Wealthfront Tax-Loss Harvesting White Paper
“A serious fiduciary with responsibility for taxable assets recognizes that only extraordinary circumstances justify
deviation from a simple strategy of selling losers and holding winners.”
– David Swensen, Unconventional Success
This white paper summarizes the motivation, design and execution of Wealthfront’s Daily Tax-Loss Harvesting service. Our Monte Carlo simulations, historical backtests and actual results demonstrate that tax-loss harvesting significantly improves the tax efficiency and ultimately the after-tax return of Wealthfront’s taxable portfolios. We believe tax-loss harvesting should be a fundamental component of most every individual’s investment management strategy.
What is tax-loss harvesting?
Tax-loss harvesting is a way to make an investment portfolio work even harder – not just in generating investment
returns, but by also generating tax savings.
Tax-loss harvesting works by taking advantage of investments that have declined in value, which is a common
occurrence in broadly diversified investment portfolios. By selling declined investments at a loss, a tax deduction
is generated – which lowers the investor’s taxes.
What’s more, any investment sold in this manner can be replaced with a highly correlated alternate investment. The
result is the risk and return profile of the portfolio is unchanged, even as tax savings are created. These tax
savings can then be reinvested to further grow the value of the portfolio.
Wealthfront developed software to make tax-loss harvesting, traditionally only available to accounts in excess of
$5 million, available to a much broader audience. Implementing tax-loss harvesting in software
also makes it possible to look for harvesting opportunities on a daily basis, which could result in significantly
greater benefit than what could be achieved from the manual end-of-year approach taken by traditional financial advisors.
Tax-Loss Harvesting is a Tax-Deferral Strategy
Tax-loss harvesting can be used to defer tax liabilities, not avoid them. As a result it has very little value if
applied over a short investment horizon (i.e. less than two years), but can be extremely valuable if
executed over a long period of time. This is best demonstrated through an example that describes the benefits under
two holding period scenarios:
Scenario 1 (one-year investment horizon)
Assume you buy 1,000 shares of ETF A at a price of $100 per share for a total investment of $100,000. A few months
later, the market declines to the point ETF A is now worth $90 per share or $90,000 total. You sell all your shares
of ETF A and replace it with an equivalent amount of ETF B (500 shares at $180 per share), which tracks an index
that is highly correlated to the one ETF A tracks. You now own a $90,000 position in ETF B and have realized a
$10,000 short-term loss for tax purposes. ETF B closes the year at $200 per share at which time you sell your entire
position. Your sale of ETF B generates a $10,000 short-term gain which balances your $10,000 short-term loss. In
this case harvesting the loss in ETF A generated no value.
Scenario 2 (five year investment horizon)
This scenario is much more complex and requires the table below to follow.
Let’s assume you started off with the exact same $100,000 investment in ETF A and a few months later it declined 10% at which time you harvested the loss and replaced it with an equivalent amount of ETF B. Once again ETF B appreciates to $100,000 by the end of the year, but this time you don’t liquidate your account. As a result your net realized short-term capital loss on this position for the year is $10,000, which generates a $4,000 tax savings when applied against your income and other realized gains under the assumption of a combined federal and state tax rate of 40%. If you reinvest that tax savings your end-of-year portfolio value is now $104,000. The next year your portfolio appreciates 1.9% to $106,000. The following year your portfolio declines in value by 11.7% to $93,600 at which time you once again harvest a loss of $400 (on your previously reinvested tax savings), which generates a $160 ($400 x 40%) tax savings for that year. You reinvest the $160 and the following two years your portfolio is flat and increases to $104,160 respectively. At the end of year 5 you liquidate the portfolio. At this point you have to pay the tax due on the $10,000 appreciation of ETF B and the $400 loss in year three that is recaptured. However this time the gains are long-term capital gains, so you pay the lower 25% combined federal plus state tax rate, which results in a negative $2,600 cash flow ($10,400 long-term capital gain x 25%). The last row of the table calculates the annual tax savings as a percentage of the portfolio value at the beginning of each year. This metric is commonly known in the investment industry as the Tax Alpha. The average Tax Alpha for the five years including the tax due at the end is 0.28%.
