November 15, 2022
As an investor, you want to be able to reduce a loss as much as possible when a particular investment underperforms. Losses are rarely appreciated if you are looking to accumulate wealth but investment companies can use different methods to help you recover some of your loss. One company, Betterment, has one up on other companies with their Tax Loss Harvesting+ (TLH+) program. It enables investors to gain a larger recovery and ensures that your investment money continues to bring a profit.
Getting around the IRS's Wash Sale Rule can be done rather easily but it must be done correctly to get the benefit you want. When it is maneuvered right, tax loss harvesting can enable you to reduce your losses and help you lower taxes in the current year and in the future.
The Wash Sale Rule states that you must first sell the stock that produced the loss and get a realized sum. There is no actual loss until you sell it and add in any costs. Then, you can turn around and reinvest that money but you cannot put it into the same security or in one that is considered "substantially identical" within 30 days. If you do, it negates the benefit of being able to take it off your taxes.
When choosing a new investment, you must not choose one that is performing well because the profit may not allow you to have any benefit from a loss. If you were invested in mutual funds and you like the overall industry performance, you can stay within the same type of industry by choosing a stock or exchange-traded funds (ETFs).
The loss can be used to offset your gains so that you do not need to pay taxes on those gains at a higher tax rate – especially when they are from short-term capital gains. If you have a loss, you can use it to reduce your taxable income by up to $3,000. This can also be done when you do not have any capital gains. Tax loss harvesting cannot be applied to a 401(k) or an IRA.
One way to build an even larger portfolio would be to reinvest the balance of the stock value realized and add the money gained by tax loss harvesting each year. By taking $3,000 off of your income taxes, if you are in the 30% tax bracket, it would reduce your taxes by $900. Take that extra $900 and invest it back into your portfolio.
Because $3,000 is the maximum you can subtract from your taxes in a single year, you also have the advantage of applying a loss to future years. If your total loss was $5,000, for instance, you can take $3,000 off of this year's taxes, and then $2,000 off in the following year.
As its name sounds, this is an automated service that some companies use to generate deliberate losses for income tax purposes. The goal in these platforms is to automatically sell and reinvest securities. They buy and sell based on certain algorithms and have minimal human involvement.
Betterment has improved the automated process to be able to help clients get even better results and it does so while keeping its prices low. Although the actual process is sophisticated, it is fully automated and uses an index fund ETF portfolio. This enables our company to give you the correct mix of asset classes with diversification and downside management of risk.
An important part of Betterment's tax loss harvesting is rebalancing your portfolio to harvest the best results come tax time. Between the years 2000 and 2013, customers received an average gain of 0.77% on their returns – after-tax.
Problems That May Occur with Automated Tax Loss Harvesting
When the TLH+ program was created, the goal was to add features that other automated programs did not possess. One of these problems was that other company’s automated programs delayed selling and reinvesting for 30 days and more. Although this would ensure no problems with a wash sale, it could also create a condition called cash drag – limiting the possible returns on your investment.
A problem called switchback can also be created if the system is not programmed to take it into account. This occurs when money from a sale is reinvested into a presumably underperforming security that suddenly reverses the trend and starts gaining in value. When that occurs, you could end up with an even greater gain – which would cause you to lose some or all of the value of tax harvesting.
During the time that the replacement security is in effect, its value can go down, which increases the loss. It can also reverse its trend and add to the gains. If this happens, it can result in short-term capital gains (STCG) when the replacement security is sold. This could be a problem because, on your taxes, long-term capital losses (LTCL) are subtracted from long term capital gains (LTCG) first. If there are no losses left, you will then pay taxes on the entire short term capital gains, which falls into a higher tax rate.
Betterment has designed its system of asset management and tax harvesting to avoid the potential problems that other systems do not. With a primary goal of lowering your tax liability, this is not the only goal. It is just as important to maximize your gains at the same time. This is done by not permitting your cash to have cash drag on it at any time. It is quickly re-invested at your selected risk level.
Each asset class also has trigger thresholds to ensure that they give you the best opportunities to gain large tax offsets. This ensures that your assets with high- and low-volatility are harvested at the best time.
Investors that have money invested in a 401(k) or an IRA are also protected by our program by protecting you from permanently disallowed losses. A tertiary ticker system helps protect you from this potential problem.
At Betterment, the TLH+ plan is holistic. It does not consist of just a way to harvest continuously but aims to treat your investments in a highly tax-efficient manner. This includes every transaction you make, including your deposits, withdrawals, rebalancing, and more. We take precautions to completely avoid creating short-term capital gains.
By keeping our prices low, Betterment makes our software services available to a wider range of clients. We can do this through technology and make it available to all qualified clients. We aim to simplify your life by taking care of your investments, eliminating your need to spend hours choosing the right products, ensuring a good balance, and by giving you the tax loss harvesting you need to reduce your taxes.
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