While the case for tax loss harvesting is fairly clear—using investment losses to offset investment gains and potentially ordinary income can have obvious value—quantifying the value of a tax loss harvesting strategy can be more difficult.

Boris Khentov, the VP of Operations at Betterment at the time, published a 2014 report breaking down Betterment’s Tax Loss Harvesting+™ methodology that provides some insight into how much tax benefit there can be in using tax losses to offset income and taxable gains. Betterment’s report has been modified over time, but the 2014 version includes backtesting calculations that can actually help put a number to the benefits of harvesting losses from an investment portfolio.

Based on backtesting from 2000 to 2013, Khentov estimated that the tax loss harvesting benefit of Betterment’s methodology would have provided an extra 0.77% in annual after-tax returns for a “typical customer” which they defined as a California resident earning $100,000 annually.

In this post, we’ll dive deeper into tax loss harvesting, the unique aspects of Betterment’s TLH+™ methodology, and the potential benefits of harvesting a capital loss.

Introduction to Tax Loss Harvesting

What is Tax Loss Harvesting?

Tax loss harvesting is a strategy used by investors to offset capital gains with capital losses in order to reduce their tax liability. This can help investors reduce their overall tax bill in a number of ways.

Capital gains or capital losses are only recognized once an investor sells their holding. For instance, suppose John purchases $10,000 of XYZ Inc. and the value of that stock increases to $12,000. John’s investment has grown, but it isn’t until he actually sells his investment that he would recognize a capital gain.

Similarly, let’s assume that John purchased $10,000 of XYZ Inc. and the value of that stock fell to $8,000. John’s investment has declined, but it isn’t until he actually sells his investment that he would have a capital loss. If John is intentionally selling investments due to the tax consequences, then this is called tax loss harvesting.

Short-Term Vs. Long-Term Capital Gains

It is also important to note that the holding period of an investment does influence the capital gains treatment. Investments held for less than 12 months when sold will result in short-term capital losses. Investments held for 12 months or longer will result in long-term capital losses.

This distinction is important because capital gains are taxed at different rates and capital losses offset income differently depending on whether gains or short- or long-term. Long-term capital gains are subject to preferential capital gains tax rates of 0%, 15%, and 20% depending on one’s income. Additionally, the Net Investment Income Tax (NIIT) or Medicare surtax can add an additional 3.8% tax to long-term capital gains for some investors, and state taxes on capital gains income can also apply.

Short-term capital gains, on the other hand, are taxed at ordinary income rates. That means that short-term capital gains could be taxed at rates as high as 37% at the federal level plus state taxes.

When an investment declines in value, capital losses can offset both long-term and short-term capital gains. However, long-term capital gains are offset first. Additionally, if there are no long-term or short-term capital gains remaining to offset, up to $3,000 of ordinary income at one’s top marginal rate (potentially 37% plus state taxes) can be offset by tax losses harvested. Additionally, losses can be carried forward to offset future gains or reduce taxes on ordinary income in future tax years.

Why is Tax Loss Harvesting Important?

Reducing taxes can have a significant impact on an investor’s overall returns. Even a small reduction in taxes can add up over time, particularly when compounded with reinvested savings. Additionally, tax loss harvesting can help investors manage their overall tax liability, particularly in years where they have realized significant capital gains.

As noted in Khentov’s report, there are at least four different ways that a tax loss harvesting transaction can benefit an overall investment strategy:

1. Tax deferral
2. Pushing capital gains into a lower tax rate
3. Converting ordinary income into long-term capital gains
4. Permanent tax avoidance

Tax Deferral

By far, the most common benefit of tax loss harvesting is tax deferral—i.e., the pushing of tax liabilities off into the future. This is because there is an aspect of tax loss harvesting that is often overlooked: While you can get an immediate reduction in tax liability when you sell investments for tax purposes, you are also reducing your cost basis and potentially increasing future tax liabilities.