As you can see Scenario 2 results in a significant Tax Alpha even though all of the realized losses are
ultimately balanced with an equivalent realized gain. The positive Tax Alpha that results from this scenario can be
attributed to the reinvestment of the tax savings and the significant difference in tax
rates between short-term capital gains and long-term capital gains. The size of the Tax Alpha would have
been much greater had we included the potential Tax Alpha that could have been generated from the reinvestment of
dividends generated by the ETFs and any add-on deposits made to the account. All things being equal, the higher the
deposit rate, the higher the potential Tax Alpha. It should also be noted that the benefit of tax-loss harvesting
increases as your tax rate increases. It even increases if your tax rates increase during the investment horizon.
The value of tax-loss harvesting is maximized if your portfolio is never liquidated. This is possible even when you
expect to employ your portfolio for your retirement needs. For example, you can place the appreciated assets in your
portfolio in a Charitable Remainder Trust (CRT) or similar vehicle – generating income for yourself in retirement
while donating the remainder of your portfolio to a non-profit organization of your choice. Because non-profits are
not taxed, they are able to sell your highly appreciated assets and generate retirement income for you with no
regard to the basis or tax-liability of those assets.
Similarly, you can choose to pass on all or a large percentage of your portfolio to your heirs. Because your heirs
receive a step-up in basis for the portfolio on your death, they are again able to take full advantage of the
portfolio’s value without regard to its low tax basis or its tax liability.
Finally, instead of fully liquidating your portfolio in retirement, you can liquidate only a part of the portfolio
and pass on or donate the rest. Such partial liquidation approaches, when done tax-efficiently, can again allow you
to keep most of the gains of tax-loss harvesting (see analysis below).
Who should use tax-loss harvesting?
Tax-loss harvesting is generally valuable for all taxable investors who have a long-term investment horizon.
Harvested losses can be applied to offset both capital gains generated by the investor and up to $3,000 in ordinary
income annually. Furthermore, any losses that cannot be applied in a given tax year can be carried over indefinitely
to offset future income and capital gains.
Of course, tax-loss harvesting is especially valuable for investors who regularly recognize capital gains. These
gains can come from the sale of company stock, real estate or just about any investment. Tax-loss harvesting can
even be used to minimize the gains associated with liquidating a portfolio to move to a new financial advisor.
Wealthfront Daily Tax-Loss Harvesting service
Harvesting losses at the Asset Class level
For taxable accounts, Wealthfront offers the Wealthfront daily tax-loss
harvesting service for no additional charge. We monitor your portfolio daily to look for opportunities to
harvest losses on the ETFs that represent each asset class in your portfolio. Under the right circumstances (to be
described later in this white paper) we will sell one of your ETFs that is trading at a loss and replace it with an
alternative ETF that represents a different but highly correlated index to maintain the risk and return
characteristics of your portfolio. We will then hold that alternative ETF in your portfolio for a minimum of 30 days
to avoid wash sales (described below). We will not sell the alternative ETF until it can be sold for a loss (which
will generate additional tax-loss harvesting benefit).
The following two tables list the primary and alternative ETFs we use to represent each asset class
Our service, which looks for harvesting opportunities daily, stands in stark contrast to year-end
tax-loss harvesting services, which only look to harvest losses at the end of each calendar year. We
believe daily TLH offers more than double the benefit than traditional year-end TLH based on our research presented
Our asset class level tax-loss harvesting strategy uses a cost-benefit analysis framework to evaluate potential
harvesting opportunities for each ETF lot currently trading below its cost basis as follows:
Benefit is calculated by multiplying the potential realized capital loss incurred from selling an ETF times either
the short-term or long-term capital gains tax rate, depending on the ETF’s holding period.
Cost captures the trading cost of selling the primary ETF and buying the secondary ETF. (Note: this cost is merely
the bid-ask spread of the two ETFs because Wealthfront clients never incur any commissions.)
Threshold is an estimate of the expected future harvesting benefit which is modeled by assessing the likelihood that
a better harvesting opportunity is available by waiting longer to perform the tax-loss harvesting trade (and thus
potentially capturing more of the ETF’s decline). Expected return and volatility of each asset class are used as
parameters in this estimate.
