Tax Loss Harvesting+ Methodology

TABLE OF CONTENTS

1. Navigating the Wash Sale Rule
2. The Betterment Resolution
3. TLH+ Mannequin Calibration
4. Greatest Practices for TLH+
5. How we calculate the worth of TLH+
6. Conclusion

There are lots of methods to get your investments to work tougher for you— diversification, draw back danger administration, and an applicable mixture of asset lessons tailor-made to your beneficial allocation. Betterment does this routinely by way of its ETF portfolios.

However there may be one other manner that can assist you get extra out of your portfolio—utilizing funding losses to enhance your after-tax returns with a way known as tax loss harvesting. On this article, we introduce Betterment’s Tax Loss Harvesting+™ (TLH+™): a complicated, totally automated device that Betterment prospects can select to allow.

Betterment’s TLH+ service scans portfolios repeatedly for alternatives (momentary dips that end result from market volatility) for alternatives to comprehend losses which will be helpful come tax time. Whereas the idea of tax loss harvesting just isn’t new for rich buyers, TLH+ makes use of quite a few improvements that typical implementations might lack. It takes a holistic strategy to tax-efficiency, searching for to optimize user-initiated transactions along with including worth by automated exercise, resembling rebalances.

What’s tax loss harvesting?

Capital losses can decrease your tax invoice by offsetting features, however the one strategy to understand a loss is to promote the depreciated asset. Nonetheless, in a well-allocated portfolio, every asset performs a necessary position in offering a chunk of complete market publicity. For that cause, an investor mustn’t need to quit potential anticipated returns related to every asset simply to comprehend a loss.

At its most elementary stage, tax loss harvesting is promoting a safety that has skilled a loss—after which shopping for a correlated asset (i.e. one that gives comparable publicity) to switch it. The technique has two advantages: it permits the investor to “harvest” a helpful loss, and it retains the portfolio balanced on the desired allocation.

How can it decrease your tax invoice?

Capital losses can be utilized to offset capital features you’ve realized in different transactions over the course of a 12 months—features on which you’d in any other case owe tax. Then, if there are losses left over (or if there have been no features to offset), you possibly can offset as much as $3,000 of bizarre revenue for the 12 months. If any losses nonetheless stay, they are often carried ahead indefinitely.

Tax loss harvesting is primarily a tax deferral technique, and its profit relies upon totally on particular person circumstances. Over the long term, it may add worth by some mixture of those distinct advantages that it seeks to offer:

• Tax deferral: Losses harvested can be utilized to offset unavoidable features within the portfolio, or capital features elsewhere (e.g., from promoting actual property), deferring the tax owed. Financial savings which might be invested might develop, assuming a conservative development charge of 5% over a 10-year interval, a greenback of tax deferred can be price $1.63. Even after belatedly parting with the greenback, and paying tax on the $0.63 of development, you’re forward.
• Pushing capital features right into a decrease tax charge: If you happen to’ve realized short-term capital features (STCG) this 12 months, they’ll usually be taxed at your highest charge. Nonetheless, when you’ve harvested losses to offset them, the corresponding achieve you owe sooner or later might be long-term capital achieve (LTCG). You’ve successfully turned a achieve that might have been taxed as much as 50% immediately right into a achieve that shall be taxed extra calmly sooner or later (as much as 30%).
• Changing bizarre revenue into long-term capital features: A variation on the above: offsetting as much as $3,000 out of your bizarre revenue shields that quantity out of your prime marginal charge, however the offsetting future achieve will seemingly be taxed on the LTCG charge.
• Everlasting tax avoidance in sure circumstances: Tax loss harvesting supplies advantages now in alternate for growing built-in features, topic to tax later. Nonetheless, beneath sure circumstances (charitable donation, bequest to heirs), these features might keep away from taxation totally.

At a excessive stage, the so-called “wash sale rule” disallows a loss from promoting a safety if a “considerably similar” safety is bought 30 days after or earlier than the sale. The rationale is {that a} taxpayer mustn’t take pleasure in the advantage of deducting a loss if they didn’t actually eliminate the safety.

The wash sale rule applies not simply to conditions when a “considerably similar” buy is made in the identical account, but in addition when the acquisition is made within the particular person’s IRA/401(okay) account, and even in a partner’s account. This broad utility of the wash sale rule seeks to make sure that buyers can’t make the most of nominally completely different accounts to keep up their possession, and nonetheless profit from the loss.

A wash sale involving an IRA/401(okay) account is especially unfavorable. Usually, a “washed” loss is postponed till the substitute is bought, but when the substitute is bought in an IRA/401(okay) account, the loss is completely disallowed.

