Wealthfront Tax-Loss Harvesting White Paper
"A serious fiduciary with responsibility for taxable assets recognizes that only extraordinary circumstances justify deviation from a simple strategy of selling losers and holding winners."
- David Swensen, Unconventional Success
This white paper summarizes the motivation, design and execution of Wealthfront’s two tax-loss harvesting (TLH) strategies - our Daily Tax-Loss Harvesting service and Wealthfront’s Tax-Optimized US Index Portfolio. Our historical simulations and actual results show tax-loss harvesting significantly improves the tax efficiency and ultimately the after-tax return of Wealthfront’s taxable portfolios. We believe tax-loss harvesting should be a fundamental component of most every individual’s investment management strategy.
What is tax-loss harvesting?
Tax-loss harvesting is a way to make an investment portfolio work even harder - not just in generating investment returns, but by also generating tax savings.
Tax-Loss Harvesting works by taking advantage of investments that have declined in value (a common occurrence in broadly diversified investment portfolios). By selling declined investments at a loss, a tax deduction is generated - which lowers the investor’s taxes.
What’s more, any investment sold in this manner can be replaced with a highly correlated alternate investment. The result is that the risk and return profile of a portfolio is unchanged, even as tax savings are created. These tax savings can then be reinvested to further grow the value of the portfolio.
Wealthfront developed software to make tax-loss harvesting, traditionally only available to accounts in excess of $5 million, available to a much broader audience. Implementing tax-loss harvesting in software also makes it possible to look for harvesting opportunities on a daily basis, which could result in significantly greater benefit than what could be achieved from the manual end-of-year approach taken by traditional financial advisors.
For whom is it applicable?
Tax-Loss Harvesting is generally valuable for all taxable investors as harvested losses can be applied to both offset capital gains generated by the investor and up to $3,000 in ordinary income annually. Furthermore, any losses that cannot be applied in a given tax year can be carried over indefinitely to offset future income and capital gains.
Of course, tax-loss harvesting is especially valuable for investors who regularly recognize capital gains. These gains can come from the sale of company stock, real estate or just about any investment. Tax-Loss Harvesting can even be used to minimize the gains associated with liquidating a portfolio to move to a new financial advisor.
Wash sale management
Normally, you recognize a loss when you sell a security for less than its cost basis. However, if you buy the same or substantially identical security within 30 days of the sale, the wash sale rule applies and you are not allowed to claim the tax benefit .
In the case of applying tax-loss harvesting to a portfolio of index funds or passive ETFs, you need to use two securities that track different indexes to avoid violating the substantially identical clause of the wash sale rule. Swapping an ETF with another that tracks the same index from a different issuer (i.e. Vanguard vs. Schwab) would violate the substantially identical rule.
The risk of a wash sale increases with the number of rebalancing trades made as part of the ongoing management of a portfolio. If not carefully managed, a security sold to harvest a loss might be re-purchased for another reason (change in asset allocation, rebalancing, dividend reinvestment, withdrawal or deposit) and the tax benefit could be disallowed, defeating the purpose of tax-loss harvesting. We carefully manage the interaction and timing of trades within our portfolio management service to avoid wash sales.
The situation becomes more complex in the case of multiple accounts, as the wash sale rule applies to all of an investor’s accounts including IRAs — as well as spousal accounts for joint filers. For example, if an investor sells a security in her personal non-retirement account and repurchases it within 30 days in her IRA, it’s considered a wash sale; if her spouse purchases the same security within 30 days in his personal non-retirement account, it’s also viewed as a wash sale. Wealthfront monitors all the accounts it manages for each client to avoid any transactions that might trigger a wash sale. We also urge all of our clients to consult with their tax advisors to confirm that our tax-loss harvesting strategies are right for them.
Tax-loss Harvesting doesn’t eliminate tax liabilities but rather serves to defer them to a point in the future.
Investors still come out ahead, however, by deferring tax payments to a much later date - potentially many years from now.