We execute two trades when we believe the Benefit – Cost exceeds the Threshold:
- We sell the specific ETF lot to recognize a loss, and
- We purchase the same dollar amount of a similar, but not substantially identical, ETF (see the table above for the alternative ETFs we use for each asset class) to maintain the desired asset class exposure.
We evaluate every ETF tax lot in each eligible account every day, and execute trades when our system identifies the
Wash sale management
One complexity in executing our daily tax-loss harvesting strategy is the management of wash sales. Normally, you
recognize a loss when you sell a security for less than its cost basis. However, if you buy the same
or substantially identical security within 30 days of the sale, the wash sale rule applies and you are not
allowed to claim the tax benefit
It should be noted that a wash sale does not completely eliminate the benefit of harvesting a loss, but only reduces
that benefit by the amount of the wash sale itself. For example, if you sell 1,000 shares of a particular ETF to
harvest a loss but happen to buy 10 shares of the same ETF within 30 days, you will still be able to take advantage
of the harvested loss on roughly 990 of the 1,000 shares originally sold – as only 10 shares are actually subject to
the wash sale rule in this
In the case of applying tax-loss harvesting to a portfolio of index funds or passive ETFs, you need to use two
securities that track different indexes to avoid violating the substantially identical clause of the wash
sale rule. Swapping an ETF with another that tracks the same index from a different issuer (i.e. Vanguard
vs. Schwab) would violate the substantially identical rule. As a result, you’ll see that the secondary ETFs
presented in the table above are focused on tracking a different but highly correlated index from the recommended
The risk of a wash sale increases with the number of rebalancing trades made as part of the ongoing management of a
portfolio. If not carefully managed, a security sold to harvest a loss might be re-purchased for another reason
(change in asset allocation, rebalancing, dividend reinvestment, withdrawal or deposit) and the tax benefit could be
disallowed, defeating the purpose of tax-loss harvesting. We carefully manage the interaction and timing of trades
within our portfolio management service to help avoid wash sales.
The situation becomes more complex in the case of multiple accounts, as the wash sale rule applies to all of an
investor’s accounts including IRAs – as well as spousal accounts for joint filers. For example, if an investor sells
a security in her personal non-retirement account and repurchases it within 30 days in her IRA, it’s considered a
wash sale; if her spouse purchases the same security within 30 days in his personal non-retirement account, it’s
also viewed as a wash sale. Wealthfront monitors all the accounts it manages for each client to avoid any
transactions that might trigger a wash sale. We also urge all of our clients to consult with their tax advisors to
confirm that our tax-loss harvesting strategies are right for them.
Wherever possible we use assumptions for our analyses that are based on the actual observed behavior of Wealthfront
clients since we launched our daily tax-loss harvesting service in October 2012. We believe this approach most
fairly portrays the expected value to the client who is likely to use our service.
Our critical assumptions are:
- Client age: 37 (median age of our tax-loss harvesting clients)
- Marital status: Married (the majority of our clients are married)
- Annual income: $260,000 (the average joint income reported by our tax-loss harvesting clients)
- State of residence: California (the most popular state of residence for our tax-loss harvesting
clients. Residents of high state income tax states represent the vast majority of our tax-loss harvesting clients.)
- Combined federal and state short-term capital gain tax rate: 42.7% (the marginal tax rate for
married California clients with an average annual income of $260K = 33% federal tax rate + 3.8% additional tax on Net
Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California
state taxes for federal taxes)
- Combined federal and state long-term capital gain tax rate: 24.7% (the marginal tax rate for
married California clients with an average annual income of $260K = 15% federal tax rate + 3.8% additional tax on Net
Investment Income for those earning above $200K (ACA tax) + 9.3% CA tax rate – the anticipated deduction of California
state taxes for federal taxes)
- Portfolio risk level: 7 (the average risk score on a scale of 0 – 10 for our tax-loss harvesting
clients). A risk level 7 portfolio would be allocated across six asset classes as follows:
- Investment cash flows: An initial deposit of $100,000 followed by add-on deposits of $10,000 each
quarter. (The average Wealthfront tax-loss harvesting client actually adds an average of nearly 20% of her original deposit
each quarter. See chart below.)
