wealthfront and tax loss harvesting

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whitecliff
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wealthfront and tax loss harvesting

Post by whitecliff » Tue Apr 18, 2017 11:43 am

I am 34 years old and an employee of a company and do not qualify for any pre tax investments due to income. I am currently doing a backdoor roth and stealth IRA via an HSA. I am currently just investing with after tax dollars via vanguard in a target date fund. My question about wealthfront is dealing with tax loss harvesting in passively managed index funds. Wealthfront claims that proper tax loss harvesting can increase your return by about 2%. I am very skeptical of this claim. I am currently not doing any tax loss harvesting and not sure how beneficial it is in passive index funds. Is the 25 basis points they charge worth the tax loss harvesting and the nice pretty interface? Someone teach me something. Thanks

alex_686
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Re: wealthfront and tax loss harvesting

Post by alex_686 » Tue Apr 18, 2017 11:58 am

In theory yes, there are better tax loss harvesting sachems out there than passively investing in the S&P 500. I have seen this in action. It is a sophisticated strategy that requires lots of trading. Mind you it was in the 90s. It was only worth it for accounts that were north of 5 million. I can see computers slashing costs to bring this down to ordinary folks. I have no direct knowledge of Wealthfront.

The goal is to reduce you capital gain taxes when you cash out of your account. Long term capital gains is currently at 20%. This can be reduced but not eliminated. Using a off the back of the envelope calculations, the 2% seems a bit optimistic. That would require annual capital gains of 10% and the elimination of all tax liabilities.

whitecliff
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Re: wealthfront and tax loss harvesting

Post by whitecliff » Tue Apr 18, 2017 12:18 pm

Thank you for the reply but I understand the concept of tax loss harvesting but if you have a portfolio that consists of only 3 to 4 index funds is tax loss harvesting actually anything that is substantial in that instance?

alex_686
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Re: wealthfront and tax loss harvesting

Post by alex_686 » Tue Apr 18, 2017 12:38 pm

whitecliff wrote:Thank you for the reply but I understand the concept of tax loss harvesting but if you have a portfolio that consists of only 3 to 4 index funds is tax loss harvesting actually anything that is substantial in that instance?
Scenario #1: You invest 100k in a S&P 500 index fund. It goes up by 10% so you know have 110k, 100k in cost basis, 10k in unrealized gains, and 2k tax deferred liability.

Scenario #2: You invest 100k in the 500 stocks of the S&P 500. Your portfolio as a whole goes up by 10%. So same as investing in a index fund. However some stocks have gone up dramatically while others have declined. Sell the losers, generate losses, sell a offsetting amount of winners, then reinvest everything back into the S&P 500. You now have a portfolio worth 11k, 105k in cost basis, and 5k in unrealized gains, and a 1k tax deferred liability.

Now compound this over 8 years. The person holding the index fund is now worth 200k with a cost basis of 100k, so tax liability of 20k. The one churning their portfolio is also worth 200k but has a cost basis of 150k, so a tax liability of 10k. A extra 1% a year.

This is obviously a idealized situation. While churning the account you want to keep it reasonably close to the S&P 500, avoid wash sales, and keep trading expenses low.

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Earl Lemongrab
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Re: wealthfront and tax loss harvesting

Post by Earl Lemongrab » Wed Apr 19, 2017 12:26 pm

alex_686 wrote:The goal is to reduce you capital gain taxes when you cash out of your account.
No, that isn't the general goal. For the most part, you want to take tax losses now against ordinary income by increasing your capital gains in future years.
This week's fortune cookie: "You will do well to expand your horizons." Ow. Passive-aggressive and vaguely ominous.

NYC_Guy
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Re: wealthfront and tax loss harvesting

Post by NYC_Guy » Wed Apr 19, 2017 12:35 pm

alex_686 wrote:
whitecliff wrote:Thank you for the reply but I understand the concept of tax loss harvesting but if you have a portfolio that consists of only 3 to 4 index funds is tax loss harvesting actually anything that is substantial in that instance?
Scenario #1: You invest 100k in a S&P 500 index fund. It goes up by 10% so you know have 110k, 100k in cost basis, 10k in unrealized gains, and 2k tax deferred liability.

Scenario #2: You invest 100k in the 500 stocks of the S&P 500. Your portfolio as a whole goes up by 10%. So same as investing in a index fund. However some stocks have gone up dramatically while others have declined. Sell the losers, generate losses, sell a offsetting amount of winners, then reinvest everything back into the S&P 500. You now have a portfolio worth 11k, 105k in cost basis, and 5k in unrealized gains, and a 1k tax deferred liability.