For one thing, the immediate tax savings from tax-loss harvesting can be reinvested and compounded over time. $10,000 in tax-savings today, for example, reinvested at a 5% annual return grows to more than $26,000 after 20 years. Paying a 50% tax on the appreciated tax savings and paying back the original $10,000 still leaves you with an $8,000 gain from Tax-Loss Harvesting [$26,000 - $10,000 - ($26,000-$10,000) x 50%].
What’s more, if you don’t end up selling all of your investments and instead choose to pass them on to your heirs or donate them to a non-profit organization, then you actually never have to pay back the original tax liability. This is because your heirs will receive a step-up in basis for the assets that you pass down, eliminating any capital gain tax liability for those assets. Non-profit organizations will similarly not owe any taxes upon selling the assets you donate.
Our white paper attempts to measure the maximum potential benefit of tax-loss harvesting by calculating an industry standard parameter called tax alpha, which quantifies an account’s maximum potential tax benefit each year. How much of the tax alpha benefit you will capture as an investor depends heavily on holding period and estate planning assumptions. In other words you will get little benefit from tax-loss harvesting if you only use the service for one year, but almost all the tax alpha benefit if you hold for long periods and make intelligent decisions when withdrawing assets.
Tax alphas calculated in this white paper are based on historical results, which may not happen in the future. All assumptions in this white paper are based on the actual observed behavior of typical Wealthfront clients.
Wealthfront Daily Tax-Loss Harvesting service
Asset-level Tax-Loss Harvesting
For taxable accounts with a minimum investment of $100,000, Wealthfront offers the Wealthfront Daily Tax-Loss Harvesting service for no additional charge. It monitors your portfolio daily to look for opportunities to harvest losses on the ETFs that represent each asset class in your portfolio. Under the right circumstances (to be described later in this white paper) we will sell one of your ETFs that is trading at a loss and replace it with an alternative ETF that represents a different but highly correlated index to maintain the risk and return characteristics of your portfolio. After 30 days we will sell the alternative ETF and replace it with the original (primary) ETF.
The following two tables list the primary and alternative ETFs we use to represent each asset class.
Table 1: Recommended primary (initial) ETFs
|Asset Classs||Primary ETF||Vendor||Underlying Index||Expense Ratio|
|US Stocks||VTI||Vanguard||CRSP US Total Market||0.05%|
|Foreign Stocks||VEA||Vanguard||FTSE Developed Markets Ex-North America||0.10%|
|Emerging Markets||VWO||Vanguard||FTSE Emerging Markets||0.18%|
|Dividend Stocks||VIG||Vanguard||NASDAQ US Dividend Achievers Select Index||0.10%|
|Natural Resources||DJP||Barclays iPath||Dow Jones UBS||0.75%|
|TIPS||SCHP||Schwab||Barclays Capital US TIPS||0.07%|
|Municipal Bonds||MUB||iShares||S&P National Municipal||0.25%|
Table 2: Recommended secondary ETFs
|Asset Classs||Secondary ETF||Vendor||Underlying Index||Expense Ratio||Correlation to
|US Stocks||SCHB||Schwab||DJ Broad US Market||0.04%||99%|
|Foreign Stocks||SCHF||Schwab||FTSE Developed Markets Ex-US||0.09%||99%|
|Emerging Markets||IEMG||iShares||MSCI Emerging Markets||0.18%||99%|
|Dividend Stocks||SCHD||Schwab||Dow Jones U.S. Dividend 100||0.07%||97%|
|Natural Resources||VDE||Vanguard||MSCI Energy||0.14%||73%|
|TIPS||VTIP||Vanguard||Barclays Capital US TIPS 0-5 Years||0.10%||83%|
|Municipal Bonds||TFI||State Street||Barclays Capital Municipal||0.30%||83%|
Our service, which looks for harvesting opportunities daily, stands in stark contrast to year end tax-loss harvesting services, which only look to harvest losses at the end of each calendar year. Based on our research (presented below), we believe daily TLH offers approximately 50% more benefit than the traditional year-end TLH.
