Joe D. Investor buys $100,000 of the Vanguard FTSE Emerging Markets (VWO). VWO is the “primary” emerging market ETF at both Wealthfront and Betterment. Poor Joe’s investment loses$10,000 in the first year, so Joe sells VWO and buys the iShares Core MSCI Emerging Markets (IEMG), Wealthfront and Betterment’s “secondary” emerging market ETF.
Joe can now claim the $10,000 as a long-term capital loss. If Joe has $10,000 of realized long-term capital gains to offset, then he just saved himself $2,000 in taxes, assuming a 20 percent capital gains tax rate. As I mentioned earlier, the savings will be greater once you factor in state capital gains taxes.
Joe is on the ball, so he actually invests the $2,000 savings. To keep things simple, we’ll say he doubles down and buys more IEMG.
Then Joe gets lucky; IEMG rebounds. His initial investment is once again worth $100,000, and the $2,000 harvest is now worth $2,222.22. Joe sells the whole thing.
Now Joe owes taxes on his capital gains. He gained $10,000 on his first tranche of IEMG, and $222.22 on the second. At the same 20 percent tax rate, he now owes $2,044.44 in capital gains taxes (assuming at least a 12-month holding period). He withdraws the doubled-down $2,000, and takes the $44.44 out of his $222.22 gains, netting a total of $177.78, assuming no trading costs along the way.
So, over a two-year period when Joe’s emerging market investments went nowhere, Joe used tax-loss harvesting to earn 0.18 percent, before trading costs. That’s 0.09 percent per year.
But is that 0.09 percent pure profit?
VWO and IEMG track different indexes. The difference is South Korea and small-caps—IEMG includes them, while VWO does not. From Jan. 2, 2008 through Aug. 7, 2014, this has led to a median rolling one-year index returns differential of 0.78 percent. Sometimes VWO outperformed; other times IEMG prevailed.
But one thing is for certain: They’re not the same. The trade most likely will not run afoul of the Internal Revenue Service’s “substantially identical” rule, but will come with opportunity cost. In fact, for 95 percent of the rolling one-year periods measured, the performance gap between the two indices was larger than our hypothetical 0.09 percent tax-loss harvest return.
Joe D. Investor’s story stared with a randomly unlucky trade. Did you notice other sources of randomness? Plenty of situations could have changed Joe’s overall returns, making them more—or less.
The biggest variable is probably tax rates—both state and federal. The higher your tax rates at the time of the harvest, the larger your tax savings. The opposite holds at the time of liquidation, when you face your lowered cost basis. Joe’s liquidation rates could be high, if, for example, he’s in his peak earnings years, needs to use taxable savings to send his kids to college, and also happens to be in a tax-the-rich political climate. On the other hand, if Joe were a retiree with no income and a mortgage, he’d beat the taxman.
Betterment’s and Wealthfront’s tax-loss harvesting white papers point out that Joe can get out of the liquidation tax by dying or giving his investments to charity. Congratulations?