Tax-Loss Harvesting is Killing Your Nest Egg

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.

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Keith Schroeder


  1. Fiby on February 3, 2017 at 4:11 pm

    It’s also worth noting that when a mix of short term and long term capital losses are carried forward and you have no capital gains, so they’re used against income, short term losses are used up first (which is disadvantageous).

    Whoa didn’t realize capital losses die with you even if you’re married. That’s really strange. You can only get $3k in capital losses deduct against income per return, but your spouse doesn’t get to carry forward your capital losses?

    “However, Wisconsin only allows $500 per year against other income.”
    So say I lived in Wisconsin and claimed a $3000 capital loss on my federal taxes. This year I can only claim $500 against my Wisconsin AGI. What happens to the other $2500? Does it carry forward or does it just disappear?

    • Keith Schroeder on February 3, 2017 at 4:42 pm

      Fiby, you add the $2,500 back into income on the Wisconsin tax return. You need to live forever to completely use even a modest capital loss carry forward unless you produce some gains to apply against the losses.

      And yes, as a reminder to all, your spouse does not get to use your capital loss whether you are dead or alive. Maybe I’ll work a small example over the weekend to show how weird this can get. I’m preparing taxes Sunday so I might take a break then and illustrate limits on capital loss deductions.

  2. TJ on February 3, 2017 at 4:20 pm

    What I don’t like about these robo’s is that they don’t consider your income tax bracket or your state taxation. When I used Betterment, I manipulated the software to put me in 100% stocks because their bond recommendation for my tax bracket was horrible. Most people wouldn’t have the financial acumen to recognize that. Once the software is able to recognize that someone in California should have their bonds in a California muni fund, or someone in a low tax bracket should be in taxable bonds instead of tax exempt, I would feel more comfortable recommending it. I assume most people aren’t just choosing the most aggressive option despite their answers to the questionnaire, but who knows. I’ve always said they make sense for a high bracket person, particularly in a state that doesn’t have income taxes, but I see them marketed all the time at millennials with really small portfolios and I don’t believe it to be the best choice for those people.

    • Keith Schroeder on February 3, 2017 at 4:46 pm

      TJ, some people benefit from robo investing and TLH. But too many invested in these platforms should not be. And you are 100% right, too many bonds and too many of the wrong kinds of bonds are built into the TLH platforms. That is why they under perform broad-based index funds over even modest periods of time.

  3. Physician On FIRE on February 4, 2017 at 8:17 pm

    It’s best to keep the portfolio simple when planning to TLH, and the Robo advisors only complicate matters in my opinion.

    My strategy has been to avoid duplicating funds that I hold in taxable in any other accounts, and I TLH back and forth between similar Vanguard mutual funds. I use Total Stock Market and S&P 500 as trading partners, and two similar (but not substantially identical) international funds.

    Last year, I was able to take advantage of TLH opportunities in January, February, Brexit (, and early November to the tune of $40,000 in losses, or 13+ years worth of ordinary income deductions at $3,000 a pop.


    • Keith Schroeder on February 6, 2017 at 11:43 am

      We work the same, PoF, on TLH issues. The robo-advisers over diversify (IMHO) into bonds, commodities and international. My research shows that is why they tend to under perform. You are paying for a smoother ride and some tax benefits. Some people should use Betterment, other not. No one solution for the whole crowd.

  4. scott on February 6, 2017 at 9:05 pm

    Keith. I am curious to get your perspective as a preparer. What does a 1099 from Betterment look like? Have you seen enough of them to get an idea of what is typical? I know betterment boasts of being able to trade fractional shares. Is their algorithm executing trades of small lots and fractional shares on a daily basis in order to harvest losses? I am picturing a 1099 with hundreds of transactions that results in a data entry nightmare at tax time.

    • Keith Schroeder on February 6, 2017 at 9:24 pm

      Scott, the 1099 is a composite. One entry for long and one for short-term transactions. There is no 728 pages of trades.

      By the way, if I get a statement with a million transactions, I scan and attach to the return, only entering the composite amount. For me, the accounting is a short, simple entry.