An example may help clarify. Suppose John above purchased his stock in XYZ Inc. for $10,000 and sold it 15 months later for $8,000. Let’s further suppose John had long-term capital gains income to offset at a 15% rate so he got an immediate tax benefit of $300 of tax savings ($2,000 loss * 15%). However, if John purchases a new investment with his $8,000, his cost basis for computing a capital gain is now only $8,000, so if that investment grows to $15,000 and he sells it 2 years from now, he’ll have a $7,000 capital gain and owe $1,050 in capital gains assuming he’s still subject to a 15% tax rate.

Had John not engaged in tax loss harvesting and harvested his $300 of tax savings, he would have owed 15% on a $5k gain ($15k current value minus $10k cost basis), resulting in a future tax liability of only $750. In both scenarios, John pays a total net tax liability of $750, but with tax loss harvesting, he got to defer an extra $300 of tax liability he otherwise would have had to pay early on into the future. And since a dollar is worth more today than it is in the future, it’s beneficial to take advantage of opportunities in the tax code to defer liabilities into the future.

Pushing Capital Gains Into A Lower Tax Rate

A very straightforward benefit of tax loss harvesting is offsetting short-term capital gains. Since both federal and state taxes can add up to 50% or more on short-term capital gains, offsetting short-term capital gains with capital losses can help reduce the tax rate that will ultimately be applied to those gains in the future.

Converting Ordinary Income Into Long-Term Capital Gains

Similar to pushing capital gains into a lower tax rate, tax loss harvesting can allow for opportunities to convert ordinary income into long-term capital gains. The opportunity is limited here to only the $3,000 that can be offset from ordinary income in a given year, but there is still potential for significant tax savings over time.

Tax Savings Through Permanent Tax Avoidance

The greatest potential benefit of tax loss harvesting comes when taxes can be avoided entirely. Two of the most common scenarios for this include charitable donations and leaving an estate for heirs.

Let’s revisit John’s scenario from before where his $10,000 investment in XYZ Inc. declined to $8,000 and he harvested his $2,000 loss and received $300 of benefit from doing so. Now let’s assume the investment he purchased with his $8,000 proceeds grows to be worth $15,000. We noted previously that he would be subject to $1,050 of long-term capital gains tax at a 15% tax rate in this $7,000 gain if he were to sell his stock, but if John is charitably inclined, he can avoid this entirely by giving the stock to a charitable organization. Through his generous donation, John is able to reap the tax benefits of the $300 of tax savings associated with his tax loss harvesting transaction, while also never paying taxes on the growth.

Similarly, if John were to pass away and his children inherit his account, investments in a taxable brokerage account would be eligible for a step-up in cost basis at his time of death, again avoiding tax liability entirely while also getting the benefit of the $300 tax savings from his tax loss harvesting.

Limitations of Traditional Tax Loss Harvesting Strategies

While tax loss harvesting can be a valuable tool for investors, it is not without its limitations. One common limitation is the “wash sale” rule, which prohibits the repurchase of a “substantially identical” security within 30 days of selling it at a loss. This can limit an investor’s ability to fully utilize their losses, as they may be unable to immediately reinvest the proceeds from the sale.

Additionally, traditional tax loss harvesting strategies often rely on “switchback” trades, where an investor sells a security at a loss and immediately repurchases a similar security. While this can help the investor avoid the wash sale rule, it can also expose them to higher taxes in the future. This is because any short-term capital gains realized through the switchback trade will be taxed at a higher rate than long-term capital gains.

As we’ll touch on later, in order to address these limitations and provide a more tax-efficient solution, Betterment’s TLH+ feature does help plan around these issues. TLH+ is designed to minimize taxes on every transaction, including withdrawals, deposits, and rebalancing, and to coordinate wash sale management across both taxable and IRA/401(k) accounts.

Negative Tax Arbitrage

Negative tax arbitrage refers to the situation where tax loss harvesting strategies end up causing an investor to pay more in taxes than they would have without the strategy. There are a few scenarios in which this can occur.