We evaluate the effectiveness of our tax-loss harvesting using several techniques. For most analyses, we quantify the benefit of tax-loss harvesting by measuring a parameter called annual Tax Alpha, the industry standard metric that quantifies an account’s potential tax benefit each year. We calculate the annual Tax Alpha using the following formula:
- STCL is the short-term net capital loss realized
- STTR is the combined federal and state short-term capital gains tax rate
- LTCL is the long-term net capital loss realized
- LTTR is the combined federal and state long-term capital gains tax rate
- PortfolioBeginningBalance is the value of the portfolio at the beginning of each year
As the above formula shows, Tax Alpha increases with the investor’s tax rate. As a result, tax-loss harvesting is
most powerful for investors who live in high-tax states, as is the case for most Wealthfront clients.
For multi-year investment periods, the investment horizon we expect for most of Tax-Loss Harvesting clients, we also compute a backtested IRR (Internal Rate of Return) metric. This metric is a measure of investment performance over long time horizons especially when multiple cash flows (such as add-on deposits and reinvestment of tax savings) are present.
Quantifying the Value of Tax Deferral – Monte Carlo Simulation Method
To precisely quantify the value of tax-deferral created through tax-loss harvesting, we performed a Monte Carlo
analysis. This type of simulation is the gold standard for quantifying the expected future impact of investment
We evaluated the performance of our daily tax-loss harvesting algorithms across three investment periods (10 years,
20 years and 30 years) and three different withdrawal rates (none, 50% at the end of the investment period and full
withdrawal at the end of the investment period).
In the investment phase, we simulated the future returns of two portfolios: the Wealthfront diversified risk level 7
portfolio with daily tax-loss harvesting and the Wealthfront diversified risk level 7 portfolio with no tax-loss
To model the expected return of the asset classes in these portfolios, we constructed an asset return model by
estimating a two-regime multivariate Gaussian model from historical data. The two regimes correspond to the
bull-market regime and bear-market regime respectively. The market alternates between the two regimes, where the
bull-market regime is characterized by positive expected return, low volatility and low correlation while the
bear-market regime is characterized by negative expected return, high volatility and high correlation, as we
observed in the asset classes’ historical behavior. The asset returns’ conditional joint distribution conditioned on
each regime is modeled using a multivariate Gaussian distribution. The model parameters comprise of a regime
transition matrix, and the mean and covariance of the two conditional Gaussian distributions, all of which are
estimated from the asset classes’ historical return data.
In our Monte Carlo simulation, we first sample asset class returns from the asset class return joint distribution
model and transform them into ETF prices. For the daily tax-loss harvesting portfolio, any tax savings generated by
tax-loss harvesting are reinvested into the portfolio at the beginning of the next tax year. For both portfolios,
we assume an initial deposit of $100,000 and follow on deposits of $10,000 at the beginning of every quarter.
At the end of the investment phase, we calculate the value of each simulated portfolio and apply the three
liquidation strategies. We then subtract each liquidation scenario’s expected taxes to produce after-tax values for
all the portfolios.
This allows us to compare the after-tax value of a tax-loss harvesting portfolio vs. a non tax-loss harvesting
portfolio under the three liquidation scenarios – simply by taking a difference between the two post-liquidation,
after-tax portfolio values.
The table below presents the results of 1,000 Monte Carlo simulations for each of the nine pairs of assumptions
covering the length of the investment phase of the portfolio (10, 20 and 30 years) and the three liquidation scenarios.
The first column, No Liquidation, represents the annualized value at the end of the holding period if no
securities were sold. This calculation is the most common definition for Tax Alpha.
While Tax Alpha is an excellent way to represent the raw benefit of tax-loss harvesting, critics claim it overstates
the true benefit of tax-loss harvesting because the lower cost bases that result from all the tax-loss harvesting
transactions are not accounted for if no liquidations are made. We therefore calculated the annual after-tax
benefit of tax-loss harvesting under two aggressive withdrawal scenarios: a 50% withdrawal after the holding period
and a complete withdrawal. In reality, these are highly conservative assumptions. Most investors are more likely to
withdraw a relatively small percentage each year upon retirement, which would lead to a benefit much closer to the
Tax Alpha calculated in the first column. Fortunately, the benefit of tax deferral is so positive over long time
periods that even the most conservative assumption of full liquidation results in a tax benefit that preserves
approximately 70% of the Tax Alpha (1.08%/1.55%).
