Inside Robo Advisor Tax Loss Harvesting

September 09, 2014

Not so fast, says Michael Kitces, financial advisor and the author of the “Nerd’s Eye View” blog, who writes that tax-loss harvest yields could be as little as 2 basis points a year, and that the practice is far from riskless.

You read that right: Kitces thinks that the robo advisors’ estimates are up to 50,100 and even 150 times too high.

With my son’s bank account on the line, I’ll need to sort through these claims. I’m going to focus on tax-loss harvesting this time, and leave rebalancing for another day. It’s messy work, so please expect to get a little nerdy as we walk through the mechanics of a tax-loss harvest.

Tax-Loss Harvest Example

Tax-loss harvesting adds value by deferring tax payments, allowing clients to invest the tax savings. But the deferral isn’t forever, and it comes at a price: death, or taxes. Harvesting lowers your cost basis, increasing your future capital gains taxes, unless you manage to pass along the lowered-basis stocks to your heirs.

Let’s look at a simple hypothetical example. I’ve laid out the trades and taxes of my straw man, Joe D. Investor, in the table below. This model applies the top long-term federal capital gains rate, but excludes state taxes, for simplicity’s sake.

Action Investment Value Tax Savings Value Total Value Variable
Buy VWO (primary fund) 100,000   100,000  
After one year, VWO loses 10% 90,000   90,000 Time elapsed, % investment change
Sell VWO, buy IEMG (secondary fund) 90,000   90,000 Transaction costs
Calculate tax savings (20% of $10,000 = $2,000)       Your tax rate, holding period, availability & type of capital gains to offset
Invest the tax savings in IEMG (secondary fund) 90,000 2,000 92,000 Reinvestment returns
After another year, IEMG regains the initial loss. Sell IEMG 100,000 2,222 102,222 Time elapsed, % investment change
Pay Capital Gains Taxes of 2,000 (20% of $10,000) plus $44 (20% of 222) 98,000 2,178 100,178 Your tax rate, holding period
Net returns     0.18%  
Annualized net returns     0.09% Time elapsed, % net returns
Opportunity cost     0.78% Returns difference between primary and secondary fund

 

The story goes like this:

 

 

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