Tax Loss Harvesting: Enough is Enough

I recently had a conversation about the benefits of tax-loss harvesting, specifically about the benefits offered by several leading robo-advisors who perform “daily” tax loss harvesting, and if “traditional” human financial advisors are losing their edge in this space. Tax loss harvesting (TLH) and specifically aggressive TLH, is one of the primary selling points of robo-advisors.

Most of the robo-advisors claim that their aggressive TLH strategy will add nearly 1% per year (right now on Wealthfront’s website they are claiming a whopping 1.55% per year!) in additional risk-free return. I’m not going to take too much time taking apart their assumptions, but needless to say you need to be fairly creative with the math to get to that high of a number. And of course, tax loss harvesting isn’t perfect or free; there are costs and risks involved.

What costs and risks? Well here is just part of Wealthfront’s disclosure about their tax loss harvesting process.

Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors.

Most major robos are quick to admit that:

1) One of the primary benefits, the ordinary income offset, is capped at $3,000 per year and

2) You would have to have annual realized short-term capital gains every year in the amount of the loss harvested to “maximize” the benefits of TLH.  So, basically no one. I have never had a client who has regularly generated a large amount of short-term capital gains. We’re long-term investors, why would we have so many short-term capital gains?

One thing missing from much of the discussion around TLH from the robo advisors is that over time, you run out of opportunities to take tax losses. Unless you are aggressively and substantially saving huge dollar amounts into an after-tax account each year, benefits as a percentage of your overall after-tax account are going to decline for a very simple reason: markets go up over time. You can take losses and reset your cost basis lower and lower, but eventually, markets go up. Eventually, your basis will be equal to the lowest point in the markets over a several-year period. You only have to look at a portfolio that has been invested for 10 years to see this: there aren’t going to be losses to harvest. So the idea that you will, forever, get a 1% or higher benefit from tax-loss harvesting is a misstatement at best.

My question ultimately is this: How much is enough? Do you need to be constantly turning over your portfolio to try to wring out every $15 tax loss from every position you own, and in the process generate a 40 page 1099 each spring? Or is there a “good enough” level of tax loss harvesting for most investors?

Out of curiosity I pulled some figures from actual clients over the past few years to see what kind of losses we had harvested in a large, very broadly diversified taxable portfolio. To give you an idea of where these opportunities were, let’s look at annual returns for some popular asset classes (note that these are not representative of actual client portfolios).

Fund 2013 2014 2015 2016
SPY 32.31% 13.46% 1.25% 12.00%
VB 37.70% 7.63% -3.76% 18.44%
VXUS 14.61% -4.74% -4.19% 4.81%
VWO -4.92% -0.07% -15.81% 12.21%
VNQ 2.31% 30.36% 2.42% 8.60%
VWIUX -1.48% 7.33% 2.94% 0.19%

You can see there were some funds with annual losses, and this doesn’t even take into account intra-year declines, which by default are nearly always worse than an annual return. If you owned international stocks or small caps or bonds, you probably had some chance to take losses in the last several years. That’s all I’m driving at.

Okay, time for some math. I pulled a handful of client account that had been around for at least a few years and looked at what amount of losses were harvested. For the random accounts sampled, in 2015 I harvested between 2% and 4% of the account value, and in 2016 between 1.5% and 4%. The variance depended primarily on asset allocation and inception dates. So in each of 2015 and 2016 you could estimate that we were taking around 3% of account value in harvested losses ($3,000 on every $100,000 in the portfolio). If you want to use some of the ridiculous math supported by certain robo advisors, you can get pretty close to that translating to 1.5% in tax alpha. But I think that’s absurd.

What you really get is a $3,000 current year ordinary income tax deduction, which is valuable. Yay! And then you get to bank any losses over and above that amount to offset future gains. Gains that you might take from rebalancing or from freeing up cash in a portfolio for retirement expenses. Again, this is a very good thing. You’re creating tax deferral in a taxable environment. Big win. But we arrived at these figures without constant daily trading of ETFs to pick up $10-$15 losses, risking bid/ask spreads, portfolio drift, trade execution risks and paying brokerage commissions. These figures were the result of reasonable, intra-year harvesting of substantive losses. No 40 page 1099-Bs required. Tax loss harvesting is great, but the presumed benefits of aggressive daily loss harvesting over a more “traditional” strategy are likely highly overstated.

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