A current fad in the world of personal finance and investing is so-called “tax-loss harvesting.” If you’re not familiar with the concept, tax-loss harvesting refers to the perfectly true observation that up to $3,000 in capital losses can be deducted from ordinary income each year, and it’s one of the biggest selling points of “robo advisors,” the automated investing services that manage accounts on your behalf.
Due to my unfortunate literal tendency, I had the apparently unprecedented idea of checking whether this is actually worthwhile. This isn’t rocket science: we need only compare the value of a $3,000 reduction in ordinary income to the cost of maintaining an account with one of these services.
There are a number of automated advisory services, so for simplicity’s sake let’s take a look at the big three: Wealthfront, Betterment, and FutureAdvisor. Purely from the generosity of my spirit I’m going to give each service the benefit of the doubt and assume that they really will achieve $3,000 in capital losses each and every calendar year.
What are $3,000 in capital losses worth?
In the United States we have 7 marginal income tax rates, and since the $3,000 in capital losses will be deducted from your income at the margin, the value of the loss depends on your marginal income tax rate:
- 10%: $300
- 15%: $450
- 25%: $750
- 28%: $840
- 33%: $990
- 35%: $1,050
- 39.6%: $1,188
For an automated advisory service to be worth paying for, the amount paid to the service must be lower than the value of the tax-loss harvesting the service provides. Since automated advisory services charge based on the amount of money they manage, this creates the curious situation where the value of the service goes up the higher your marginal tax rate and goes down the more money you hold with them.
What we can easily identify is your breakeven point, where you begin to pay more in advisory fees than you receive in reduced income tax liability.
Wealthfront has a 0.25% annual advisory fee and claims to provide tax-loss harvesting services to every client, regardless of account balance, and manages your first $10,000 invested for free. Assuming they’re able to realize $3,000 in capital losses on accounts of any size, the breakeven points for someone in each marginal income tax bracket are:
- 10%: $130,000
- 15%: $190,000
- 25%: $310,000
- 28%: $346,000
- 33%: $406,000
- 35%: $430,000
- 39.6%: $485,200
Betterment charges the same 0.25% annual advisory fee as Wealthfront, but doesn’t exempt the first $10,000 from fees so the breakeven points are identical to those above, less that $10,000 amount.
FutureAdvisor charges 0.5% of assets under management each year, which means you’ll pay more in advisory fees than you earned in reduced income tax liability at the following account values:
- 10%: $60,000
- 15%: $90,000
- 25%: $150,000
- 28%: $168,000
- 33%: $198,000
- 35%: $210,000
- 39.6%: $237,600
What about offsetting capital gains?
It’s also true that capital losses can be used to offset capital gains. While only $3,000 of capital losses can be used to offset ordinary income, an unlimited amount of capital losses can be used to offset realized capital gains.
This leads me to the rather embarrassing question I’m forced to ask: why do you have capital gains?
Last year the Vanguard 500 (VFIAX) distributed $0 in capital gains.
Last year the Vanguard Total International Stock Index (VTIAX) distributed $0 in capital gains.
If you’re recording large capital gains each tax year you definitely have a problem, but that problem isn’t going to be solved by automated tax loss harvesting, that problem is going to be solved by getting — and staying — in some low-cost Vanguard index funds. That’s true whether you have invested $100,000 or $1,000,000. Constructing a portfolio that spins off capital gains each year and then paying somebody to offset them with capital losses isn’t a second-best, third-best, or fourth-best option.
It’s literally the worst option.
Go ahead and roboinvest if you think they know something you don’t
I do not have any reason to believe that backtesting is an interesting or useful way to build a portfolio. But I do believe backtesting is an extremely popular way to build a portfolio, and I’m sure these and the many other automated investing firms are great at it. So if you, like many investors, believe that backtesting is an interesting and useful, and hopefully profitable, way to build a portfolio, I don’t see any reason not to invest with one of these automated investing services.
If you’re right, and these model portfolios outperform buying and holding some low-cost Vanguard funds, then you win twice: you outperform us lazy, skeptical investors and you make a little money each year harvesting capital losses.
If you’re wrong, then the good news is that you’re not alone, but the bad news is you’re paying out of pocket each year for the privilege of underperforming.