Author Topic: Very Confused About Tax Loss Harvesting (Wealthfront Direct Index Investing)  (Read 4044 times)

Singuy

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I have done a lot of research but I am still confused about some of the aspect of the TLH provided by wealthfront direct indexing.

My household income bracket is 33% with no state income tax.

I want to use wealthfront and join their direct indexing program thinking it's probably a good idea for my income tax bracket and the 0.25% point is discounted since I don't have to pay the vanguard fee for index funds. I figure TLH can make up the difference.

I understand the concept of netting..but where I am confused is this.

If a stock is not sold within the year, then any gains will not be subjected to taxes correct?
So with TLH, the robo will just sell individual stocks from the direct index that have lost money and leave the ones that have gained in value alone or is there a mandatory netting and I can only harvest the tax loss if my net ends up in the negatives?

Also please comment if wealthfront direct indexing is worth it for me. Eventually the account will be a million after 4 years.

seattlecyclone

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If a stock is not sold within the year, then any gains will not be subjected to taxes correct?

The current federal long-term gains rate is 0% only for people whose regular income bracket is 15% or lower. In your current tax bracket, the capital gains tax would be 15%, plus 3.8% for any amount of this income that puts your total income over $200k (for a single person) or $250k (for a married couple).

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So with TLH, the robo will just sell individual stocks from the direct index that have lost money and leave the ones that have gained in value alone or is there a mandatory netting and I can only harvest the tax loss if my net ends up in the negatives?

There's no law requiring them to sell any stocks that have gains in order to offset losses. Net losses are just fine, but capped at $3,000 per year, with any remainder carrying over to the next year. My understanding is Wealthfront won't sell the winners unless you want to reduce your overall stock holdings.

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Also please comment if wealthfront direct indexing is worth it for me. Eventually the account will be a million after 4 years.

The thing about tax loss harvesting in general is that the market trends upwards. Perhaps some of your shares will go down within a few years after you buy them, and that will be a good opportunity to harvest losses. This does provide a real benefit. Because the market trends upwards, there's only so much harvesting you can do on a particular position. Eventually you will have harvested losses at the bottom, and the price will never go down to that level again. Therefore as you add more money over the years, you should expect that an increasing fraction of your taxable portfolio will never be eligible for loss harvesting again. However you still have to pay Wealthfront their 0.25% per year to hold this money for you.

Also since they hold your money in the form of hundreds of individual stocks, it's not really reasonable to transfer the shares out in kind and manage them yourself. It's technically possible, but way too much hassle. So if you go this route, you're basically stuck with them until you're willing to liquidate your entire portfolio and pay whatever taxes are due.

Just something to consider.

Singuy

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If a stock is not sold within the year, then any gains will not be subjected to taxes correct?

The current federal long-term gains rate is 0% only for people whose regular income bracket is 15% or lower. In your current tax bracket, the capital gains tax would be 15%, plus 3.8% for any amount of this income that puts your total income over $200k (for a single person) or $250k (for a married couple).

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So with TLH, the robo will just sell individual stocks from the direct index that have lost money and leave the ones that have gained in value alone or is there a mandatory netting and I can only harvest the tax loss if my net ends up in the negatives?

There's no law requiring them to sell any stocks that have gains in order to offset losses. Net losses are just fine, but capped at $3,000 per year, with any remainder carrying over to the next year. My understanding is Wealthfront won't sell the winners unless you want to reduce your overall stock holdings.

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Also please comment if wealthfront direct indexing is worth it for me. Eventually the account will be a million after 4 years.

The thing about tax loss harvesting in general is that the market trends upwards. Perhaps some of your shares will go down within a few years after you buy them, and that will be a good opportunity to harvest losses. This does provide a real benefit. Because the market trends upwards, there's only so much harvesting you can do on a particular position. Eventually you will have harvested losses at the bottom, and the price will never go down to that level again. Therefore as you add more money over the years, you should expect that an increasing fraction of your taxable portfolio will never be eligible for loss harvesting again. However you still have to pay Wealthfront their 0.25% per year to hold this money for you.