One such scenario is when unrelated long-term capital gains (LTCG) are present in an investor’s portfolio. If an investor harvests a loss and then uses an unconditional 30-day switchback strategy to recoup the loss, the rules require that the harvested loss be applied against the unrelated LTCG. This means that the harvested loss gets used up entirely, exposing the entire short-term capital gain (STCG) from the switchback as taxable. As a result, the harvested loss that was supposed to shelter the highly taxed STCG ends up being used to shelter a lower-taxed LTCG, resulting in far greater tax liability than if no harvest had taken place.

Another instance of negative tax arbitrage can occur in connection with dividend payments. If certain conditions are met, some exchange-traded fund (ETF) and mutual fund distributions are treated as “qualified dividends,” taxed at lower rates. One of these conditions is holding the security for more than 60 days. However, if the dividend is paid while the position is in the replacement security during a rigid 30-day switchback, the condition can never be met. This means that up to 20% of the dividend is lost to taxes (depending on an individual’s tax rates), as it is not given the favorable treatment of qualified dividends.

Unsophisticated tax loss harvesting strategies, such as the unconditional 30-day switchback, can result in negative tax arbitrage traps for investors. This is especially true for investors who regularly generate significant LTCG, as they would benefit the most from effective tax loss harvesting. However, if their portfolios are harvested with the 30-day switchback over the years, it is not a question of “if” the switchbacks will convert some LTCG into STCG, but “when” and “how much.”

To avoid negative tax arbitrage, it is crucial for tax loss harvesting strategies to be managed intelligently and holistically. This means not just looking for opportunities to harvest losses regularly, but also seeking to make every transaction tax efficient, including withdrawals, deposits, and rebalancing. It also involves coordinating wash sale management across both taxable and IRA/401(k) accounts as seamlessly as possible, so that transactions, including dividend reinvestments or portfolio rebalancing, don’t accidentally violate wash sale rules.

Betterment’s Tax Loss Harvesting Strategy: TLH+

Tax loss harvesting (TLH) can be a highly effective way to improve investor returns without taking on additional downside risk. However, traditional TLH strategies have not always been executed in the most tax-efficient manner. To address this, Betterment developed TLH+, a proprietary algorithm that that they use to optimize every transaction for tax efficiency, including withdrawals, deposits, and rebalancing.

Betterment provides a summary of the following features of their TLH+ offering:

1. No exposure to short-term capital gains in an attempt to harvest losses
2. No negative tax arbitrage traps
3. Zero cash drag at all times
4. Dynamic trigger thresholds for each asset class
5. Tax loss preservation logic extended to user-realized losses
6. No disallowed losses through overlap with Betterment IRA/401(k)
7. Harvests also take the opportunity to rebalance across all asset classes rather than just re-invest in the same asset class.

The features of Betterment’s TLH+ methodology are important since the use of those same assumptions is underlying Betterment’s analysis. DIY tax loss harvesting and even many other software TLH tools are not as sophisticated as Betterment’s approach, so the benefits of TLH will vary based on how it is implemented.

Tax Loss Harvesting Analysis Results

In order to evaluate the performance of Betterment’s TLH+ feature, Khentov conducted backtesting between 2000 and 2013. This allowed Khentov to observe the model’s performance during familiar market conditions, although, as Khentov notes, it’s important to note that forward-looking simulations may provide a more reliable approach for design and calibration. In Betterment’s backtesting, they found that TLH+ produced twice as many tax offsets as the commonly used 30-day switchback strategy.

To better understand the value of TLH+ over time, Betterment used a measure called the Internal Rate of Return (IRR) to calculate the excess return that a TLH+ portfolio would have generated relative to a baseline Betterment portfolio. They assumed a constant 70% stock allocation, an initial $50,000 investment on 1/1/2000, and twice monthly auto-deposits of $750, escalated 5% annually to account for inflation and salary growth. All dividends were reinvested to rebalance the portfolio and taxed according to existing tax rules over the entire period.