Our asset class level tax-loss harvesting strategy uses a cost-benefit analysis framework to evaluate potential harvesting opportunities for each ETF lot currently trading below its cost basis as follows:
Benefit is calculated by multiplying the potential realized capital loss incurred from selling an ETF times either the short-term or long-term capital gain tax rate, depending on the ETF’s holding period.
Cost represents the potential tax liability on the appreciation of the alternative ETF during the 30 days it was used to replace the original ETF.
Threshold is a function of each ETF’s estimated volatility over the 30 day holding period.
We execute two trades when we believe the Benefit - Cost exceeds the Threshold:
- We sell the specific ETF lot to recognize a loss, and
- We purchase the same dollar amount of a similar, but not substantially identical, ETF to maintain the desired asset class exposure.
We evaluate every ETF tax lot in each eligible account every day, and execute trades when our system identifies the necessary conditions.
We evaluate the effectiveness of our tax-loss harvesting by measuring a parameter called annual tax alpha, which quantifies an account’s potential tax benefit each year. We calculate the annual tax alpha using the following formula:
- STCL is the short-term net capital loss realized
- STTR is the combined Federal and California state short-term capital gain tax rate. We use the maximum federal marginal tax rate of 43.4% (39.6% + 3.8% for tax payers who earn in excess of $200,000) and the maximum California tax rate of 12.3.%
- LTCL is the long-term net capital loss realized
- LTTR is the combined Federal and California state long-term capital gain tax rate. We use the maximum federal tax rate of 23.8% (20% + 3.8% for tax payers who earn in excess $200,000) and top California tax rate of 12.3%
- PortfolioBeginningBalance is the value of the portfolio at the beginning of each year
As the above formula shows, Tax Alpha increases with the investor’s tax rate. As a result, Tax-Loss Harvesting is most powerful for investors in high-tax states such as California, New York, New Jersey, and Massachusetts (states where most of Wealthfront’s clients reside).
In this section we present the backtested results that could have been achieved with our asset class level tax-loss harvesting strategy on an average Wealthfront portfolio. The tested portfolio was diversified across six asset classes with the following allocation:
|US Stocks||Vanguard VTI ETF||
|Foreign Stocks||Vanguard VEA ETF||
|Emerging Markets||Vanguard VWO ETF||
|Dividend Stocks||Vanguard VIG ETF||
|Natural Resources||iPath DJP ETF||
|Municipal Bonds||iShares MUB ETF||
We assumed an investor initially deposits $100,000 at the beginning of 2000 and then deposits $10,000 each quarter thereafter through November 2013. This behavior models the behavior we observed from our existing clients. The portfolio was periodically rebalanced using Wealthfront’s standard rebalancing algorithms (see our Investment Methodology white paper for more on our rebalancing approach). We sold the primary ETF and bought the alternate ETF, and then swapped back to the primary ETF after 30 days assuming it did not conflict with a rebalancing event when we detected tax-loss harvesting opportunities that did not trigger a wash sale.
The graph below displays the resulting annual tax alpha that would have been generated by Wealthfront’s asset class level tax-loss harvesting strategy by year.
Annual Tax Alpha for an Average Daily TLH Porfolio (2000-2013)
Since 2000, this TLH strategy produced an average annual tax alpha of 1.13% and was most valuable in major down markets.
The tax alpha we quote is net of gains that result from portfolio rebalancing. Rebalancing should always generate gains because it forces you to sell your winners and buy more of your relative losers. Tax alpha in the chart above was negative in 2007 solely due to rebalancing associated with trimming highly appreciated equities.
Tax alpha can also be negative in the unusual circumstance where the market declines precipitously and then recovers very quickly in the following year. In that case we harvest a loss on the primary ETF and then the replacement (or alternative) ETF appreciates significantly in the 31 days we hold it. That is what happened at the end of 2008 and the beginning of 2009. The sum of the losses and gains generated from the trades of the primary and alternative ETFs still resulted in a net positive tax alpha, but because it transpired across years, the tax alpha appears better than it was in 2008 and worse than it was in 2009. We specifically choose a tax loss harvesting trading threshold that is highly unlikely to result in a net loss after factoring in the potential gain on the recovery trade.