Also since they hold your money in the form of hundreds of individual stocks, it's not really reasonable to transfer the shares out in kind and manage them yourself. It's technically possible, but way too much hassle. So if you go this route, you're basically stuck with them until you're willing to liquidate your entire portfolio and pay whatever taxes are due.

Just something to consider.

Is that 3000 dollars worth of net losses meaning at my tax bracket, I get to save 33% x 3000 max?

Also I feel like I can hit this number yearly even during the later years since I am doing dollar cost averaging direct deposits of about 200k/year. I'm sure the robo can find something to harvest from hundreds of stocks. Once the

So if I am taxed at  capital gain later in life when I decide to retire, but harvest and get 33% deducted from the loss, I see a win win for me or am I missing something?

Also it looks like Vanguard charges 0.16% in fees for their vanguard 500..and wealthfront charges 0.25% for direct indexing..seems like I am just paying an extra 0.09% and am sure to make it back from just the tax savings alone.

Please let me know if this is all wishful thinking and I'm missing something.

« Last Edit: May 21, 2016, 06:12:39 PM by Singuy »

seattlecyclone

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Is that 3000 dollars worth of net losses meaning at my tax bracket, I get to save 33% x 3000 max?

Yes, if you have a net capital loss it counts against regular income, so max of 33% x $3,000 for you.

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Also I feel like I can hit this number yearly even during the later years since I am doing dollar cost averaging direct deposits of about 200k/year. I'm sure the robo can find something to harvest from hundreds of stocks.

Yes, they'll probably find something among those hundreds of stocks. Keep in mind that your fees will increase every year as you add more money, but the amount you can deduct is strictly limited to that $3,000 times your tax rate at that time.

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So if I am taxed at  capital gain later in life when I decide to retire, but harvest and get 33% deducted from the loss, I see a win win for me or am I missing something?

Harvesting losses to defer taxes on your eventual gains can be beneficial even if the tax rate for the harvested loss is the same as the tax rate for the eventual gain. If the gain is taxed at a lower rate it's even better.

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Also it looks like Vanguard charges 0.16% in fees for their vanguard 500..and wealthfront charges 0.25% for direct indexing..seems like I am just paying an extra 0.09% and am sure to make it back from just the tax savings alone.

The 0.16% is only for the Investor shares version. Once you get $10,000 invested you qualify for Admiral shares which only charge 0.05%. So you're paying a 0.2% cost difference, for a potential benefit of $1,000 per year. Even if you assume you would harvest $0 in losses if you invested yourself and $3,000 each year under Wealthfront, Wealthfront becomes more expensive when your investments cross the $500k mark.

There's no magic in harvesting losses either. I harvested several thousand worth this January when the market took a brief dip. You just have to look at your account once in a while to see if anything is worth less than it was when you bought it. Now the opportunities to do this are a bit more limited when you own index funds instead of individual stocks because you need the whole market to go down rather than a few individual stocks out of hundreds, but you can still do it.

That said, Wealthfront is a great alternative to traditional financial advisors that charge you 1% to invest in funds that have high fees of their own. If you really feel a need to pass the responsibility for your investments over to someone else, Wealthfront is one of the better ones.

MustacheAndaHalf

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If you expect to have a million within years, you should qualify for Admiral class shares of S&P 500 very quickly, and that has an expense ratio of 0.05% per year.

I'd also like to reinforce a point seattlecyclone made: capital losses become less likely over time.  Maybe you gain 6% per year, and worry about a -24% loss.  Well, after 4 years of gains give you +26% (6% compounded 4 years).  If you take a -24% loss, you're still above your purchase price - it's not a taxable loss.

Singuy

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If you expect to have a million within years, you should qualify for Admiral class shares of S&P 500 very quickly, and that has an expense ratio of 0.05% per year.

I'd also like to reinforce a point seattlecyclone made: capital losses become less likely over time.  Maybe you gain 6% per year, and worry about a -24% loss.  Well, after 4 years of gains give you +26% (6% compounded 4 years).  If you take a -24% loss, you're still above your purchase price - it's not a taxable loss.

I think what you are saying is once my stocks are switched to a lower basis point after harvesting the tax loss, it's most unlikely to harvest again in the future because there's no where to go but up.

