A decade ago, Wealthfront revolutionized the investing space by being among the first automated investment services to offer Tax-Loss Harvesting to clients. Tax-loss harvesting is the crown jewel of tax management strategies, and it represents what we consider to be the only reliable way for investors to outperform the market, as it allows you to do so on an after-tax basis. While traditional advisors have long offered tax-loss harvesting to wealthy investors, Wealthfront uses software to monitor portfolios daily, allowing us to harvest losses far more efficiently and make the strategy available to a far larger clientele. We’re proud to offer our ETF-level Tax-Loss Harvesting to clients with just $500 and at no extra cost, and we’re delighted to have offered this important and powerful service for ten years.
Wealthfront’s Tax-Loss Harvesting involves selling an ETF which has declined in value and replacing it with a highly correlated but not identical ETF to maintain the overall risk and return characteristics of your portfolio. The losses can then be used to offset any taxable gains you may have that year (and, if you have losses left over, up to $3,000 of ordinary income), resulting in a lower tax bill. While the individual losses themselves can be small, the cumulative effect on your tax bill can be potentially quite large. The total estimated benefit for all of our clients is staggering, and we think that’s worth celebrating.
In the years since Wealthfront launched Tax-Loss Harvesting, our software has harvested nearly $3.2 billion in losses to help clients lower their taxes at no extra cost ($1.5 billion of which was harvested in 2022 and $2.8 billion of which was over the last five years). Assuming a 37.5% marginal tax rate, the losses harvested by Wealthfront over the last decade could be worth an estimated $1.19 billion in tax savings to Wealthfront clients –– not even taking into account the potential for those savings to be reinvested.
A powerful tax-minimization strategy in all market conditions
Wealthfront’s Tax-Loss Harvesting is a powerful tool in a broad range of market conditions. You might assume it would only be valuable in a year when the market is down, but this isn’t true. While Tax-Loss Harvesting is very useful in market conditions with a high degree of volatility (like what we’ve seen in 2022 and so far in 2023), the service can even harvest losses and generate potential tax savings in a year when the market is up overall. Software is uniquely suited to maximize the benefits of Tax-Loss Harvesting. By monitoring portfolios on a daily basis, Wealthfront can take advantage of temporary dips in the market.
While it is unlikely an individual investor will consistently outperform the broader market on a pre-tax basis, tax-loss harvesting presents an opportunity to outperform on an after-tax basis. In fact, tax-loss harvesting represents what we consider to be the only reliable way to get excess after-tax returns. This is because losses generated from selling positions that have declined in value can offset any gains realized in the other parts of the portfolio. Net tax losses up to $3,000 can also be deducted from ordinary income and the investor can carry additional losses forward to future years.
Tax-loss harvesting is a tax deferral strategy, but that’s not the only way it can save you money. The tax savings generated can also be reinvested and compounded over time, allowing you to take advantage of the time value of money. As a result, you are better off paying taxes later rather than sooner. In addition, the long-term capital gain tax rate you pay on your decreased basis will be lower than the tax rate from which you benefited from harvesting a short-term capital loss. Moreover, if the portfolio is held for a future bequest to one’s heirs or is used for a charitable contribution, the tax implications can potentially be minimized or even avoided entirely in some cases under current tax laws.
US Direct Indexing: A more advanced form of Tax-Loss Harvesting
In 2013, Wealthfront also introduced a more advanced form of Tax-Loss Harvesting known as US Direct Indexing and updated the service to its current form in 2015. For clients with $100,000 or more in a taxable Automated Investing Account at Wealthfront, even greater tax savings can be achieved with US Direct Indexing. This service takes advantage of the volatility of the individual stocks that make up the US stocks portion of client portfolios. Since 2015, US Direct Indexing has generated an estimated annual after-tax benefit worth an additional 0.53% of the US stocks portion of clients’ portfolios compared to ETF-level Tax-Loss Harvesting over the same period, assuming a 37.5% marginal tax rate. US Direct Indexing can help lower your tax bill even more than our ETF-level Tax-Loss Harvesting service because even during periods when the overall stock market rises, there are always some stocks and sectors that decline, even if only temporarily.
Let’s illustrate this technique with an example, using the S&P 500 as a market proxy. (The same strategy can be used for a total stock market index.) We can replicate the behavior of the S&P 500 by holding a sample of the stocks in the index. These stocks are chosen to replicate the industry and size composition of the index while minimizing tracking error between the sample and the overall index. Now suppose large pharmaceutical stocks have declined in value. You might sell Merck to realize a loss and buy Pfizer to enable you to continue to track the index. Or if the autos declined you could sell Ford and buy General Motors. Automating the process, one can continuously look for losses to harvest, potentially adding a meaningful amount to the annual after-tax return of the investor.
Like Wealthfront’s Tax-Loss Harvesting, US Direct Indexing is available at no additional cost. To learn more about our US Direct Indexing service, please see our white paper.
Build long-term wealth on your own terms
At Wealthfront, we believe that investors should focus on what they can control: fees, risk, and taxes. It was this belief that led us to build our Tax-Loss Harvesting and US Direct Indexing services, both of which are designed to help clients to improve their after-tax returns at no additional cost. We’re proud to have been among the first automated investment services to introduce tax-loss harvesting so Wealthfront clients can keep more of what they earn with no extra effort. We’ve long said that tax-loss harvesting is the most valuable reason to choose a robo-advisor, and after a decade, we think the results of our service speak for themselves.
The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer, or recommendation, to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.
The effectiveness of the Tax-Loss Harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront Advisers and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term).Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
Investment management and advisory services–which are not FDIC insured–are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and financial planning tools are provided by Wealthfront Software LLC (“Wealthfront”). Brokerage products and services are offered by Wealthfront Brokerage LLC, member FINRA/SIPC. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.
Wealthfront Advisers, Wealthfront Brokerage and Wealthfront are wholly owned subsidiaries of Wealthfront Corporation.
© 2023 Wealthfront Corporation. All rights reserved.
About the author(s)
Dr. Burton G. Malkiel, the Chemical Bank Chairman’s Professor of Economics, Emeritus, and Senior Economist at Princeton University, is Wealthfront's Chief Investment Officer. Dr. Malkiel is the author of the widely read investment book, A Random Walk Down Wall Street, which helped launch the low-cost investing revolution by encouraging institutional and individual investors to use index funds. Dr. Malkiel, also the author of The Elements of Investing, is one of the country’s leading investor advocates. View all posts by