In 2007 and 2009 the backtested tax alpha was negative due largely to the impact of rebalancing. As equities appreciated during the 2003-2007 market run-up, our rebalancing algorithm sold equities in order to allocate more of the portfolio to bonds. In 2009, as equities bottomed, our algorithm did the same but in the other direction - selling bonds to purchase more equities. Although these actions were largely beneficial to the investor, they did generate taxable gains and thus a negative tax alpha.
Using the same assumptions, the graph below demonstrates that tax-loss harvesting is valuable for all levels of risk and generally increases as one’s risk tolerance increases. That’s because higher risk levels result in higher allocations to more volatile asset classes (such as stocks) and will thus result in more harvesting opportunities.
Mean Tax Alpha between 2000-2013 of All Asset Allocation Portfolios
Tax Alpha by Income Level and Risk Level (2000-2013)
We are aware that not all our clients are in the highest tax bracket. To present a more comprehensive picture of TLH’s benefit for clients in different tax situations, we estimated the tax alpha for six representative income levels among our clients for all risk levels, presented in the following table. We assumed clients are single and used the federal and California tax code in 2014.
|Tax Rates*||(28, 15, 9.3)||(36.8, 18.8, 9.3)||(36.8, 18.8, 11.3)||(43.4, 23.8, 11.3)||(43.4, 23.8, 12.3)||(43.4, 23.8, 13.3)|
*(Federal Short Term, Federal Long Term, CA State)
Wealthfront launched our asset class level tax-loss harvesting service in October 2012. The graph below presents a composite of our clients’ realized tax alpha by month since our launch, plotted against their overall cumulative pre-tax, net-of-fee, time-weighted returns.
Tax Alpha & Cumulative Return for Daily Tax-Loss Harvesting Clients (since inception)
Monthly Tax Alpha (Left Axis)
Cumulative Return (Right Axis)
We were able to harvest an average tax alpha of 0.70% (0.63% in June alone) for our clients during a time when our composite portfolio return was 16.3%. This tax alpha would not have been realized using the traditional year end tax-loss harvesting approach because all the ETFs employed would have recovered their June loss by that time. This example helps illustrate the advantage of daily vs. year end tax-loss harvesting.
During this period, our clients recognized taxable gains of 0.31% due to the combination of rebalancing transactions (including the change to our new asset allocations associated with the launch of optimized asset location in March 2013), clients changing their risk score and tax-loss harvesting recovery trades that resulted in a recognized gain on the alternate ETF. Even net of these gains, our clients recognized a net tax alpha of 0.40% in a year when their portfolios were up considerably.
Wealthfront Tax-Optimized US Index Portfolio
Harvesting losses at the individual stock level
Index funds and index-based ETFs form the core of many diversified portfolios including the ones provided by Wealthfront to its clients.
Such funds / ETFs generally have two objectives:
- Track their benchmark index as closely as possible. This is imperative to accurately represent a particular asset class.
- Track their benchmark index as tax efficiently as possible -- passing on as few taxable gains as possible to their investors
Index funds and ETFs can achieve the latter goal because they are inherently tax-efficient. Such funds have low turnover because securities that comprise an index seldom change (5-20% annual turnover depending on the index). Index fund issuers like iShares and Vanguard are also able to intelligently realize losses on the underlying securities in their funds and ETFs to minimize the gains they have to distribute to their investors each year.
However, ETF and index funds have one disadvantage in providing the optimum tax-efficiency for their investors - legally they are not able to pass on tax-losses to investors. So while iShares and Vanguard can use any realized losses in their funds to minimize any gains they distribute to investors, any left-over losses can not be used to reduce the investor’s taxes even further.