Now compound this over 8 years. The person holding the index fund is now worth 200k with a cost basis of 100k, so tax liability of 20k. The one churning their portfolio is also worth 200k but has a cost basis of 150k, so a tax liability of 10k. A extra 1% a year.

This is obviously a idealized situation. While churning the account you want to keep it reasonably close to the S&P 500, avoid wash sales, and keep trading expenses low.
This. The theory makes perfect sense, the execution seems ok, the wealthfont fees are ok. But I haven't pulled the trigger for a few reasons. Mostly, I'm just not comfortable with WF's size and staying power. If Fido, Schwab or Vanguard start offering the service for decent fees (even if just for a portion of my portfolio like Large Cap Blend/S&P 500), I will be all in.

whitecliff
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Re: wealthfront and tax loss harvesting

Post by whitecliff » Wed Apr 19, 2017 12:55 pm

So is it incorrect to say that there is not much tax loss harvesting to do with 3 index funds? I see it if you have tons of individual stocks and can dump the losers at the end of the year but that isn't the case with a 3 or 4 fund portfolio. The basics of my question which no one has really touched on is if wealthfront basically advises a 3 or 4 fund portfolio with index funds can their internal auto tax loss harvesting make up the 25 basis points of their fees in increased gains?

alex_686
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Re: wealthfront and tax loss harvesting

Post by alex_686 » Wed Apr 19, 2017 1:01 pm

Earl Lemongrab wrote:
alex_686 wrote:The goal is to reduce you capital gain taxes when you cash out of your account.
No, that isn't the general goal. For the most part, you want to take tax losses now against ordinary income by increasing your capital gains in future years.
It depends on the size of the account and one time frame. One can reduce ordinary income by only $3,000 a year, so that is a limitation. On the plus size you get that gain immediately.

For small accounts with a short time horizon harvesting losses now is the better option. For larger accounts with long time horizon it still makes sense to immediately harvest loses and reinvest those tax savings. However at some point the benefits are going to come from lower capital gains.

There are tax drag formulas out there which can tell you where the tipping point is.
Last edited by alex_686 on Wed Apr 19, 2017 1:03 pm, edited 1 time in total.

NYC_Guy
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Re: wealthfront and tax loss harvesting

Post by NYC_Guy » Wed Apr 19, 2017 1:02 pm

whitecliff wrote:So is it incorrect to say that there is not much tax loss harvesting to do with 3 index funds? I see it if you have tons of individual stocks and can dump the losers at the end of the year but that isn't the case with a 3 or 4 fund portfolio. The basics of my question which no one has really touched on is if wealthfront basically advises a 3 or 4 fund portfolio with index funds can their internal auto tax loss harvesting make up the 25 basis points of their fees in increased gains?
Not necessarily. Most of my equities are in US total, Int'l total and SCV. I have had plenty of opportunities to TLH one of those classes when the others are up. And remember you do this on a lot for lot basis. Your overall US total may be up in the aggregate (a net positive return), but individual lots may be down. It's one of the main reason that holding a single target date fund doesn't make sense for me. Plus you pay a bit more in fees. And that assumes you can find a target date fund that matches your desired AA.

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Earl Lemongrab
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Re: wealthfront and tax loss harvesting

Post by Earl Lemongrab » Wed Apr 19, 2017 1:40 pm

alex_686 wrote:
Earl Lemongrab wrote:
alex_686 wrote:The goal is to reduce you capital gain taxes when you cash out of your account.
No, that isn't the general goal. For the most part, you want to take tax losses now against ordinary income by increasing your capital gains in future years.
It depends on the size of the account and one time frame. One can reduce ordinary income by only $3,000 a year, so that is a limitation. On the plus size you get that gain immediately.

For small accounts with a short time horizon harvesting losses now is the better option. For larger accounts with long time horizon it still makes sense to immediately harvest loses and reinvest those tax savings. However at some point the benefits are going to come from lower capital gains.

There are tax drag formulas out there which can tell you where the tipping point is.
I'm not following. Taking losses now generates more capital gains in the future. Unless your CG rate in the future is higher, then there's no benefit. Taking losses against ordinary income is an immediate and probable future benefit.
This week's fortune cookie: "You will do well to expand your horizons." Ow. Passive-aggressive and vaguely ominous.