If not managed appropriately, wash gross sales can undermine tax loss harvesting. Dealing with proceeds from the harvest just isn’t the only real concern—any deposits made within the following 30 days (whether or not into the identical account, or into the person’s IRA/401(okay)) additionally have to be allotted with care.

Avoiding the wash

The only strategy to keep away from triggering a wash sale is to keep away from buying any safety in any respect for the 30 days following the harvest, holding the proceeds (and any inflows throughout that interval) in money. This strategy, nonetheless, would systematically hold a portion of the portfolio out of the market. Over the long run, this “money drag” might damage the portfolio’s efficiency.

Extra superior methods repurchase an asset with comparable publicity to the harvested safety that’s not “considerably similar” for functions of the wash sale rule. Within the case of a person inventory, it’s clear that repurchasing inventory of that very same firm would violate the rule. Much less clear is the therapy of two index funds from completely different issuers (e.g., Vanguard and Schwab) that observe the identical index. Whereas the IRS has not issued any steerage to counsel that such two funds are “considerably similar,” a extra conservative strategy when coping with an index fund portfolio can be to repurchase a fund whose efficiency correlates intently with that of the harvested fund, however tracks a unique index.

TLH+ is usually designed round this index-based logic, though it can’t keep away from potential wash gross sales arising from transactions in tickers that observe the identical index the place one of many tickers just isn’t at present a main, secondary, or tertiary ticker (as these phrases are outlined on this white paper). This case might come up, for instance, when different tickers are transferred to Betterment or the place they had been beforehand a main, secondary, or tertiary ticker. Moreover, for some portfolios constructed by third events (e.g., Vanguard, Blackrock, or Goldman Sachs), sure secondary and tertiary tickers observe the identical index. Sure asset lessons in portfolios constructed by third events (e.g., Vanguard, Blackrock, or Goldman Sachs) would not have tertiary tickers, such that completely disallowed losses might happen if there have been overlapping holdings in taxable and tax-advantaged accounts.

Choosing a viable substitute safety is only one piece of the accounting and optimization puzzle. Manually implementing a tax loss harvesting technique is possible with a handful of securities, little to no money flows, and rare harvests. Property might nonetheless dip in worth however doubtlessly get better by the top of the 12 months, subsequently annual methods or rare harvests might depart many losses on the desk. The wash sale administration and tax lot accounting essential to assist extra frequent harvesting shortly turns into overwhelming in a multi-asset portfolio—particularly with common deposits, dividends, and rebalancing.

An efficient loss harvesting algorithm ought to have the ability to maximize harvesting alternatives throughout a full vary of volatility eventualities, with out sacrificing the investor’s international asset allocation. It ought to reinvest harvest proceeds into correlated alternate belongings, all whereas dealing with unexpected money inflows from the investor with out ever resorting to money positions. It must also have the ability to monitor every tax lot individually, harvesting particular person heaps at an opportune time, which can depend upon the volatility of the asset. TLH+ was created as a result of no accessible implementations appeared to unravel all of those issues.

Present methods and their limitations

Each tax loss harvesting technique shares the identical fundamental purpose: to maximise a portfolio’s after-tax returns by realizing built-in losses whereas minimizing the unfavourable impression of wash gross sales.

Approaches to tax loss harvesting differ primarily in how they deal with the proceeds of the harvest to keep away from a wash sale. Beneath are the three methods generally employed by guide and algorithmic implementations.

After promoting a safety that has skilled a loss, present methods would seemingly have you ever …

The hazards of switchbacks

Within the 30 days main as much as the switchback, two issues can occur: the substitute safety can drop additional, or go up. If it goes down, the switchback will understand an extra loss. Nonetheless, if it goes up, which is what any asset with a constructive anticipated return is predicted to do over any given interval, the switchback will understand short-term capital features (STCG)—kryptonite to a tax-efficient portfolio administration technique.

An try and mitigate this danger might be setting a better threshold primarily based on volatility of the asset class—solely harvesting when the loss is so deep that the asset is unlikely to thoroughly get better in 30 days. After all, there may be nonetheless no assure that it’ll not, and the value paid for this buffer is that your lower-yielding harvests can even be much less frequent than they might be with a extra subtle technique.

Examples of unfavourable tax arbitrage

Unfavorable tax arbitrage with automated 30-day switchback

An automated 30-day switchback can destroy the worth of the harvested loss, and even improve tax owed, reasonably than cut back it. A considerable dip presents a wonderful alternative to promote a complete place and harvest a long-term loss. Proceeds will then be re-invested in a extremely correlated substitute (monitoring a unique index). 30 days after the sale, the dip proved momentary and the asset class greater than recovered. The switchback sale leads to STCG in extra of the loss that was harvested, and truly leaves the investor owing tax, whereas with out the harvest, they might have owed nothing.