This limitation disappears, however, if the investor holds the individual securities that comprise the index in their own account. With full ownership of the underlying index securities, an investor can claim both the gains and the losses from such securities’ movements. With the ability to sell individual stocks for tax-loss harvesting purposes, the resulting portfolio can thus provide a wealth of tax-loss harvesting opportunities by harvesting losses at the individual stock level - something we call stock level tax-loss harvesting.
The opportunity to deliver a stock level tax-loss harvesting service prompted firms like Aperio Group and Parametric Portfolio Associates to pioneer managed portfolios of stocks that harvest tax-losses for their clients while emulating a specific index. These firms have demonstrated you can generate significant tax alpha if you are willing to incur modest tracking differences from the designated index. Unlike index funds, Parametric and Aperio prioritize both harvesting tax-losses as well as tracking the index. Together, these firms have attracted more than $100 billion under management. Unfortunately, to access Aperio and Parametric, most investors have to utilize accounts with private wealth managers that may require a minimum account of $5 million with a premium fee on top of the costs of the Aperio and Parametric services.
Meanwhile, Wealthfront is able to offer a stock level tax-loss harvesting service to a broader set of investors by lowering the minimum account size to $500,000. This service is also offered at no additional fee beyond Wealthfront’s normal advisory fee and with no commission charges.
Combining Daily Tax Loss Harvesting with Stock Level Tax Loss Harvesting
Wealthfront has leveraged its software expertise to offer a unique service that combines asset class level tax-loss harvesting with stock level tax-loss harvesting.
Called the Wealthfront Tax-Optimized US Index Portfolio, this service replaces the ETF normally used to represent US stocks in a Wealthfront portfolio with up to 501 individual securities - the 500 stocks in the S&P 500 index and an ETF used to represent non-S&P 500 smaller capitalization companies.
The 500 individual stocks are used to closely track the performance of the S&P 500 index while providing opportunities for stock level tax-loss harvesting. Meanwhile, the smaller cap ETF is included so the portfolio better tracks the broader US stock market ETF that is being replaced.
As shown below, the resulting Wealthfront account continues to hold the other ETFs common to Wealthfront investments (such as Foreign Stocks, Emerging Markets, Dividend Stocks, etc.) and continues to perform Daily Tax-Loss Harvesting on these ETFs.
Asset Level TLH
with Asset Level &
Stock Level TLH
|US Stocks||Vanguard (VTI)||Vanguard (VTI)||Wealthfront Tax Optimized
US Index Portfolio
|Foreign Stocks||Vanguard (VEA)||Vanguard (VEA)||Vanguard (VEA)|
|Emerging Markets||Vanguard (VWO)||Vanguard (VWO)||Vanguard (VWO)|
|Dividend Stocks||Vanguard (VIG)||Vanguard (VIG)||Vanguard (VIG)|
|Natural Resources||iPath (DJP)||iPath (DJP)||iPath (DJP)|
|TIPS||Schwab (SCHP)||Schwab (SCHP)||Schwab (SCHP)|
|Municipal Bonds||iShares (MUB)||iShares (MUB)||iShares (MUB)|
Wealthfront is the first and only company to combine asset level and stock level tax-loss harvesting. We offer this service to accounts of only $500,000, one-tenth the size of what the competition requires.
Costs and Minimums
The cost of implementing the Wealthfront Tax-Optimized US Index Portfolio is actually less than the Vanguard ETF it replaces. Vanguard currently charges a 0.05% management fee for the Vanguard US Total Stock Market ETF (VTI). Our management fee for the Wealthfront Tax-Optimized US Index Portfolio comes out to 0.03%.
This is because we charge no management fee for the 80% of the Tax-Optimized US Index Portfolio that’s compromised of individual S&P 500 stocks. The cost of that position (including all commissions) is completely covered by the Wealthfront’s 0.25% advisory fee. The remaining 20% of the Tax-Optimized US Index Portfolio is compromised of the Vanguard Extended Market ETF (VXF) which comes with a 0.14% management fee - resulting in a 0.03% management fee for the entire Tax-Optimized US Index Portfolio.