The longer the holding period, the greater the percentage of the Tax Alpha that is realized (87% for the 30-year
holding period vs. 70% for the 10-year holding period). The percentage of Tax Alpha that is realized on liquidation
declines slightly if the tax rate specifically increases on the liquidation date. Interestingly Tax Alpha
increases from what is presented in the table above if tax rates increase during the investment horizon.
As you can see, the annual after-tax benefit declines as the holding period increases. That is likely due to a
significantly reduced number of tax-loss harvesting opportunities as the portfolio compounds over time.
One should keep in mind that these results understate the likely value of tax-loss harvesting to
Wealthfront’s clients because they add deposits to their accounts at a higher average rate than assumed in our
To enable a more detailed analysis into possible Tax Alpha outcomes, we provide a table the presents the annual Tax
Alpha assuming no liquidation for each of the three investment horizons (10, 20 and 30 years) by risk level and tax
To provide some context, the following table maps the joint income levels referenced in the three tables above to
the federal and state tax rates applied in our simulation:
As you can see from the tables above, the benefit of tax-loss harvesting increases as tax rates and risk levels
increase. What you might not realize is the benefit also increases if tax rates increase during the investment
horizon at any time prior to the date of portfolio liquidation.
Our conclusion from the simulations is there is significant benefit from the tax deferral produced by tax-loss
harvesting. Even if the portfolio is fully liquidated, an investor with a 30-year time horizon can expect to have
at least 28% more in their retirement assets (an average of 0.93% over 30 years) if they employ daily tax-loss
harvesting throughout their investment period.
Quantifying the Value of Tax Deferral – Backtested Tax-Alpha
A second way to quantify the benefit of tax-loss harvesting is to evaluate the benefit that could have been received
if it were applied to the past. This is commonly known as the backtesting approach. In this section we present the
backtested results that could have been achieved with our daily tax-loss harvesting service on an average risk
level 7 Wealthfront portfolio.
We assumed an investor initially deposits $100,000 at the beginning of 2000 and then deposits $10,000 each quarter
thereafter through August 2014. This assumption understates the behavior we observed from our existing clients as
described above. The portfolio was periodically rebalanced using Wealthfront’s standard rebalancing algorithms (see
our Investment Methodology white paper for
more on our rebalancing approach).
We backtested both the performance of our average portfolio with and without tax-loss harvesting using the same
assumptions as we did for our Monte Carlo simulation. We calculated the difference in performance of the
non-tax-loss harvesting version of the portfolio versus the tax-loss harvesting one, to understand the full benefit
of this approach.
The graph below displays the annual Tax Alpha (assuming no portfolio liquidation) that would have been generated by
Wealthfront’s daily tax-loss harvesting strategy by year.
Since 2000, this tax-loss harvesting strategy produced an average annual Tax Alpha of
1.35% and was most valuable in major down markets. You will notice the back
tested Tax Alpha assuming no liquidation for the past 14 years of 1.35%
was actually between the simulated Tax Alphas generated for 10 and 20-year periods (1.55% and 1.22% respectively)
Using the same assumptions, the graph below demonstrates that tax-loss harvesting is valuable for all levels of risk
and generally increases as one’s risk tolerance increases. That’s because higher risk levels result in higher
allocations to more volatile asset classes (such as stocks) and will thus result in more harvesting opportunities.
We are aware that not all our clients match the tax and income assumptions used in the analysis above. To present a
more comprehensive picture of TLH’s benefit for clients in different tax brackets, we estimated the Tax Alpha for
six representative income levels among our clients for all risk levels, presented in the following table. As with
all our analyses, we assumed our clients are married and are subject to the appropriate federal and California tax
codes for 2014.
As you can see the benefit is significant at every tax and risk level and increases as tax rates and risk levels
increase. We strongly suggest that you do not increase your risk level to get more tax-loss harvesting benefit
because it is more likely to lead to a level of volatility that will cause you to prematurely liquidate and lose
money (see DALBAR
Evaluating Tax Efficiency: The Wealthfront Maximum Tax Alpha Ratio™
To understand the efficacy of our daily tax-loss harvesting algorithm, we further compare the Tax Alpha we’re able
to generate (per above) with the theoretical maximum Tax Alpha possible in any given year.