I understand this point, but because I am constantly purchasing new stocks(or the same stocks) at different price points bi-weekly, I am pretty sure no matter when I harvest, I should always see losses or does it not work that way?

Say Stock A I bought it at 100 shares at 8 dollars...next week it goes up to 10..I buy another 100 shares at 10 dollars..then it goes down to 9 dollars..can I harvest a loss of the second portion of that 100 shares I bought at 10 or not?

seattlecyclone

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Say Stock A I bought it at 100 shares at 8 dollars...next week it goes up to 10..I buy another 100 shares at 10 dollars..then it goes down to 9 dollars..can I harvest a loss of the second portion of that 100 shares I bought at 10 or not?

You can harvest the losses on the second group of 100 shares. The point is that now you're paying management fees for 200 shares but are only able to benefit from their loss harvesting service on 100 shares. Then in a year you might be paying management fees for 1,000 shares but only able to benefit from loss harvesting service on 100 of them, and so on. The management fee you pay scales up with your overall holdings, while the amount of loss harvesting you can do is related to your recent contributions. At some point the cost will surpass the benefit. At that point you're really stuck because you own 500 different appreciated stocks that are too much of a hassle to manage yourself, but too expensive to liquidate in favor of simpler mutual funds.

forummm

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Cyclone always gives great advice. I agree with him. Like most people, you'll generally be better off just leaving your money in Vanguard in their 0.05% ER admiral funds.

MustacheAndaHalf

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If you feel it's worth the trouble, you could manage two accounts:

1. Your betterment account where you make new purchases.  Recent purchases can be tax loss harvested as you say.
2. After a number of years, transfer stocks over to Vanguard when their cost basis becomes high enough that tax loss harvesting is unlikely.  (I'm not sure if Vanguard will have your cost basis of the original purchase - you might need to track it yourself)

Technically yes new purchases can be tax loss harvested.  But while the bulk of your account grows beyond where tax loss harvesting is likely, it also grows larger than your annual contributions.  If you're worried about each detail and optimizing, why are you paying 0.25% just to have Betterment manage details?

Vanguard's S&P 500 and Total Stock Market both have 0.05% expense ratios, compared to Betterment's 0.25% annual expense.  Come to think of it, I don't believe Betterment "absorbs" the expense ratio - that makes no sense.  An expense ratio is charged to the assets of a fund internally, without approval of any kind.  Nobody outside the fund can stop the expense ratio or pay it themselves.  So at Betterment, you're looking at 0.25% plus the expense ratio.

On $1 million, the 0.25% expense ratio means an extra $2,500 / year in fees.  How many hours would it take you to do tax loss harvesting yourself?  Let's say you check twice a year, and you sell S&P 500 and buy Total Stock Market to realize losses.  Takes a few minutes, but let's say it takes 2 hours.  So for about 4 hours work a year you save $2500 in fees, or roughly $600 / hour of effort.  And if you get used to it, it would take less time, so $800 / hour or $1200 / hour could be achievable.  I think you can save a lot by doing the Betterment work yourself.

But if you go with Betterment anyways, it's extremely unlikely they are absorbing the expense ratio for your funds.  You are paying an additional 0.25%, in addition to the fund quietly having it's own expenses.
« Last Edit: May 22, 2016, 09:39:22 AM by MustacheAndaHalf »

Singuy

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If you feel it's worth the trouble, you could manage two accounts:

1. Your betterment account where you make new purchases.  Recent purchases can be tax loss harvested as you say.
2. After a number of years, transfer stocks over to Vanguard when their cost basis becomes high enough that tax loss harvesting is unlikely.  (I'm not sure if Vanguard will have your cost basis of the original purchase - you might need to track it yourself)

Technically yes new purchases can be tax loss harvested.  But while the bulk of your account grows beyond where tax loss harvesting is likely, it also grows larger than your annual contributions.  If you're worried about each detail and optimizing, why are you paying 0.25% just to have Betterment manage details?

Vanguard's S&P 500 and Total Stock Market both have 0.05% expense ratios, compared to Betterment's 0.25% annual expense.  Come to think of it, I don't believe Betterment "absorbs" the expense ratio - that makes no sense.  An expense ratio is charged to the assets of a fund internally, without approval of any kind.  Nobody outside the fund can stop the expense ratio or pay it themselves.  So at Betterment, you're looking at 0.25% plus the expense ratio.

