know.

It's not that it's "hard", I just have no interest in monitoring my finances on a daily basis.

[bryan]

Making money is good.  Your goal is to maximize your after-tax profits; not minimize your taxes.  Selling investments to offset gains elsewhere in your portfolio seems like biting off your nose to spit the IRS to me. 

The best investors are interested in holding their investments forever and thus would not worry about a temporary dip in what the market is willing to pay for small pieces of the company.  I'm not sure how applying taxation principles to this philosophy would change it any.

Well, after-tax profits are directly dependent on how much you pay in taxes ;) It's a good idea to avoid all costs, taxes included (now or later).

Allegedly you can TLH and always be invested (though, I don't think you can do swaps atomically with stocks... but practically market buy/sell should be okay for liquid assets..).

[seattlecyclone]

I would have missed the losses that Betterment harvested for me this year, but also may have booked larger losses on my own. Impossible to know.

It's not that it's "hard", I just have no interest in monitoring my finances on a daily basis.

You don't need to monitor daily. You'll do all right checking once or twice a year and harvesting any losses that you see then. Check monthly and you'll have an opportunity to do a little bit better. Checking daily will be slightly better still, but you're really getting into diminishing returns territory there. If you're not in the withdrawal phase, the benefit you can get from harvesting losses maxes out at ($3,000 * your tax rate) per year. However as your portfolio grows, the amount you can pay to these robo-advisors will also grow.

If you're just getting started and have a $40k portfolio, you might rationally decide that a $100 management fee (Betterment's 0.25% fee for that asset level) is totally worth the convenience of having your investments rebalance themselves and harvest losses themselves. But as your portfolio grows, the fee grows with it. Why does this make sense? It really isn't any harder to manage a $1 million portfolio than it is to manage a $40,000 portfolio.

[Alex321]

All these responses have been very helpful, so thank you.

This is something I had not thought of at all:

"When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase."

The taxable portion of my portfolio is around $500k, and that's been built up over the bull market over the past few years, so there's taxable gain liability in there. Every cent of it is in VTCLX, which I feel does a good job keeping the dividends low and qualified. So "nuking this out" (old Navy expression), if the Betterment premium is an additional 0.25%, that's $1,250 per year, if I gave them control of everything, starting now and rising over time. That wipes out the benefit of a $3,000 deduction against ordinary income. But I think what would be more significant is that I would have to pay capital gains taxes to do the transfer, and that would be something like $15,000. Giving up that "free loan" I'm currently carrying, 7%, yadda yadda, is foregoing another $1,050 per year.

I suppose two possible alternatives would be to either transfer a much smaller amount to Betterment, or to simply direct future investments there.

In my mind, it seems that the tax benefits/free loan of deferring taxes should at least be very competitive with the idea of tax loss harvesting, but they're mutually exclusive. You have to pick one or the other. Here's where I get my mindset of the tax benefits of never, ever selling:

http://beginnersinvest.about.com/od/capitalgainstax/a/Using-Deferred-Taxes-To-Increase-Your-Investment-Returns.htm

If they are indeed two similar options, then it would seem that the one with more simplicity and lower fees would win out most of the time. Because I'm also concerned with the idea that TLH is in the habit of selling something when it's down specifically because it's down. Yeah, I know, you can buy something that's supposed to represent the same value, but is that really what you're doing? Maybe.

You can probably see that I'm trying to justify making no changes whatsoever. I just want to feel like it's a mathematically sound decision, and not just one based on inertia and my own stubbornness.

[Scandium]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

So the optimal thing would be to transfer specific lots out of Betterment after 3 years or so.

The optimal thing would be to harvest losses yourself. It really isn't hard.

I would have missed the losses that Betterment harvested for me this year, but also may have booked larger losses on my own. Impossible to know.

It's not that it's "hard", I just have no interest in monitoring my finances on a daily basis.

Yeah I thought it wasn't hard, and it isn't really. But I (tried) to harvest some losses in VTSAX and VTIAX in my taxable, easy enough. But then realized that I buy VTIAX in my 401k every 2 weeks! It also has the S&P and the extended market fund, which together might be considered the same as VTSAX. And I have reinvest dividends on both there an in my taxable. AND i have an auto-transfer into the same two funds in taxable every month which I forgot to skip once. So it's totally in violation of wash sale rules!