Scrooge McDuck
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Re: wealthfront and tax loss harvesting

Post by Scrooge McDuck » Wed Apr 19, 2017 1:42 pm

If you own a collection of Vanguard index funds, you will likely experience very small capital gain distributions. In fact, over the last decade or so, I'm not sure I've experienced *any* capital gains distributions from my various Vanguard equity funds. (But don't rely on my memory - better to look into it yourself.) So you may not have enough taxable gains to make a service like Wealthfront worthwhile.

The 2% number they quoted you is probably based on a very optimistic scenario. For example, when the investor holds a lot of actively managed funds that generate lots of capital gains distributions.

I looked into a similar service from a company called Parametric a long time ago and decided it didn't make sense for me because - like you - I was going to mainly be holding a bunch of Vanguard index funds which would not generate much in the way of capital gains.

On the other hand, perhaps you will sell some of your Vanguard funds at some point. This may generate the large capital gains you need to justify a service like Wealthfront.

NYC_Guy
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Re: wealthfront and tax loss harvesting

Post by NYC_Guy » Wed Apr 19, 2017 1:51 pm

Scrooge McDuck wrote:If you own a collection of Vanguard index funds, you will likely experience very small capital gain distributions. In fact, over the last decade or so, I'm not sure I've experienced *any* capital gains distributions from my various Vanguard equity funds. (But don't rely on my memory - better to look into it yourself.) So you may not have enough taxable gains to make a service like Wealthfront worthwhile.

The 2% number they quoted you is probably based on a very optimistic scenario. For example, when the investor holds a lot of actively managed funds that generate lots of capital gains distributions.

I looked into a similar service from a company called Parametric a long time ago and decided it didn't make sense for me because - like you - I was going to mainly be holding a bunch of Vanguard index funds which would not generate much in the way of capital gains.

On the other hand, perhaps you will sell some of your Vanguard funds at some point. This may generate the large capital gains you need to justify a service like Wealthfront.
This is the point. Assuming, at some point, you begin to sell instead of accumulate, all those capital losses become valuable. At the least, they result in tax deferral. And if you give away your biggest gainers to charity or they become part of an inheritance, that deferral becomes complete tax avoidance due to the way the charitable and inheritance tax laws work. Tax deferral is super valuable to overall return if you are and will remain in a high tax bracket.

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House Blend
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Re: wealthfront and tax loss harvesting

Post by House Blend » Wed Apr 19, 2017 3:23 pm

whitecliff wrote:Wealthfront claims that proper tax loss harvesting can increase your return by about 2%. I am very skeptical of this claim. I am currently not doing any tax loss harvesting and not sure how beneficial it is in passive index funds. Is the 25 basis points they charge worth the tax loss harvesting and the nice pretty interface?
Yes TLH can be worthwhile, but you should not believe the marketing fluff from brokers that are offering to sell you TLH as a service. They are eager to paint it as being worth X% per year, because they charge fees of Y% per year.

Note that any share you bought and held for (say) 30 years will have hit bottom at some point. There's a decent chance that the bottom will be below the price you paid. If you harvested that loss at bottom (exchanging it for something similar), then there will be no more losses from that investment to harvest. Ever. However, your TLH service will continue charging Y% per year for it, even though there is no way to extract more TLH value from that share.

If you are willing to learn enough to do your own income taxes and the rules that govern taxation of sales of shares (specific share ID, wash sales, long term and short term gains and losses,...), you can get plenty of value out of it yourself, even if all you own are the components of a 3-fund portfolio. However, you can't expect the benefits to show up overnight.

The first value you'll see is the potential to deduct $3,000 annually against ordinary income, in exchange for possibly having to pay LT cap gains tax on equal amounts at some point in the future. If you accumulate substantial carryover losses beyond that, then you will also be postponing taxes on other cap gains farther off into the future. If you die with unused carryover losses, the leftovers no longer have any value; you can still view them as having offered a kind of insurance against having to pay cap gains tax.

alex_686
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Re: wealthfront and tax loss harvesting

Post by alex_686 » Wed Apr 19, 2017 3:38 pm

Earl Lemongrab wrote:I'm not following. Taking losses now generates more capital gains in the future. Unless your CG rate in the future is higher, then there's no benefit. Taking losses against ordinary income is an immediate and probable future benefit.
You are correct. It is better to take tax gains today and reinvest then delay tax gains. It is better to reduce higher taxes then lower taxes, so for most people it is better to slash ordinary income than capital gains.

The issue is that you top out at 3k per year.

Once you clear the first tier you want to start working at the second tier. Continue to tax loss harvesting but you want to shift gears and focus on reducing long term capital gains. Can't do anything more this year so you might was well focus on the long game.

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