A Guide to Tax Loss Harvesting & Robo Advisors

Roger Berger for Dough Roller writes: Tax loss harvesting is one of the few free lunches in the world of investing. With a little planning, you can reduce or even eliminate your capital gains in any given year. In some cases, you may also get a deduction from ordinary income of up to $3,000.

Tax Loss Harvesting, sometimes abbreviated TLH, has come into its own tanks to robo advisors. Services such as Betterment and Wealthfront have promoted their automated investment services with the help of TLH. They promise to increase your effective returns by harvesting losses on a daily basis. The promised benefits exceed the cost of their services, which I recently compared.

Today we’re going to talk about tax loss harvesting. We’ll cover how it works, its benefits, its limitations, and how you can use it to defer taxes. We’ll also look at the implications for those who use robo advisors that offer TLH services.

Capital Losses

The basic concept is simple. Let’s assume you invest $25,000 in an S&P 500 index fund.  Following a down market, you sell the investment a year later for $20,000.  The result is a loss of $5,000.

The loss can reduce your tax liability in one of three ways:

1. First, the loss can be used to offset any realized gains during the year. If you had sold a second investment for a $5,000 gain, the loss would offset the gain, eliminating any tax liability.
2. Second, after gains have been eliminated, any remaining capital losses can be applied to ordinary income up to a maximum annual deduction of $3,000.
3. Finally, if you still have capital losses after offsetting gains and $3,000 of ordinary income, the losses can be carried forward to future tax years.

Now to some complications.

Wash Sale Rule

There are times when we sell investments at a loss for reasons that have nothing to do with taxes.  Perhaps we need the cash and the investment just happens to be down. In other instances we’ve decided to change or investment plan.

With tax loss harvesting, the sale of losing investments is strategic.  We are selling specifically for the tax benefits.  Enter the wash sale rule.  SNIP - the article continues @ Dough Roller, click here to continue reading....