One of the hottest new trends in portfolio management is something called tax loss harvesting. It’s a fancy sounding (and actually a rather old) tax deferral strategy with a simple implementation that has grown in popularity due to the rise of the “Robo Advisor”. This strategy allows you to incur current losses in an investment and defer the taxes paid by swapping into a fund that is similar, but not “substantially identical”. For example, if you invested $10,000 in the S&P 500 via SPY and the S&P 500 declines by 5% then you can book your $500 loss and swap into a similar fund such as QQQ which tends to perform with a high correlation to the SPY. You’ll still get similar performance from the new fund, but you’ll have booked a tax deferral for future use against gains. The kicker is that the fund you buy cannot be “substantially identical” according to the IRS. In other words, you have to swap into a fund that is materially different than the one you currently own. So, you wouldn’t want to sell SPY and then buy VOO which is Vangaurd’s S&P 500 fund because they’re the same fund in essence.
Tax loss harvesting is an effective tax deferral strategy that you should consider, but you have to be careful about how you go about implementing this because there’s no free lunch here. The IRS limits annual deferrals to just $3,000 so, for most investors with considerable assets this tax deferral strategy isn’t making or breaking your portfolio. It can be a nice marginal after tax boost to returns, but it is absolutely not something you should construct your entire portfolio strategy around because the benefits are not that substantial.
A further problem for high net worth investors is the risk of audit due to wash sale violations. For instance, many of the large Robo Advisors use VDE as a replacement fund for DJP as a commodity index. These funds are not substantially identical. In fact, they’re very different funds:
There’s a potentially bigger issue here that the IRS is very unclear about. That’s the issue of wash sales. The IRS doesn’t want you booking losses and buying the same thing 2 minutes later. The IRS hasn’t updated their view here and the growth in ETFs has made this a very murky area. Problem is, if you look at the funds that many Tax Loss Harvesting firms utilize you’ll find that there is no material difference between the funds. For instance, one of the more prominent Robo Advisor firms uses SCHF and VEA for tax loss harvesting. The performance of these funds is compared below:
As you can see the funds are literally the exact same thing. Personally, I would never attempt to harvest losses with these two funds because I don’t think there would be a chance in the world of being able to explain the difference to the IRS. In addition, the Robos don’t know what your other accounts looks like so all of this churning of accounts could actually be creating wash sales in other accounts without your knowing it. The Robos are trying to cut costs on the middleman, but might be inviting the IRS in the backdoor. If you’re using one of the big Robo Advisors it might be smart to reach out to your tax attorney just to be clear here. Given how new many of these firms are and the tax season this makes for a good time to get clarity on the issue. In general, I’d veer towards better safe than sorry. I’ve never felt wholly comfortable with tax loss harvesting and this is the main reason why….
In general, the issue of having to use a materially different holding makes the benefits of tax loss harvesting very murky. Assuming you have to use a materially different fund, the added benefit of the strategy comes down to how well you pick the new funds. In other words, you become a market timer inside of a strategy that generally isn’t supposed be to designed around how well you can time certain asset choices.
Michael Kitces has done some of the best work on tax loss harvesting around. He concludes that it’s essentially a form of tax deferral that is made out to be more impactful in most cases than it actually is. But it depends on your specific situation. Ultimately, what we’re looking at is an interest free loan from Uncle Sam due to what looks like a tax loophole. My guess is that this loophole will get closed or clarified substantially as technology becomes more pervasive and the strategy becomes more widely used. So you might want to take advantage of it while it’s still available. But consult a tax attorney first and look under the hood where it’s being done.
The last issue of note is that most of your “passive” money should be invested in retirement accounts to begin with. This money is already tax deferred so there’s no value in using one of these services in your retirement accounts. They’re really only valuable in taxable accounts which tend not to be as passive. This substantially reduces any value in harvesting losses there.
Technology is great and I think that the Robo Advisors are wonderful for investors who can’t afford any sort of professional help (do-It-yourselfers don’t need Robos or advisors in my opinion). But you have to really look under the hood here before moving forward. If tax loss harvesting sounds too good to be true then that might just be the case.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.