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Is tax loss harvesting a good financial investment strategy?

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Wealthfront says they offer a service that is usually only something the rich can afford via financial advisers. It's called tax loss harvesting. They offer this service even to small investors. Is tax loss harvesting a good financial investment strategy though?
asked Apr 4, 2016 in Investing by JLettermanMB (43,340 points)
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It looks like what Wealthfront is doing is legit, and can boost returns for accounts of all sizes, especially when the market is volatile. Before I get to why, an explanation of how this works is in order.

 

Tax Loss Harvesting: Basic Primer

 

Tax loss harvesting exists because of a quirk in IRS regulations. Suppose you buy $25000 in stock X. Six months later, the market has tanked, and your stock is now only worth $22500. You've just lost $2500 that can be used to reduce your overall taxable income, which means you'll save around $500 on your taxes if your income is close to the national average.

 

Thing is, you still have $22500 worth of stock X sitting in your investment account. Your market exposure hasn't changed a bit. If you just let that stock sit there and the market rebounds during the same tax year, bye-bye tax savings. That idea behind tax loss harvesting is that you can preserve that tax loss by selling your shares of stock X and buying a similar stock, let's call it stock Y. Selling the stock that lost value "locks in" the associated tax losses, even if the market rebounds.

 

Let's suppose that after buying stock Y, the market rebounds, and your stock ends up valued at $27500. If you had just kept stock X and it ended up this way, your return would be 10% minus that tax due on your $2500 in capital gains, but since you sold stock X and used that money to buy stock Y, your rate of return is 12% ($2500 + $500 in harvested tax losses).

 

One point is that it's important for the new stock you buy to harvest tax losses be a correlate of the first stock to keep your market exposure the same. Two stocks, A and B, are correlated if stock A and stock B tend to gain and lose value in equal amounts and in response to the same market events.[1]

 

Wealthfront's Strategy

 

What Wealthfront has done is basically automate the harvesting process. Every day, a bot scans your portfolio for harvestable tax losses and buys new stocks to generate additional returns from those losses. If you already have a Wealthfront account, all you have to do is log into your account and activate the feature.[2] It doesn't appear to be very risky at all, but always consult a trained financial advisor if you have doubts.

 

Wealthfront Tax Loss Harvesting Returns

 

[1] http://www.investopedia.com/articles/taxes/08/tax-loss-harvesting.asp

[2] https://www.wealthfront.com/tax-loss-harvesting

answered Apr 4, 2016 by colin (2,080 points)
edited Apr 4, 2016 by colin

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