To compute the maximum possible Tax Alpha, we perform our back-test in a manner that assumes all future prices are
known and thus perform any harvesting transactions at the absolutely perfect point in time (i.e. the lowest
price of any given asset in every tax year).
The Wealthfront Maximum Tax Alpha (MTA) Ratio™ reveals how effective a given tax-loss harvesting strategy is. It is
represented as follows:
By definition, the maximum any strategy can achieve is 100%.
As can be seen in the graph below, this simulation indicates that our current daily tax-loss harvesting algorithm
captures approximately 80% of the Maximum Tax Alpha that could be captured in that time period.
This leads us to believe there is very little additional benefit that can be gained through additional tweaks
based on our current assumptions. Although small improvements are theoretically possible, there’s
unlikely to be another daily asset class-based tax-loss harvesting algorithm that’s significantly better than our
Comparison of Daily vs. One-time (i.e. End-of-Year) Tax-Loss Harvesting
As mentioned above, our tax-loss harvesting service checks your portfolio daily for tax-loss harvesting
opportunities. This stands in stark contrast to the more common tax-loss harvesting approach that checks your
portfolio only once per year (typically at the end of the year).
To understand the value that our daily strategy brings versus the more common end-of-year strategies, we
computed the average Tax Alpha over the six most recent 10-year periods for both approaches.
We use the same portfolio and cash flow assumptions as in the Tax Alpha analysis above and present these results in
the below graph.
As the above graph shows, daily TLH significantly outperforms end-of-year TLH for every 10-year period examined by a
In fact, the average annual Tax Alpha across the six 10-year periods is
1.29% for daily TLH vs. only 0.52% for end-of-year TLH. In other words,
daily TLH generated more than double the benefit of end-of-year TLH.
Quantifying the Value of Tax Deferral – Backtested Differential IRR
An additional way to quantify the benefit of Tax-Loss Harvesting is via a backtested computation of IRR.
IRR (Internal Rate of Return) is an industry standard measure of investment performance, used especially in cases where multiple cash flows (such as additional deposits and reinvestments of tax savings) are involved.
To evaluate the value of Tax-Loss Harvesting we compute a Differential IRR measure defined as:
Differential IRR = IRR (Wealthfront Risk-7 Portfolio with Daily Tax-Loss Harvesting) –
IRR (Wealthfront Risk-7 Portfolio with No Tax-Loss Harvesting)
For both portfolios we assume the same pattern of cash flows listed in our assumptions and no portfolio liquidation. Furthermore, for the Tax-Loss Harvesting portfolio we assume that the tax savings from each tax year are reinvested into the portfolio at the beginning of the next tax year.
The chart below displays the differential IRR for each 10-year period within the years 2000 to 2014.
As the chart shows, Daily Tax-Loss Harvesting shows impressive IRR over the 10-year periods with a minimum of 1.27% in the period of 2003 to 2013 and a maximum of 1.90% in the period of 2000 to 2009.
The average across the 6 periods is an IRR of 1.55%. Interestingly, this number matches the tax-alpha obtained in the no liquidation scenario of our 10-year Monte Carlo simulation – the closest match for our IRR analysis above.
To parallel the liquidation scenarios studied in our Monte Carlo simulations, we also applied similar liquidation assumptions to this analysis — computing an average differential IRR for the 10-year periods above under a 50% and a full portfolio liquidation assumption. As in our Monte Carlo analysis, the results show that much of the benefit is retained even if the portfolio is liquidated at the end of each 10-year period. For example, under a full liquidation assumption, the average differential IRR for the six 10-year periods above, still comes out to 0.77% — right around 50% of the no liquidation value above. With a more realistic 50% liquidation assumption, this comes out to an IRR of 0.98% — or nearly two-thirds of the no liquidation IRR.
Quantifying the Value of Tax Deferral – Empirical Method
Wealthfront launched our daily asset-level tax-loss harvesting service in October 2012. The graph below presents a
composite of our clients’ realized Tax Alpha by month since our launch, plotted against their overall cumulative
pre-tax, net-of-fee, time-weighted returns.
