Sophisticated investors have been harvesting losses manually for decades to acquire tax benefits. Betterment and Wealthfront made harvesting losses easier and more efficient than ever since 2008. Betterment alone has reached $5 billion under management.

Personal finance bloggers tend to love tax-loss harvesting without much mention of risk. A few bloggers have expressed doubts over the whole process, but their numbers are few and their voices drown out by the scream of the crowd. Betterment’s affiliate program has caused concern positive reviews are biased. Betterment’s affiliate program has tightened for bloggers investing with the company and with published reviews due to recent SEC rule changes. As a result, many bloggers must end their affiliate relationship with Betterment or take down their reviews of the company.

The truth about TLH is not as clean cut as some would have you believe. Taxes and performance are two issues every investor needs to consider prior to investing with any company engaged in TLH.

How TLH Works

Tax-loss harvesting is when you sell a security at a loss for tax purposes. The IRS knows this strategy can be used to generate substantial phantom tax losses by taxpayers. There are rules to prevent doing just that.

Sales of a security at a loss are not deductible if you buy a substantially identical stock/security within 30 days of the sale. This includes the purchase of options to purchase a substantially identical security. Disallowed loses from a wash sale are added to the basis of the purchased substantially identical security.

Wash sales in a traditional IRA are lost forever! Using Betterment or other similar programs increase the risk you will have a wash sale. When Betterment sells a security at a loss and you buy a substantially identical security in your IRA unwittingly, the wash sale loss is disallowed forever. The taxpayer’s basis in the IRA is not increased by the amount of the disallowed loss. Understand now? No? Then you either must allow Betterment to handle all your investments or don’t use them at all. It is the only way to steer clear of this pitfall.

Using the Harvested Loss

Capital losses, including harvested losses are applied first against other capital gains. If all gains are used before the losses, up to $3,000 can be deducted against other income. Most states follow the federal rule. However, Wisconsin only allows $500 per year against other income.

Long-term capital gains taxes reach 20% for taxpayers in the 39.9% tax bracket. The alternative minimum tax has a 22 ½% LTCG rate. (AMT issues will need to wait for another post as the issues surrounding AMT are massive.) If you are in the 10% or 15% tax bracket, LTCGs are taxed at zero and harvested losses are worthless. In lower brackets you want to gain harvest to increase your basis while paying little or no tax.

The Net Investment Income Tax may add 3.8% to the LTCG tax bill of high earners. There is a possibility this could change in the near future. (I am writing this in early 2017.)

Excess capital losses must be deducted (yes, there is a very limited opportunity to avoid this, for the tax accountants reading) up to $3,000 each year until used, even if it provides no benefit. When a capital loss is carried forward, it is applied to capital gains first again. If excess still exists, up to $3,000 is deducted. (Example: If you only have $1,000 of loss left over then you only get to deduct $1,000.)

Investors in Prosper, Lending Club or similar investments have an added issue. Loan defaults in the micro-lending arena are treated as capital losses. As you will see shortly, larger capital losses carried forward can cause nasty tax problems. Later collections are treated as capital gains.

The $3,000 deduction against other income is at your marginal tax rate. Since the $3,000 comes off the top, it comes off at your highest tax rate. Therefore, a $3,000 deduction for a taxpayer in the 33% tax bracket will see her tax liability drop $990. State taxes may allow for additional savings.

TLH reduces your basis. Later, when you sell, your gains are taxed at the LTCG rate (assuming you held the investment more than a year). Even in the 20% LTCG bracket, you still pay 13% less than what you saved. The good news is you get a tax break now and pay later at a discount. The problem? It only applies to $3,000 per year.

The tax savings on the above example is $130 max. It seems like a lot of horsing around for such a small real gain.

Betterment and Wealthfront

Disclosure: I am not an affiliate of either company. If I am asked to be an affiliate I might agree, but as of this writing I have no intention of pursuing that course. I also do not have any investments with either company.

Technology has brought Modern Portfolio Theory front and center. Back in the 1990s when I was a securities guy, we talked about the efficient frontier and Modern Portfolio Theory a lot.

Modern Portfolio Theory entered our world in 1952 when Harry Markowitz published a paper called “Portfolio Selection”.

Betterment and Wealthfront can now automate the entire process, balancing the investment and taxes for maximum results. There are fees connected to the service, of course. The fees are generally small, but they do reduce the value of the tax benefit.