As a result of a technical nuance in the way in which features and losses are netted, the 30- day switchback may end up in unfavourable tax arbitrage, by successfully pushing present features into a better tax charge.

When including up features and losses for the 12 months, the foundations require netting of like towards like first. If any long-term capital achieve (LTCG) is current for the 12 months, you should internet a long-term capital loss (LTCL) towards that first, and solely then towards any STCG.

Unfavorable tax arbitrage when unrelated long-term features are current

Now let’s assume the taxpayer realized a LTCG. If no harvest takes place, the investor will owe tax on the achieve on the decrease LTCG charge. Nonetheless, when you add the LTCL harvest and STCG switchback trades, the foundations now require that the harvested LTCL is utilized first towards the unrelated LTCG. The harvested LTCL will get used up totally, exposing your complete STCG from the switchback as taxable. As a substitute of sheltering the extremely taxed achieve on the switchback, the harvested loss acquired used up sheltering a lower-taxed achieve, creating far larger tax legal responsibility than if no harvest had taken place.

Within the presence of unrelated transactions, unsophisticated harvesting can successfully convert present LTCG into STCG. Some buyers repeatedly generate vital LTCG (as an illustration, by steadily diversifying out of a extremely appreciated place in a single inventory). It’s these buyers, in actual fact, who would profit essentially the most from efficient tax loss harvesting.

Unfavorable tax arbitrage with dividends

Unfavorable tax arbitrage may end up in reference to dividend funds. If sure circumstances are met, some ETF distributions are handled as “certified dividends”, taxed at decrease charges. One situation is holding the safety for greater than 60 days. If the dividend is paid whereas the place is within the substitute safety, it won’t get this favorable therapy: beneath a inflexible 30-day switchback, the situation can by no means be met. In consequence, as much as 20% of the dividend is misplaced to tax (the distinction between the upper and decrease charge).

To make sure that every asset class is supported by optimum securities in each main and alternate (secondary) positions, we screened by expense ratio, liquidity (bid-ask unfold), monitoring error vs. benchmark, and most significantly, covariance of the alternate with the first.¹

Whereas there are small price variations between the first and alternate securities, the price of unfavourable tax arbitrage from tax-agnostic switching vastly outweighs the price of sustaining a twin place inside an asset class.

TLH+ contains a particular mechanism for coordination with IRAs/401(okay)s that requires us to select a 3rd (tertiary) safety in every harvestable asset class (besides in municipal bonds, which aren’t within the IRA/401(okay) portfolio). Whereas these have a better price than the first and alternate, they aren’t anticipated to be utilized usually, and even then, for brief durations (extra under in IRA/401(okay) safety).

Parallel Place Administration

As demonstrated, the unconditional 30-day switchback to the first safety is problematic for quite a few causes. To repair these issues, we engineered a platform to assist TLH+, which seeks to tax-optimize consumer and system-initiated transactions: the Parallel Place Administration (PPM) system.

PPM permits every asset class to include a main safety to characterize the specified publicity whereas sustaining alternate and tertiary securities which might be intently correlated securities, ought to that lead to a greater after-tax final result.

PPM supplies a number of enhancements over the switchback technique. First, pointless features are minimized if not completely prevented. Second, the parallel safety (might be main or alternate) serves as a protected harbor to attenuate wash gross sales—not simply from harvest proceeds, however any money inflows. Third, the mechanism seeks to guard not simply harvested losses, however losses realized by the shopper as properly.

PPM not solely facilitates efficient alternatives for tax loss harvesting, but in addition extends most tax-efficiency to customer-initiated transactions. Each buyer withdrawal is a possible harvest (losses are bought first). And each buyer deposit and dividend is routed to the parallel place that might decrease wash gross sales, whereas shoring up the goal allocation.

PPM has a desire for the first safety when rebalancing and for all money circulate occasions—however all the time topic to tax concerns. That is how PPM behaves beneath numerous circumstances:

Wash sale administration

Managing money flows throughout each taxable and IRA/401(okay) accounts with out needlessly washing realized losses is a fancy downside.

TLH+ operates with out constraining the way in which that prospects favor contributing to their portfolios, and with out resorting to money positions. With the advantage of parallel positions, it weighs wash sale implications of each deposit and withdrawal and dividend reinvestment, and seeks to systematically select the optimum funding technique. This technique protects not simply harvested losses, but in addition losses realized by withdrawals.