On $1 million, the 0.25% expense ratio means an extra $2,500 / year in fees.  How many hours would it take you to do tax loss harvesting yourself?  Let's say you check twice a year, and you sell S&P 500 and buy Total Stock Market to realize losses.  Takes a few minutes, but let's say it takes 2 hours.  So for about 4 hours work a year you save $2500 in fees, or roughly $600 / hour of effort.  And if you get used to it, it would take less time, so $800 / hour or $1200 / hour could be achievable.  I think you can save a lot by doing the Betterment work yourself.

But if you go with Betterment anyways, it's extremely unlikely they are absorbing the expense ratio for your funds.  You are paying an additional 0.25%, in addition to the fund quietly having it's own expenses.

I think we are talking about two different things. Betterment doesn't offer direct indexing so it's the management fees PLUS the vanguard expense ratio. Wealthfront offers direct indexing, meaning you literally own hundreds of stocks..basically as if you are buying the index fund individually. Advantages to this using Wealthfront is

1. You don't have to pay per trade fee..imagine the amount of money that will require for 100-500-1000 trades
2. You can tax loss harvest individual stocks vs the entire index..which has very high opportunity for harvest. 
3. Harvesting individual stocks will reset the "losers" into a lower basis point so higher potential for growth

I don't think betterment's robo auto balancing and the tax loss harvesting is worth the cost when you only have like 7 assets. That's very easy to harvest. But when it comes to hundreds of stocks..then it's not so easy to me anyways.

So a couple things I have to consider as cyclone points out.

At investing 200k/year of new stocks, I am 100% sure I can harvest 3k worth of losses every year. 3k worth of losses is worth about 1300 to me. At 0.25 fees, minus what vanguard would of charged me at 0.05%..I'll end up with 0.2% fees..meaning if my account is bigger than 650k, I'll end up paying for extra vs the vanguard account.
Eventually I feel that even if I stop putting in 200k/year ...the dividend reinvestment in itself can get me my 3k worth of tax harvest.
That being said..I also shouldn't overlook what that 1300 worth of savings can bring if I reinvest that.

But here's the thing..if it only takes me 2.5 years to hit 650k..which means I would have saved perhaps 2k worth in taxes(with fees already subtracted).  And then afterwards, I'll end up paying more than a vanguard admiral account.

So is resetting the individual stocks in a direct index fund to a lower basis point due to tax harvesting worth the fees?  I feel like this is worth something too..in which it's not something I can do with Vanguard index funds. Based on my tax bracket, I feel like the more I earn from my investment the better since capital gains tax is way less than my income tax bracket.

« Last Edit: May 22, 2016, 10:01:08 AM by Singuy »

forummm

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If you feel it's worth the trouble, you could manage two accounts:

1. Your betterment account where you make new purchases.  Recent purchases can be tax loss harvested as you say.
2. After a number of years, transfer stocks over to Vanguard when their cost basis becomes high enough that tax loss harvesting is unlikely.  (I'm not sure if Vanguard will have your cost basis of the original purchase - you might need to track it yourself)

Technically yes new purchases can be tax loss harvested.  But while the bulk of your account grows beyond where tax loss harvesting is likely, it also grows larger than your annual contributions.  If you're worried about each detail and optimizing, why are you paying 0.25% just to have Betterment manage details?

Vanguard's S&P 500 and Total Stock Market both have 0.05% expense ratios, compared to Betterment's 0.25% annual expense.  Come to think of it, I don't believe Betterment "absorbs" the expense ratio - that makes no sense.  An expense ratio is charged to the assets of a fund internally, without approval of any kind.  Nobody outside the fund can stop the expense ratio or pay it themselves.  So at Betterment, you're looking at 0.25% plus the expense ratio.