The 500 stocks needed to emulate the S&P 500 necessitate a minimum portfolio size of at least $150,000. That translates to a total minimum required account size of $500,000 since approximately 30% of our average client’s portfolio is allocated to US stocks.
Wealthfront 500 (WF500)
We call the up to 500 individual securities owned as part of the Wealthfront Tax-Optimized US Index Portfolio the Wealthfront 500.
The Wealthfront 500 selects individual stocks to minimize tracking error from the S&P 500, not based on their fundamentals or any perspective on whether they are fairly valued by the market. We use the money allocated to this part of the client portfolio to purchase the vast majority of the stocks that comprise the S&P 500 index in roughly the same weights as in the index. We then harvest losses on any Wealthfront 500 stocks based on a threshold (similar to the threshold described above with ETFs) and use the proceeds to purchase other highly correlated stocks within the S&P 500. In some cases, we may purchase more of an existing holding. For example, if Coca-Cola misses an earnings estimate and drops precipitously in value we would sell Coke and use the proceeds to buy more PepsiCo, as a stock that likely maintains the Wealthfront 500’s correlation with the S&P500 in the absence of Coca-Cola.
Wealthfront 500 Methodology
We balance two competing objectives with our stock-level tax-loss harvesting service: maximize tax alpha and minimize tracking error. We do this by maximizing a function of tax alpha minus tracking error squared. The tax alpha component encourages selling losing stocks. The tracking error component penalizes sales that cause significant tracking differences and encourages buying correlated replacement stocks from the S&P 500 that keep the overall portfolio close to the index.
We manage the portfolio and avoid wash sales by applying constraints to the optimization. For example, we enforce a maximum constraint on each stock’s relative portfolio weight to ensure portfolio diversification. We also enforce a maximum drift constraint on each stock’s weight to ensure it stays relatively close to its benchmark weight and trade direction constraints to avoid wash sales. The constrained optimization problem is a Quadratic Programming (QP) problem, which can be solved efficiently using a QP solver or a general purpose convex solver:
|Maximize||TaxAlpha - TrackingError^2|
|Subject to||The portfolio must be long only|
|Portfolio weights <= maximum weight parameter|
||Portfolio weights - benchmark weights| <= drift parameter|
|Do not trade stocks in a wash sale window|
We measure the effectiveness of the Wealthfront 500 on two dimensions: how closely it tracks the S&P 500 index and how much tax alpha it generates. We use the term tracking difference to describe the difference between the portfolio’s return and the index’s return in a given time period and tracking error for the standard deviation of the tracking differences. We use tax alpha to measure the tax benefit generated by proactively selling stocks with capital losses. We measure the metrics from backtested portfolios on a monthly basis and annualize them for convenient comparison.
- TrackingDifference = PortfolioPreTaxReturn - BenchmarkReturn
- TrackingError = StandardDeviation(TrackingDifference)
- TaxAlpha = (STCL * STTR + LTCL * LTTR) / PortfolioBeginningBalance
The definitions for STCL, STTR, LTCL, LTTR and PortfolioBeginningBalance are the same as shown above in the asset level section.
The graph below presents the backtested results for the Wealthfront 500 as compared to SPY (the most popular S&P 500 index fund).
Similar to the analysis above, this graph assumes a $100,000 initial investment followed by $10,000 add-on investments quarterly.
After-tax Total Return of SPY vs WF500 (2003-2013)
The Wealthfront 500 outperformed the SPY S&P 500 index fund in almost every year, especially in bad markets. Interestingly it outperformed SPY in some very good markets as well. The average after-tax annual return for SPY over the period was 3.8% vs. 7.0% for the Wealthfront 500.
Under the same assumptions, the below graph presents the tax alpha the Wealthfront 500 would have generated. The Wealthfront 500 generated tax alpha each year and an average annual tax alpha of 2.98%. By contrast, Wealthfront’s daily tax loss harvesting service (with just asset-level tax loss harvesting) would have produced little tax alpha in the years the market increased.
