One of the main reasons robo advisors are going mainstream is that they provide financial advice more conveniently and at a cheaper rate than traditional financial advisors. But it’s not always clear how they compare to traditional financial advisors when it comes to tax efficiency.
Robo advisors are tax-efficient because they leverage tax-loss harvesting to reduce your tax liability. While traditional financial advisors, too, offer tax-loss harvesting, robo advisors do it more frequently, and with less room for errors.
Lucky for you, you’re on the right blog because today’s post is all about testing Robo advisors’ credentials when it comes to tax efficiency. Read on for an informative discussion as I explore how tax-loss harvesting works, why robo advisors are more efficient at it, and so much more.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Are Robo Advisors?
Let’s provide a bit of background info before we go any further so we’re all on the same page when I start discussing the more complicated stuff later. If you’re already familiar with robo advisors, you can skip this section.
Robo are software advisors that leverage algorithms to offer investment management and financial advice through an online platform (usually an app) with minimal human intervention. Their digital advice is usually based on your inputs, i.e., your financial information.
Popular examples of robo-advisors include Wealthfront and Betterment.
Part of the appeal of robo advisors is that they have low minimums, extending their services to a wider range of individuals across different earning brackets. They’re also typically low-cost, mainly because there’s little human involvement.
Other benefits of Robo advisors are that:
- They are easy to use.
- Provide well-designed investment portfolios with automated rebalancing.
Can we add tax efficiency to that list? Let’s find out in the next section.
Why Are Robo Advisors Tax-Efficient?
The simple answer is because robo advisors offer a service known as tax-loss harvesting.
Without going into too much detail, tax loss harvesting refers to the practice of deliberately selling securities at a loss to reduce capital gains tax. The net effect of this is a lower tax liability when you realize capital gains from the sale of your investments.
Tax loss harvesting isn’t exclusively offered by robo advisors. Traditional financial advisors offer this service, too. However, robo advisors are more efficient at it.
Let me explain why.
Typically, traditional financial advisors perform tax-loss harvesting annually. They can’t do it more often because it’s a time-consuming, labor-intensive process. And if they did, those additional labor costs would be transferred to investors, making their services too costly.
By contrast, robo advisors can run tax loss harvests every day with zero human involvement, thanks to automation. In doing so, they capitalize on tax harvesting opportunities that may arise due to short-lived market downturns to minimize your tax liability as much as possible.
It’s also worth noting that automated systems are less prone to errors than humans. If done wrong, tax-loss harvests can result in run-ins with the IRS. Nobody wants to rub the IRS up the wrong way because that often comes with hefty fines.
Now that you understand why robo advisors are more efficient at tax-loss harvesting, let’s take a deeper look at how the process works. This way, you’ll understand precisely how it reduces your tax liability instead of having to take my word for it.
How Tax-Loss Harvesting Works?
The way tax-loss harvesting works is pretty simple: you deliberately sell a security held in a non-tax exempt account at a loss to offset your taxable income or capital gains. Of course, the “you” in this case refers to a robo advisor because the process is usually automated when you’re using such a service.
Let’s use an example to demonstrate how tax-loss harvesting can lower your taxable income (and subsequently reduce your tax liability).
Suppose you have a capital gain of $100,000 and fall in the 20% tax bracket. In this case, you’ll owe the government $20,000 in capital gains tax. If you sell one of the securities in your portfolio at a loss, the sum of that loss would reduce your taxable income and subsequently lower your $20,000 tax liability.
Let’s assume you sold security X at a loss of $10,000. As far as the IRS is concerned, your net capital gains would be $10,000-$10,000 = $90,000. So instead of paying $20,000 in capital gains tax, you’d end up paying $18,000 (20% x $90,000).
That, albeit with a bit of oversimplification, is how tax-loss harvesting works.
Why “oversimplification”?
Because in reality, you would only be allowed to deduct up to $3,000 in losses if you’re single or married and filing jointly with your spouse, and $15,000 if you’re married and filing separately. However, you’d still benefit from the loss because you can always carry it forward and claim a similar deduction in the following year’s tax returns.
Tax-Loss Harvesting Limitations: The Wash Sale Rule
In addition to the maximum allowable deduction I’ve just mentioned above, tax loss-harvesting comes with another limitation: the wash-sale rule. The IRS’s wash sale rule exists to prevent investors from abusing the provision to deduct losses for tax purposes.
To demonstrate how the rule works, let’s go back to the above example, where you sold security X to take advantage of tax-loss harvesting.
Once you sell security X at a loss to offset some of your capital gains, you’re not allowed to repurchase that security within 30 days. You’re also prohibited from buying any security that’s substantially identical to X. That limitation also extends to contracts/options to buy security X or anything identical to it.
The only way to stay exposed to security X without getting in trouble with the IRS would be to buy a mutual fund or an Exchange Traded Fund (ETF) that tracks the specific sector the underlying company to security X operates. This way, you get a tax break from that security and still keep your asset allocation intact.
Robo Advisors and the Wash Sale Rule: Are They Compliant?
This is a critical concern because violating the wash sale rule can invalidate your loss deduction claim. If this were to happen, a tax-loss harvest would be pointless.
Robo investment platforms typically incorporate IRS requirements like the wash sale rule in their algorithms. When a gain is realized, the algorithm counteracts it with a loss (in the manner we’ve seen in the above example) without repurchasing a similar security for portfolio rebalancing purposes.
It’s an automated process that makes sure investor portfolios remain balanced after a tax-loss harvest, all without violating the requirements set by IRS.
So if you were wondering whether robo investment platforms have loopholes that may compromise their biggest weapon when it comes to tax efficiency, the answer is no. If anything, traditional financial advisors are more prone to errors, especially since the interpretation of a “substantially identical security” may vary among experts.
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Conclusion
In summary, we’ve established that robo advisors are tax-efficient because they leverage tax-loss harvesting to minimize your tax burden. While traditional financial advisors offer this service, Robo advisors are more effective at tax-loss harvesting because they do it more frequently, with less room for errors.
Understand that as attractive a prospect as tax-loss harvesting may sound, not everyone stands to benefit from it. It’s a great tool to have at your disposal, but it shouldn’t be the only consideration when making investment decisions. Talk to an expert to determine whether it suits your financial situation.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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