On $1 million, the 0.25% expense ratio means an extra $2,500 / year in fees.  How many hours would it take you to do tax loss harvesting yourself?  Let's say you check twice a year, and you sell S&P 500 and buy Total Stock Market to realize losses.  Takes a few minutes, but let's say it takes 2 hours.  So for about 4 hours work a year you save $2500 in fees, or roughly $600 / hour of effort.  And if you get used to it, it would take less time, so $800 / hour or $1200 / hour could be achievable.  I think you can save a lot by doing the Betterment work yourself.

But if you go with Betterment anyways, it's extremely unlikely they are absorbing the expense ratio for your funds.  You are paying an additional 0.25%, in addition to the fund quietly having it's own expenses.

OP is talking about https://blog.wealthfront.com/introducing-direct-indexing/

Not Betterment.

Another point against Wealthfront is that you aren't nearly as diversified. They will buy individual stocks for you, not index funds. So with $100-500k, they will buy "up to 100" stocks for you. So at most you would have 100 firms in your portfolio, instead of the ~4000 that VTSAX holds. And it's possible that you would have a much smaller number than 100. The fewer companies you have, the more at risk you are to a big loss in one firm, and the less likely you are to own the company that has breakthrough performance (like a biotech firm that hits on a miracle drug that will be a cash cow).

seattlecyclone

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I think we are talking about two different things. Betterment doesn't offer direct indexing so it's the management fees PLUS the vanguard expense ratio. Wealthfront offers direct indexing, meaning you literally own hundreds of stocks..basically as if you are buying the index fund individually. Advantages to this using Wealthfront is

1. You don't have to pay per trade fee..imagine the amount of money that will require for 100-500-1000 trades
2. You can tax loss harvest individual stocks vs the entire index..which has very high opportunity for harvest. 
3. Harvesting individual stocks will reset the "losers" into a lower basis point so higher potential for growth

I don't think betterment's robo auto balancing and the tax loss harvesting is worth the cost when you only have like 7 assets. That's very easy to harvest. But when it comes to hundreds of stocks..then it's not so easy to me anyways.

All true. Holding individual shares does provide more opportunity to harvest losses because even when the market is up there are always a few companies that are down. If you're really set on owning all those individual shares, doing it yourself will be both expensive (due to trading fees) and time-consuming. Wealthfront's fee for doing this seems very reasonable for all the work that they're doing.

The underlying question is: does all this extra work provide a benefit that is worth the cost?

I made a quick little spreadsheet to test this.

Assumptions:
1) $200k of new money each year.
2) Money can be invested in Wealthfront direct indexing (0.25% expenses) vs. Vanguard 500 Admiral fund (0.05% expenses).
3) 7% growth of investments each year.
4) 33% tax bracket for loss harvesting.
5) Betterment harvests $3,000 of losses each year, no harvesting at all in Vanguard.

You're right that harvesting losses does allow you to save money on your taxes, which then gets reinvested and compounds. However it turns out that this effect is eclipsed by the higher fees after about 5-6 years, and Vanguard completely blows Wealthfront out of the water after that. If you assume that you'll be able to harvest losses sometimes in Vanguard, the difference happens even sooner.

Feel free to make a copy of the spreadsheet and adjust the assumptions as desired to play around with the numbers.

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So is resetting the individual stocks in a direct index fund to a lower basis point due to tax harvesting worth the fees?  I feel like this is worth something too..in which it's not something I can do with Vanguard index funds. Based on my tax bracket, I feel like the more I earn from my investment the better since capital gains tax is way less than my income tax bracket.

Feelings have no place in investing. Use numbers. :-)
« Last Edit: May 22, 2016, 10:53:01 AM by seattlecyclone »

forummm

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Another potential con on Wealthfront. It's designed to sell shares in stocks that decrease in price. Some people (like Buffett) argue that the best time to buy a stock is when it's priced too cheaply. So you are actively getting out of a stock just because the market temporarily decided to price it lower, and you lose out if the market lets it return to its prior value. Individual stocks are pretty up and down, often without a lot of reason to vary that much. Selling because something has gone down is not the greatest strategy.

Singuy

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So is resetting the individual stocks in a direct index fund to a lower basis point due to tax harvesting worth the fees?  I feel like this is worth something too..in which it's not something I can do with Vanguard index funds. Based on my tax bracket, I feel like the more I earn from my investment the better since capital gains tax is way less than my income tax bracket.