Tax Alpha for the Wealthfront 500 (2000-2013)
The graph below displays the tracking differences by year for Wealthfront 500 from its benchmark S&P 500 index, again with the same assumptions. The tracking differences each year were modest. In some years they were positive (i.e. the portfolio outperformed the benchmark) and in some years negative (i.e. the portfolio underperformed the benchmark). In this limited time sample the average difference was positive, but you should expect an average difference of 0 over the long term.
Tracking Difference of Wealthfront 500 vs. the S&P 500 (2000-2013)
The table below summarizes the tax alpha and tracking error for the Wealthfront 500 vs. SPY based on annualized monthly tracking error and the same deposit assumptions as above.
For an extra 0.72% of tracking error you could have the opportunity to increase your after tax returns by 2.98% per year. We believe that is a trade off well worth making.
|Tax Alpha||Tracking Error|
Finally, the graph below further displays the differences in Tax Alpha between different Tax-Loss Harvesting approaches for an average (risk 7) portfolio. Given the minimum account size necessary to execute the Tax-Optimized US Index Portfolio, this graph assumes an initial deposit of $500,000 with $50,000 additional deposits quarterly.
This graph includes an approach of harvesting tax-losses only at the end of the year - as is commonly done by traditional financial advisors. That approach is compared to Wealthfront’s Daily Tax-Loss Harvesting service and finally to the combined impact of Daily Tax-Loss Harvesting and the Tax-Optimized US Index Portfolio.
Tax Alpha of an Average Portfolio with Different Tax-Loss Harvesting Approaches
Daily TLH & Tax-Optimized US Index Portfolio
The combined service generated a mean tax alpha of 1.62% as compared to 0.92% for the daily asset level only tax loss harvesting service and 0.64% for a year end only asset level tax loss harvesting service. The combined service could provide significant after-tax savings and should always offer superior tax alpha to an asset level only tax loss harvesting service. The addition of stock level tax loss harvesting to an asset level tax loss harvesting service should be especially valuable in up markets.
Taken together, the empirical and backtested results in this whitepaper show a valuable role in improving after-tax returns from tax-loss harvesting - leaning on stock-level TLH during appreciating markets and both asset-class and stock-level TLH during market turmoil.
Although tax-loss harvesting may be highly valuable in improving tax efficiency, it’s important to understand that it is a tactical approach and should not interfere with strategic investment objectives such as broad diversification though an optimal asset allocation, disciplined & tax-efficient rebalancing and low-cost indexing.
Since tax-loss harvesting systematically lowers the cost basis of a portfolio by replacing securities (ETFs or stocks) that trade at a loss, investors might be concerned with how to deal with a portfolio with a low cost basis in the future. Generally speaking, portfolios with a low cost basis require more careful disposition. Investors may choose to minimize their tax liabilities by using the low basis portfolio as a charitable donation or pass the portfolio on to heirs through an estate at a stepped-up cost basis.
Tax-loss harvesting is only relevant for taxable accounts. It does not apply to tax-deferred accounts such as IRAs and 401(k) accounts, since gains and losses in those accounts are not taxable events. Tax-loss harvesting is also not typically suited for custodial accounts such as UTMA/UGMA unless the minor has significant taxable capital gains or income from other sources.
The effectiveness of tax-loss harvesting also varies for different contribution patterns. The more frequently you add to your portfolio, the greater the benefit of tax-loss harvesting because you have more tax lots at different prices to work with.
Our historical simulation and empirical results-to-date demonstrate Wealthfront’s two fully automated and daily tax-loss harvesting strategies could significantly improve a portfolio’s tax efficiency. Layered on top of Wealthfront’s diversified and rebalanced ETF portfolios, tax-loss harvesting could significantly increase after-tax returns.
Asset-class tax-loss harvesting with ETFs as provided by Wealthfront’s Daily Tax-Loss Harvesting service could be especially valuable during periods of extreme market turbulence like the periods following the terrorist attacks in 2001 and the financial crisis in 2008. Stock-level tax-loss harvesting with individual stocks as implemented with Wealthfront’s Tax-Optimized US Index Portfolio is valuable during market turbulence but also during steadily rising markets like the asset bubble from 2003-2007.