Note that in 2013, we harvested an average Tax Alpha of 0.53% (0.51% in June alone) for our clients during a time
when our composite portfolio return was 16.3%. This Tax Alpha would not have been realized using the traditional
year-end tax-loss harvesting approach because all the ETFs employed would have recovered their June loss by that
time. This example helps illustrate the advantage of daily vs. year-end tax-loss harvesting.
Although tax-loss harvesting may be highly valuable in improving tax efficiency, it’s important to understand that
it is a tactical approach and should not interfere with strategic investment objectives such as broad
diversification though an optimal asset allocation, disciplined and tax-efficient rebalancing and low-cost
Since tax-loss harvesting systematically lowers the cost basis of a portfolio by replacing securities (ETFs or
stocks) that trade at a loss, investors might be concerned with how to deal with a portfolio with a low cost basis
in the future. Generally speaking, portfolios with a low cost basis require more careful disposition. Investors may
choose to minimize their tax liabilities by using the low basis portfolio as a charitable donation or pass the
portfolio on to heirs through an estate at a stepped-up cost basis.
Tax-loss harvesting is only relevant for taxable accounts. It does not apply to tax-deferred accounts such as IRAs
and 401(k) accounts, since gains and losses in those accounts are not taxable events. Tax-loss harvesting is also
not typically suited for custodial accounts such as UTMA/UGMA unless the minor has significant taxable capital gains
or income from other sources.
The effectiveness of tax-loss harvesting also varies for different contribution patterns. The more frequently you
add to your portfolio, the greater the benefit of tax-loss harvesting because you have more tax lots at different
prices to work with.
We believe the simulated, backtested and empirical results presented in this white paper clearly demonstrate that
Wealthfront’s two fully automated and daily tax-loss harvesting services could significantly improve the after-tax
returns for young people with a long investment time horizon.
We thus believe tax-loss harvesting should be a fundamental component of most every individual’s investment management strategy
This white paper was prepared to support the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategies. This white paper is not intended as tax advice, and Wealthfront does not represent in any manner that the tax consequences described herein will be obtained or that Wealthfront’s tax-loss harvesting strategies, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting strategy and other strategies that Wealthfront may pursue are complex and uncertain and may be challenged by the IRS. This white paper was not prepared to be used, and it cannot be used, by any investor to avoid penalties or interest.
Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in these tax strategies, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.
When Wealthfront says it replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Expected returns and risk characteristics are no guarantee of actual performance.
Monte Carlo Simulations are a risk and decision analysis technique used to evaluate the outcome of portfolios over time using a large number of simulated variables to generate possible future returns. For our Monte Carlo analysis we simulated the future returns of two portfolios: the Wealthfront diversified risk level 7 portfolio with daily tax-loss harvesting and the Wealthfront diversified risk level 7 portfolio with no tax-loss harvesting. We evaluated the performance of our daily tax-loss harvesting algorithms across three investment periods (10 years, 20 years and 30 years) and three different withdrawal rates (none, 50% at the end of the investment period and full withdrawal at the end of the investment period). In our Monte Carlo simulation, we first sample asset class returns from the asset class return joint distribution model and transform them into ETF prices. For the daily tax-loss harvesting portfolio, any tax savings generated by tax-loss harvesting are reinvested into the portfolio at the beginning of the next tax year. For both portfolios, we assume an initial deposit of $100,000 and follow on deposits of $10,000 at the beginning of every quarter.
The information regarding the likelihood of various investment outcomes using Monte Carlo Simulations are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the results shown will be achieved or sustained. The charts present only a range of possible outcomes. Actual results will vary, and such results may be better or worse than the simulated scenarios. Hypothetical results have inherent limitations. Specifically, hypothetical results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from backtested performance. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations. The results are not predictions, but they should be viewed as reasonable estimates. Hypothetical results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.
The various charts displaying simulated Tax Alpha from tax-loss harvesting are historical simulated returns based on backtesting and do not rely on actual trading using client assets. Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses.
Wealthfront assumed we would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Specifically, backtested results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Actual performance may differ significantly from backtested performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations. Backtested results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented net of fees.