Feelings have no place in investing. Use numbers. :-)
[/quote]

Thanks cyclone for the spreadsheet!

But I am still looking for an answer to resetting stocks to a lower basis point..is that a possible advantage to me outside of TLH? I know TLH, with a 3000 dollar cap will run out of steam pretty fast once the account is bigger and bigger. Eventually the fees will eclipse any tax benefits I get.

But to have a robo resetting a bunch of "losers" to a lower basis point can be an advantage no?

Say I buy stock A 100 shares x 10/share. It dips down to 8..the robo harvest so 200 dollars X 33% saved on taxes..then rebuys it back at 8.50 31 days later (which now earns me 150 MORE vs no harvest at all if the stock goes up forever and never dips below 8.50 ever again).  So essentially I have saved .33x 200 + I have made 150 additionally minus a much cheaper capital gain tax.
Could this be of some value to me with my current tax rate?


MustacheAndaHalf

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Thanks for correcting me - after visiting the thread a few times I lost the "Wealthfront" context.  So the question is direct purchase of 500+ stocks by Wealthfront, and managing an individual index, v.s. Vanguard.

You might add a third comparison to your equation: Vanguard funds that divide the market as small as possible.  For example, you could look at value/growth dimensions of large-/mid-/small-cap funds.  If small cap growth does poorly, you sell those to tax loss harvest.  Having 6 separate segments of the market can provide more chances to lose & tax loss harvest than a single S&P 500 index fund.

You could even buy all of Vanguard's sector funds in proportion to their market cap.  Here ETFs are the way to go, since you can hold $400 worth of a fund for $0 commission and still get a low expense ratio.  You would own the market, but broken up by market sector.

Tax loss harvesting ultimately becomes how finely you can slice the market, so that any loss can be used as a tax loss.  Besides Wealthfront's indexing, consider dividing the market into sectors or by large/small + value/growth.

seattlecyclone

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Thanks cyclone for the spreadsheet!

But I am still looking for an answer to resetting stocks to a lower basis point..is that a possible advantage to me outside of TLH? I know TLH, with a 3000 dollar cap will run out of steam pretty fast once the account is bigger and bigger. Eventually the fees will eclipse any tax benefits I get.

But to have a robo resetting a bunch of "losers" to a lower basis point can be an advantage no?

No. In fact, having a lower cost basis is a disadvantage. You'll have a higher taxable gain in the end, meaning more taxes when you sell than if your basis was higher. Loss harvesting can make up for this (and more!), but all other things being equal a lower basis is worse. Let's look at your example.

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Say I buy stock A 100 shares x 10/share. It dips down to 8..the robo harvest so 200 dollars X 33% saved on taxes..then rebuys it back at 8.50 31 days later (which now earns me 150 MORE vs no harvest at all if the stock goes up forever and never dips below 8.50 ever again).

Okay, so you originally spent $1,000 for 100 shares. You later sold those shares for $800. The $200 capital loss saved you $66 on your taxes so you now have $866 cash. You now spend this cash for shares that cost $8.50 each, getting you 101.88 shares (assuming you can buy fractional shares).

You claim that this purchase somehow saves you $150, but I don't see how that's the case. All you did was buy some stock. This doesn't change your tax bill one bit in the current year. In fact since the share price went up while you were in cash to avoid a wash sale, you lost most of the benefit of your loss harvesting, since you only ended up with 1.88 more shares.

Let's say the shares go up to $20 in the future and you sell. You'll get $2,037.65 from the sale. This minus your $866 basis ($1,171.65) is a long-term capital gain. If your capital gains tax rate at that time is 15% you'll pay $175.75 in taxes, leaving you with $1,861.90.

What if you had never harvested losses at all? You will have 100 shares, so selling them for $20 gets you $2,000, of which $1,000 is a long-term taxable gain. You pay $150 in capital gains tax and end up with $1,850 after taxes. This is of course less than $1,861.90, but the difference comes from the fact that the extra cash you got from harvesting losses allowed you to have more shares. The lower cost basis was actually a negative here because you only ended up with an extra $11.90 despite the fact that you had an extra 1.88 shares. Those shares should have been worth $37.60.