This combination of these two approaches, therefore, is an unparalleled improvement for investors.
This white paper was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This white paper is not intended as tax advice, and Wealthfront does not represent in any manner that the tax consequences described herein will be obtained or that Wealthfront’s tax-loss harvesting strategies, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting strategy and other strategies that Wealthfront may pursue are complex and uncertain and may be challenged by the IRS. This white paper was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.
Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in these tax strategies, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.
When Wealthfront says it replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Expected returns and risk characteristics are no guarantee of actual performance.
The charts showing potential tax savings (“Annual Tax Alpha”) from the tax-loss harvesting strategies are historical simulated returns based on backtesting and do not rely on actual trading using client assets. The results are hypothetical only. Several processes, assumptions and data sources were used to create one possible approximations of how Wealthfront’s tax-loss harvesting strategy might have benefited investors in the past, and a different methodology may have resulted in different outcomes. These results were achieved by means of the retroactive application of a model designed with the benefit of hindsight. The results of the historical simulations are intended to be used to help explain possible benefits of the tax-loss harvesting strategy and should not be relied upon for predicting future performance.
We simulated the potential after-tax benefits of our tax-loss harvesting services and found that asset-class tax-loss harvesting it added an average of at least 0.92% annually and stock-level tax-loss harvesting combined with asset-class tax-loss harvesting added an average of at least 1.62%. We used several assumptions to create these possible approximations, but did not rely on actual client trading history. These results are based on a study Wealthfront conducted for the years between January 2000 and November 2013, assuming a Wealthfront account with a risk score of 7 an initial deposit of $100,000, additional quarterly deposits of $10,000, and periodic rebalancing for asset-class tax-loss harvesting and an initial deposit of $500,000, additional quarterly deposits of $50,000, and periodic rebalancing for stock-level tax-loss harvesting combined with asset-class tax-loss harvesting. Dividends and interest were not considered.
To compare the possible benefit of continuous vs. annual year-end tax-loss harvesting, we use the same assumptions for the historical simulation for the years between January 2000 and December 2012 but with tax-loss harvesting opportunities examined daily vs. annually at year-end.
Different methodologies may have resulted in different outcomes. For example, we assume that an investor’s risk profile and target allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing suitability profiles and investment objectives. Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making. Actual investors on Wealthfront may experience different results from the results shown. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.
While the data used for its simulations are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources, including independent market quotations and index information. Wealthfront believes the third-party information comes from reliable sources, but Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third-party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.
The chart showing the tax alpha and cumulative return for daily tax-loss harvesting clients is based on Wealthfront’s estimates from existing client data since we launched our asset-class tax-loss harvesting in October 2012 through October 2013. The chart was based on the subset of our clients with tax-loss harvesting enabled in their accounts and the returns and tax alpha were estimated for their accounts only. The return estimates were based on time-weighted returns. The cumulative returns were calculated by taking the composite’s daily return based on its daily balance series, where the composite’s balance is the aggregated value of all the accounts under our TLH strategy. We then compound the daily return series to get the compounded return over the period. The monthly tax alpha was calculated using the net tax benefit/liability and dividing by the aggregate balance. The net tax benefit over the period includes the liquidation of positions transferred in and sold to invest the client account in the Wealthfront portfolio.
- What is tax-loss harvesting?
- For whom is it applicable?
- Wash sale management
- Wealthfront Daily Tax-Loss Harvesting service
- Asset-level Tax-Loss Harvesting
- Performance measurement
- Backtesting results
- Empirical results
- Wealthfront Tax-Optimized US Index Portfolio
- Combining Daily Tax Loss Harvesting with Stock Level Tax Loss Harvesting
- Costs and Minimums
- Wealthfront 500 (WF500)
- Wealthfront 500 Methodology
- Performance measurement
- Backtested results