Avoiding wash sale by tertiary tickers in IRA/401(okay)

As a result of IRA/401(okay) wash gross sales are notably unfavorable—the loss is disallowed completely—TLH+ ensures that no loss realized within the taxable account is washed by a subsequent deposit right into a Betterment IRA/401(okay) with a tertiary ticker system in IRA/401(Okay) and no harvesting is finished in IRA/401(okay).

Let’s take a look at an instance of how TLH+ handles a doubtlessly disruptive IRA influx with a tertiary ticker when there are realized losses to guard, utilizing actual market knowledge for a Developed Markets asset class.

The client begins with a place in VEA, the first safety, in each the taxable and IRA accounts. We harvest a loss by promoting your complete taxable place, after which repurchasing the alternate safety, SCHF.

Loss Harvested in VEA

Two weeks go, and the shopper makes a withdrawal from the taxable account (your complete SCHF place, for simplicity), meaning to fund the IRA. In these two weeks, the asset class dropped extra, so the sale of SCHF additionally realized a loss. The VEA place within the IRA stays unchanged.

Buyer Withdrawal Sells SCHF at a Loss

Just a few days later, the shopper contributes to his IRA, and $1,000 is allotted to the Developed Markets asset class, which already comprises some VEA. Even supposing the shopper now not holds any VEA or SCHF in his taxable account, shopping for both one within the IRA would completely wash a helpful realized loss. The Tertiary Ticker System routinely allocates the influx into the third choice for developed markets, IEFA.

IRA Deposit into Tertiary Ticker

Each losses have been preserved, and the shopper now holds VEA and IEFA in his IRA, sustaining desired allocation always. As a result of no capital features are realized in an IRA/401(okay), there isn’t a hurt in switching out of the IEFA place and consolidating your complete asset class in VEA when there isn’t a hazard of a wash sale.

The end result: Prospects utilizing TLH+ who even have their IRA/401(okay) belongings with Betterment can know that Betterment will search to guard helpful realized losses every time they deposit into their IRA/401(okay), whether or not it’s lump rollover, auto-deposits and even dividend reinvestments.

Good rebalancing

Lastly, TLH+ directs the proceeds of each harvest to rebalance your complete portfolio, the identical manner {that a} Betterment account handles any incoming money circulate (deposit, dividend). A lot of the money is predicted to remain in that asset class and be reinvested into the parallel asset, however a few of it might not. Recognizing each harvest as a rebalancing alternative additional reduces the necessity for extra promoting in instances of volatility, additional lowering tax legal responsibility. As all the time, fractional shares enable the inflows to be allotted with precision.

There are two common approaches to testing a mannequin’s efficiency: historic backtesting and forward-looking simulation. Optimizing a system to ship the most effective outcomes for less than previous historic intervals is comparatively trivial, however doing so can be a traditional occasion of knowledge snooping bias. Relying solely on a historic backtest of a portfolio composed of ETFs that enable for 10 to twenty years of dependable knowledge when designing a system meant to offer 40 to 50 years of profit would imply making quite a few indefensible assumptions about common market conduct.

The superset of choice variables driving TLH+ is past the scope of this paper—optimizing round these variables required exhaustive evaluation. TLH+ was calibrated by way of Betterment’s rigorous Monte Carlo simulation framework, spinning up 1000’s of server situations within the cloud to run by tens of 1000’s of forward-looking eventualities testing mannequin efficiency. We have now calibrated TLH+ in a manner that we consider optimizes its effectiveness given anticipated future returns and volatility, however different optimizations might lead to extra frequent harvests or higher outcomes relying on precise market circumstances.

Particularly, we don’t advise you to make use of TLH+ when you can at present understand capital features at a 0% tax charge. Underneath 2023 tax brackets, this can be the case in case your taxable revenue is under $11,625 as a single filer or $89,250 in case you are married submitting collectively. See the IRS web site for extra particulars.

Graduate college students, these taking parental depart, or simply beginning out of their careers ought to ask “What tax charge am I offsetting immediately” versus “What charge can I fairly count on to pay sooner or later?”

The Scattered Portfolio: TLH+ is rigorously calibrated to handle wash gross sales throughout all belongings managed by Betterment, together with IRA belongings. Nonetheless, the algorithms can’t bear in mind data that’s not accessible. To the extent {that a} Betterment buyer’s holdings (or a partner’s holdings) in one other account overlap with the Betterment portfolio, there will be no assure that TLH+ exercise won’t battle with gross sales and purchases in these different accounts (together with dividend reinvestments), and lead to unexpected wash gross sales that reverse some or all the advantages of TLH+. We don’t suggest TLH+ to a buyer who holds (or whose partner holds) any of the ETFs within the Betterment portfolio in non-Betterment accounts. You possibly can ask Betterment to coordinate TLH+ together with your partner’s account at Betterment. You’ll be requested to your partner’s account data after you allow TLH+ in order that we might help optimize your investments throughout your accounts.