  5. scott on February 6, 2017 at 10:02 pm

    It’s great to get your take on Betterment/TLH. I think this article reads as an adendum or followup to MMMs recent post and as an accountant I am able to fill in some of the gaps in the writing but I think a few edits to the “How TLH Works” section could help the article stand on its own two feet for future WA readers, particularly those who are not accountants. While you focus on the tax consequences of TLH I think it’s important for readers to understand the basic I idea is to generate a deductible loss on the tax return without altering the economic/financial position of your portfolio in a meaningful way. Wash sale rules make this goal a bit more difficult to acheive. It would also be helpful to explain how TLH can work in conjunction with rebalancing a portfolio. The statement “sales of a security at a loss are not allowed…” is not quite true. I know what you trying to say here but it would be helpful to add some precision. The IRS could care less if you sell your securities at a loss (realization) and will not prevent you from doing so as the statement above seems to imply. They are concerned with the recognition or deduction of the loss as opposed the actual sale of the security at a loss. Also, as I’m sure you’re aware, the “within 30 days” part of the wash sale rule is talking about a 61 day window centered on the date on the loss transaction. Again since readers are explicitly asked “Understand now?”, I think it could be helpful to beef up this section a little bit for those that are trying to understand TLH.
    Additionally, if I can attempt to sort of connect some of the dots in your analysis. If a high earner is in the wealth accumulation stage they shoud probably move all of their accounts to Betterment to avoid wash sales. If someone is accumulating wealth via a Betterment account I wouldn’t expect them to have alot of capital gains being realized. If capital gains are not being realized then the benefits of TLH are limited to the taxpayer’s marginal tax rate X 3,000. So if we go back to your example, 33% x 3,000 = 990, we can then take the 990 of tax savings and divide by Betterment’s new flat fee of 0.0025. 990/0.0025 = 396,000. This gives us a rough break-even point for the account balance at which the benefits of TLH will no longer cover the Betterment management fee. So, taxpayers in the 33% bracket may be losing money at Betterment once their account balance exceeds 396,000. The Betterment fee increases as your savings grow but the benefits of TLH flatline if you don’t anticipate capital gains from other sources (such as MMM disposing of his rental property). So, we can conclude that even high income earners will see limited benefits from TLH if they have a high savings rate that quickly builds their stash to the mid six-figures. As you emphasized, the key for Betterment account owners is realizing when they need to stop and/or reverse the Betterment/TLH program.

    • Keith Schroeder on February 8, 2017 at 2:59 pm

      I made a slight change to the text, Scott, but I think said what I wanted to without getting too wordy.

      As for your second paragraph, you got it right. Because there could be other issues which make TLH a good opportunity I did not want to have the post get any longer. But you are right, there comes a point where it does not add much more value. My point is Betterment is not valuable for the TLH, but valuable because they smooth the market bumps. In your calculation you forget the possible LTCG tax when you sell. It is best to be careful with the math on tax issues as they can easily become an endless task.

  6. TheHappyPhilosopher on February 17, 2017 at 10:55 am

    Nice discussion Keith. I would also add that TLH gets pretty easy when you have a high income and are a super saver, as it’s much simpler to find the 3k in losses in a 1m portfolio than 100k. So as the value goes up you are paying higher fees to do something that becomes simpler. Correct me if I’m wrong. Also there is a cost to constantly pushing down your basis, as eventually you will have to realize those gains. For many it won’t matter, but it decreases flexibility in retirement especially at higher spending levels. Also tax laws can change. Good post!

    • Keith Schroeder on February 17, 2017 at 2:06 pm

      You bring up a good point, HP. There are a lot of moving parts to TLH and your personal situation determines your course of action.

  7. Jonah on April 11, 2017 at 6:10 pm

    Hey keith, I know when you sell at a loss in a taxable account, and repurchase in an IRA, the basis is added to it in the Ira.

    Does the IRS apply the rule the other way around, too? Sell in IRA at a loss, buy back in taxable and add the basis?

    Doesn’t seem like It because that would be too fun! Thanks,

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