The results of the historical simulations are intended to be used to help explain possible benefits of the tax-loss harvesting strategy and should not be relied upon for predicting future performance.
The chart showing the tax alpha and cumulative return for daily tax-loss harvesting clients is based on Wealthfront’s estimates from existing client data for accounts opened between October 2012 and August 2014, and after we launched asset-class tax-loss harvesting in October 2012. The chart was based on the subset of our clients with tax-loss harvesting enabled in their accounts and the returns and tax alpha were estimated for their accounts only. The return estimates were based on time-weighted returns. The cumulative returns were calculated by taking the composite’s daily return based on its daily balance series, where the composite’s balance is the aggregated value of all the accounts under our TLH strategy. We then compound the daily return series to get the compounded return over the period. The monthly tax alpha was calculated using the net tax benefit/liability and dividing by the aggregate balance. The net tax benefit over the period includes the liquidation of positions transferred in and sold to invest the client account in the Wealthfront portfolio.
Different methodologies may have resulted in different outcomes. For example, we assume that an investor’s risk profile and target allocation would not have changed during the time period shown; however, actual investors may have experienced changes to their allocation plan in response to changing suitability profiles and investment objectives. Furthermore, material economic and market factors that might have occurred during the time period could have had an impact on decision-making. Actual investors on Wealthfront may experience different results from the results shown. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.
While the data used for its simulations are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources, including independent market quotations and index information. Wealthfront believes the third-party information comes from reliable sources, but Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third-party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.
Wealthfront’s investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors.
When Wealthfront replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Wealthfront assumes no responsibility to any investor for the tax consequences of any transaction.
The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.
Wealthfront only monitors for tax-loss harvesting for accounts within Wealthfront. The client is responsible for monitoring their and their spouse’s accounts outside of Wealthfront to ensure that transactions in the same security or a substantially similar security do not create a “wash sale.” A wash sale is the sale at a loss and purchase of the same security or substantially similar security within 30 days of each other. If a wash sale transaction occurs, the IRS may disallow or defer the loss for current tax reporting purposes. More specifically, the wash sale period for any sale at a loss consists of 61 calendar days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time. Wealthfront may lack visibility to certain wash sales, should they occur as a result of external or unlinked accounts, and therefore Wealthfront may not be able to provide notice of such wash sale in advance of the Client’s receipt of the IRS Form 1099.
The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Except as set forth above, Wealthfront will monitor only a client’s (or client’s spouse’s) Wealthfront accounts to determine if there are unrealized losses for purposes of determining whether to harvest such losses. Transactions outside of Wealthfront accounts may affect whether a loss is successfully harvested and, if so, whether that loss is usable by the client in the most efficient manner.
A client may also request that Wealthfront monitor the client’s spouse’s accounts or their IRA accounts at Wealthfront to avoid the wash sale disallowance rule. A client may request spousal monitoring online or by calling Wealthfront at (650) 249-4250. If Wealthfront is monitoring multiple accounts to avoid the wash sale disallowance rule, the first taxable account to trade a security will block the other account(s) from trading in that same security for 30 days.
The S&P National Municipal (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Wealthfront. Copyright © 2015 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited Index Data Services Attachment without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.
Correlation is a measure of statistical association, or dependence, between two random variables. The values presented here are based on a particular historical sample period, data frequency, and are specific to the assets/indices used in the analysis. Correlations may change over time, such that future values of correlation may significantly depart from those observed historically.
- What is tax-loss harvesting?
- Tax-Loss Harvesting is a Tax-Deferral Strategy
- Who should use tax-loss harvesting?
- Wealthfront Daily Tax-Loss Harvesting service
- Harvesting losses at the Asset Class level
- Wash sale management
- Performance measurement
- Quantifying the Value of Tax Deferral – Monte Carlo Simulation Method
- Quantifying the Value of Tax Deferral – Backtesting Method
- Evaluating Tax Efficiency: The Wealthfront Maximum Tax Alpha Ratio™
- Comparison of Daily vs. One-time (i.e. End-of-Year) Tax-Loss Harvesting
- Quantifying the Value of Tax Deferral – Backtested Differential IRR
- Quantifying the Value of Tax Deferral – Empirical Method