First, broad-based index funds may outperform the TLH platforms. This is because Modern Portfolio Theory doesn’t have you in one broad-based investment. My experience with clients is that in up markets TLH underperforms a bit and in down markets outperforms a bit. It could be my small sample group giving me this worldview, so take it with caution. Since the market is up more than down, there is something given up for the smoother ride and the access to harvested losses.

Second, harvested losses vary a lot. Usually the early years provide the biggest benefit. As the basis drops, so do the tax benefits. It is not unusual for the first full year of the investment to produce harvested losses near 10% of recently invested capital. Harvested losses decline as the years go by unless you add more capital

TLH in Retirement

Here is where it gets tricky. What starts as a good idea ends up working against you when your taxable income declines. As you accumulate wealth by investing income, your marginal tax rate tends to be higher. Therefore, you benefit from the TLH.

In retirement, early or late, your income declines to about what you spend, maybe lower. Social Security is only partially taxed, if at all, depending on your other income. Withdrawals from non-qualified accounts are not all taxable gain as some is return of capital. Traditional retirement distributions add to income. People around here tend to live a frugal lifestyle. That is how they built a large portfolio. Therefore, they have low taxable income in retirement.

At this time you don’t want to harvest losses because they hurt you! Now you want to do the opposite. A low tax bracket means your LTCGs are very low or even 0%. Harvesting gains doesn’t have wash sale rule problems, either. You can sell at a gain and buy back the exact same security a second later without tax basis consequences. You claim the gain at the low or 0% tax rate and get the higher basis. If you sell in the future you will have a smaller gain which is good if your income has increased. Tax gain harvesting is free or close to it and doesn’t require a platform, like Betterment.

Married People and Wash Sales

As if wash sale rules weren’t hard enough to account for, married people have an added risk. The 30-day rule applies to your spouse’s account too. Like above, this means if you have a wash sale, even your spouse cannot buy a substantially identical security in her qualified or non-qualified account during the 30 day window.

If a traditional IRA is involved the basis is lost forever, again.

The only way around this is to have 100% of your investments with the same platform for you and your spouse. If not, you could run afoul of the wash sale rules without knowing it. And if the IRS finds out . . .

Who Owns the Loss? Where You Live Matters

Capital losses have one last problem to consider. Losses follow the person they belong to. If you have a capital loss and you die, the loss dies with you. Your spouse does not inherit the loss for use on her tax return.

In marital property states ( non-qualified accounts are considered owned 50/50, where each spouse gets half the loss applied to his/her account. In equitable distribution states (most states) the loss belongs to the person named on the account. It could be a joint account, but if it isn’t the loss only follows the person named on the account.

The $3,000 capital loss deduction is per return, not per person.

When a spouse dies and in a divorce, it is important to account for which spouse gets what amount of the loss carry forward. Marital property tax states are nice because it is usually a 50/50 split; one of the few benefits of working as a tax pro in Wisconsin. Equitable distribution states require some work to properly allocate the loss.

Would I Recommend Betterment or Wealthfront?

Actually, I have. Recently, at a Camp Mustache in Florida, I offered consultations. For some reason I ended up recommending Betterment to over half the people I consulted. The percentage was high so I started to feel concerned. No one answer is right for everyone.

After plenty of thought I felt comfortable with my recommendations. Betterment offered a quality service which would reduce the client’s taxes. The client was unlikely to do any TLH themselves, so it made sense to recommend.

What I don’t have control over is when the client will need to flip the process. You see, if they are in a 33% tax bracket now (saving $990 per year) and retire with a lower bracket where LTCGs are taxed at 0%, the best possible outcome for my clients, they need to reverse the process and start gain harvesting.

I don’t recommend Betterment or any TLH program for everyone. I recommend selectively if the numbers add up. The tax savings are nice, but small for most people.

Final Thoughts

Wash sale rules are complex and easy to mess up. A qualified tax professional is required for most people when they engage TLH programs.

Betterment (or other TLH platform) needs to manage all or none of your investments to assure you do not run afoul of wash sale rules.

TLH is just one tool to reduce your tax liability. I personally do not use any TLH platform, but periodically do some TLH manually. A large capital loss carried forward will not benefit my spouse if I die. Of course, Mrs. Accountant would get a step-up in basis if I kicked the bucket.

High earners benefit the most from TLH. High income also means there is probably less time available to work this stuff manually.

Young people also have more time to accumulate tax benefits. Remember, the real benefit is the $3,000 allowed against other income. Netting a $500 – $1,000 annual tax reduction is nice, but you need several years of benefits for the amount to become meaningful.

We can continue the discussion in the comments section below.