Even if I had my taxable with betterment the 401k funds would violate the rules as well, and I have reinvest dividends in my Roth account too. Maybe if you have every account with Betterment they could take care of it all. But right now I'm starting to think it's not worth it, at least not at this point.

[Alex321]

It does sound like a recipe for IRS audit disaster down the line, especially for those of us who have chosen not to FIRE but to keep adding, the totals could become substantial enough to start attracting a little bit of scrutiny.

[Interest Compound]

You seem to have it down. If you're trying to understand the Betterment argument, all you have to do is calculate the expected gain of tax loss harvesting, and compare it to the expected loss with Betterment's higher fees.

When doing the calculation, remember, tax loss harvesting on any single purchase (tax lot) can only happen when the market dips below the original purchasing price. Since the stock market typically rises over time, your ability to tax loss harvest is usually limited to the first 1-3 years after purchase.

Do the math and let us know your results! You aren't the only one having trouble with this calculation, so seeing it done with real numbers will be interesting for us all :)

So the optimal thing would be to transfer specific lots out of Betterment after 3 years or so.

The optimal thing would be to harvest losses yourself. It really isn't hard.

I would have missed the losses that Betterment harvested for me this year, but also may have booked larger losses on my own. Impossible to know.

It's not that it's "hard", I just have no interest in monitoring my finances on a daily basis.

Yeah I thought it wasn't hard, and it isn't really. But I (tried) to harvest some losses in VTSAX and VTIAX in my taxable, easy enough. But then realized that I buy VTIAX in my 401k every 2 weeks! It also has the S&P and the extended market fund, which together might be considered the same as VTSAX. And I have reinvest dividends on both there an in my taxable. AND i have an auto-transfer into the same two funds every month which I forgot to skip once. So it's totally in violation of wash sale rules!

Even if I had my taxable with betterment the 401k funds would violate the rules as well, and I have reinvest dividends in my Roth account too. Maybe if you have every account with Betterment they could take care of it all. But right now I'm starting to think it's not worth it, at least not at this point.

Yea, if you're just talking about dividends, that's not a big deal. But tax loss harvesting with an automated service in a taxable account gets complicated come tax time when you're already maxing out your 401k/IRA each year. To properly take advantage of it, you need to switch out your investments in the 401k/IRA, which has the potential to increase your overall ER since most 401k's don't have many good options.

[Tremeroy]

The best investors are interested in holding their investments forever and thus would not worry about a temporary dip in what the market is willing to pay for small pieces of the company.  I'm not sure how applying taxation principles to this philosophy would change it any.

The only tax-loss harvesting that I would engage in relates to index funds /  ETFs with substantially similar risk profiles. E.g., when I tax-loss harvest specific lots of VTI (Vanguard Total Stock Market Index), I would invest the cash proceeds in a new VOO (S&P 500 Index) position. The risk profiles of the two funds are similar, but the actually holdings are quite different, so it would stand up to any IRS scrutiny.

Also, if you are contemplating manual harvesting, do not forget to weigh the benefits against any transaction costs.

[Trudie]

... So in a way, I didn't make any money, I just deferred a tax liability.  Is the argument in favor of this that it's a "free loan from the government"?

And furthermore, to my original question, if I'm not really looking to sell either, what good is any of this? I'm really trying to fundamentally understand the Betterment argument.

There are a few reasons that tax-loss harvesting could be beneficial.

• Each year, a person may deduct up to $3,000 ofnet capital losses from one's AGI.
• As you know, there are a fair number of tax-code provisions that phase out as AGI increases.
• Tax-loss harvesting negates taxable income.
• First, any capital gains are excluded from income (often a 15% savings)
• Next, ordinary income, which is usually taxed at a higher rater than capital gains, is offset (up to the $3,000 maximum)
• These benefits generally carry down to state-level income taxation as well

I will say, your way of thinking is somewhat correct—it is trading non-taxation today for more taxation tomorrow, which is effectively a government loan. But, more importantly, you can trade 15%-39% taxation today for 15% taxation tomorrow.

Best summary I've heard so far... makes it simple.  And I might add, this assumes that you're not getting out of the market, but reinvesting right away into something that's not a wash sale.