Obama’s Unlikely Dig At Robo Advisors

As part of President Obama’s State of the Union speech last night, he took aim at a handful of tax dodges that are perceived by many as benefiting the wealthy at the expense of everyone else. Front and center is the so-called Trust Fund Loophole.

From the White House Fact Sheet:

“Close the trust fund loophole – the single largest capital gains tax loophole – to ensure the wealthiest Americans pay their fair share on inherited assets. Hundreds of billions of dollars escape capital gains taxation each year because of the ‘stepped-up’ basis loophole that lets the wealthy pass appreciated assets onto their heirs tax-free.”

Under current law, if you hold any investment with a low-cost basis, when you die, your heirs get to reset everything to fair market value. Got a portfolio of 20 ETFs, some in the money, some out of the money? Doesn’t matter. On death, it all gets marked-to-market.

Even better, under current federal law, slightly more than $5 million in assets can be transferred to your heirs without them having to pay any inheritance tax. This essentially means that a sizable chunk of capital gains tax liability just vanishes on death.

Enter The Robos

I’m a big fan of the robo advisors like Wealthfront and Betterment. I think they’re basically a force for good in the industry, and will help a lot of people make better decisions about their financial future.

But one of the big claims made by these firms is that by automating tax-loss harvesting, they’re creating extra value (assuming you’re investing in a taxable account.).

The logic is pretty simple: The firms monitor your ETF holdings, and should you have a loss that you can book at the end of the year, they’ll sell, book that loss and swap you into a nearly identical ETF. You get those tax losses on your books now, to offset potential gains.

Part Two

The second part of this, however, is that you’re continually lowering your cost basis. After all, you’re selling your losers and rebuying something very similar, which is also presumably down. After a lifetime of doing this, you can end up with a portfolio that is very low basis indeed.

The robos are clear that they know what’s going on here. From the Wealthfront Tax Loss Harvesting White Paper:

“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.”

Competitor Betterment sees this less as a caution and more as an opportunity. From their discussion of tax-loss harvesting:

“Permanent tax avoidance: Tax loss harvesting provides benefits now in exchange for increasing built-in gains, subject to tax later. However, under certain circumstances (charitable donation, bequest to heirs), these gains can avoid taxation entirely.”

Red Flag?

Now, I’m a realist. I understand that there is little chance that step-up tax basis actually disappears in the next two years, no more than that the capital gains rate climbs back up to Reagan levels. But I think it’s important to note that setting this into the national agenda suggests you can’t count on having step-up tax basis forever.

That doesn’t make tax-loss harvesting a bad idea. In fact, for many investors, even with a complete repeal of this loophole, it could still be a great idea.

Putting off taxes is in general a good idea. And the nature of a repeal is still entirely unknown. If you passed along low-basis shares to your heirs, would the low-basis value be used to account for how much could be transferred free on your death?

That could actually mean even more assets being transferred tax free than under the current system, just with a huge embedded tax liability. Would taxes have to be paid regardless of sale? In that case, maybe tax-loss harvesting is a good idea because your heirs might have lower tax burdens than you do.

It’s a lot of unknowns. Mostly, it’s a reminder that when it comes to big claims made by anyone about tax management, it’s a good idea to be skeptical, because the playing field can shift quickly.

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