The Portfolio Technique Collector: Electing completely different portfolio methods for a number of Betterment targets might trigger TLH+ to determine fewer alternatives to reap losses than it would when you elect the identical portfolio technique for your whole Betterment targets.

The Fast Liquidator: What occurs if all the further features attributable to harvesting are realized over the course of a single 12 months? In a full liquidation of a long-standing portfolio, the extra features attributable to harvesting might push the taxpayer into a better LTCG bracket, doubtlessly reversing the advantage of TLH+. For individuals who count on to attract down with extra flexibility, sensible automation shall be there to assist optimize the tax penalties.

The Imminent Withdrawal: The harvesting of tax losses resets the one-year holding interval that’s used to differentiate between LTCG and STCG. For many buyers, this isn’t a problem: by the point that they promote the impacted investments, the one-year holding interval has elapsed and so they pay taxes on the decrease LTCG charge. That is notably true for Betterment prospects as a result of our TaxMin characteristic routinely realizes LTCG forward of STCG in response to a withdrawal request. Nonetheless, in case you are planning to withdraw a big portion of your taxable belongings within the subsequent 12 months, you must wait to activate TLH+ till after the withdrawal is full to scale back the opportunity of realizing STCG.

Different Impacts to Contemplate

Buyers with belongings held in several portfolio methods ought to perceive the way it impacts the operation of TLH+. To study extra, please see Betterment’s SRI disclosures, Versatile portfolio disclosures, the Goldman Sachs sensible beta disclosures, and the BlackRock goal revenue portfolio disclosures for additional element. Purchasers in Advisor-designed customized portfolios by Betterment for Advisors ought to seek the advice of their Advisors to know the restrictions of TLH+ with respect to any customized portfolio. Moreover, as described above, electing one portfolio technique for a number of targets in your account whereas concurrently electing a unique portfolio for different targets in your account might cut back alternatives for TLH+ to reap losses attributable to wash sale avoidance.

As a result of Betterment’s month-to-month cadence for billing charges for advisory companies, by the liquidation of securities, tax loss harvesting alternatives could also be adversely affected for patrons with notably excessive inventory allocations, third get together portfolios, or versatile portfolios. Because of assessing charges on a month-to-month cadence for a buyer with solely fairness safety publicity, which tends to be extra opportunistic for tax loss harvesting, sure securities could also be bought that might have been used to tax loss harvest at a later date, thereby delaying the harvesting alternative into the longer term. This delay can be attributable to avoidance of triggering the wash sale rule, which forbids a safety from being bought solely to get replaced with a “considerably comparable” safety inside a 30-day interval.

Elements which is able to decide the precise good thing about TLH+ embody, however should not restricted to, market efficiency, the scale of the portfolio, the inventory publicity of the portfolio, the frequency and dimension of deposits into the portfolio, the supply of capital features and revenue which will be offset by losses harvested, the tax charges relevant to the investor in a given tax 12 months and in future years, the extent to which related belongings within the portfolio are donated to charity or bequeathed to heirs, and the time elapsed earlier than liquidation of any belongings that aren’t disposed of on this method.

All of Betterment’s buying and selling choices are discretionary and Betterment might determine to restrict or postpone TLH+ buying and selling on any given day or on consecutive days, both with respect to a single account or throughout a number of accounts.

Tax loss harvesting just isn’t appropriate for all buyers. Nothing herein ought to be interpreted as tax recommendation, and Betterment doesn’t characterize in any method that the tax penalties described herein shall be obtained, or that any Betterment product will lead to any explicit tax consequence. Please seek the advice of your private tax advisor as as to if TLH+ is an acceptable technique for you, given your explicit circumstances. The tax penalties of tax loss harvesting are complicated and unsure and could also be challenged by the IRS. You and your tax advisor are answerable for how transactions carried out in your account are reported to the IRS in your private tax return. Betterment assumes no duty for the tax penalties to any shopper of any transaction.

See Betterment’s TLH+ disclosures for additional element.

Then, we pulled the overall charges charged to the customers on the account in query that had been accrued in 2022 and 2023 from our charge accrual data and in contrast that to the tax invoice discount. If the tax invoice discount was larger than the charges, we thought of TLH+ to have not directly paid for the charges within the account in query for the taxpayer in query. This was the case for 69% of consumers.²