For tax rates, Betterment assumed a single California resident (where Betterment has the most customers) making $100,000/year (federal: 28% on income, 15% on LTCG; state: 9.3%). It’s important to note that these tax rates were in effect during the backtest period, which was between 2000 and 2013. Betterment assumed that harvested losses were offset against ordinary income up to $3,000 and the excess, if any, against LTCG outside the portfolio. This mimics a typical scenario where an investor waits until the end of the year to trigger LTCG tax-free while still utilizing the more valuable ordinary income offset.

To factor in the liquidation of embedded gains, Betterment calculated IRR for three scenarios: full liquidation on 1/1/2014, liquidation of 50% of the portfolio on 1/1/2014, and no liquidation. It’s important to note that the comparison was apples to apples, with the non-TLH+ portfolio also being liquidated and taxes paid.

Even with full liquidation, TLH+ would have delivered tax alpha of 0.62%. This means that TLH+ was able to generate an excess return of 0.62% over the baseline Betterment portfolio due to tax savings. At 50% liquidation, a tax alpha of 0.77% was observed, and with no liquidation, a tax alpha of 0.92% was observed.

Betterment does make an important disclosure that the results above did benefit from the bear market of 2000-2002. The quick decline in the original investment does maximize time for future deferral in this scenario. Different market environments will exist in future years and an initial investment loss will not always be experienced.

That said, Betterment’s deferral period of only 13 years can understate the value of tax loss harvesting, particularly when even retirees may have 30+ year investment horizons and opportunities may exist to shelter gains from taxes entirely. For this reason, Betterment felt that the tax alpha of 0.77% (50% liquidation after 13 years) provided a reasonable estimate for their typical customer earning $100,000 and living in California.

However, benefits may be even greater for high-income earners, those with longer time horizons, and those with short-term gains to offset. Betterment conducted some follow-up analyses computing the tax alpha for an individual earning at the maximum California rates at the time (federal: 39.6% on income, 23.8% on LTCG; state: 12.3%), and found higher levels of tax alpha.

For an investor earning $500,000, tax alpha was 0.85% higher with full liquidation, 1.09% higher with 50% liquidation, and 1.30% higher with no liquidation.

Furthermore, for those with short-term capital gains available as well, tax alpha climbed to 0.94% under full liquidation, 1.17% under 50% liquidation, and 1.40% with no liquidation.

Long-Term vs. Year-By-Year Benefit Distinction

It is also important to note that the benefit of tax loss harvesting, like many other financial planning strategies, can be quite “lumpy” — meaning that the benefits may be larger in some years than others. This lumpiness of financial planning value has been noted in studies like Vanguard’s Advisor Alpha, as well as others that have looked at the value of financial advisors.

Not surprisingly, Betterment found that the same applies to tax loss harvesting. In some years, the benefit was very large (6% or higher in 2000-2002), but in other years there was little to no value observed.

Betterment’s analysis identified a mean annual tax offset of 1.94% over this 13-year period, despite the fact that value in a given year varied a lot. Notably, this annual tax offset calculation is not a true after-tax measure. This is a reflection of the upfront benefit (tax loss harvesting savings), but we also need to consider to long-term cost (higher tax liability in the future). Nonetheless, the opportunities for tax loss harvesting will come disproportionately when we have down markets that increase opportunities for claiming losses come tax time.

Betterment also compared their TLH+ methodology to other automated TLH approaches (most commonly using the 30-day switchback), and found that TLH+ provided 1.94% of annual tax offset versus only 0.95% for less sophisticated TLH approaches.

DIY investors may wish to pay particular attention to the difference between Betterment’s sophisticated approach and less sophisticated tools, as managing your own investment portfolio is likely to be, at best, more akin to lesser automated tools. Furthermore, it’s realistic to assume that DIY TLH will lag even less sophisticated TLH tools, which is one more reason why I’m a big fan of even DIY investors using a sophisticated robo-advisor like Betterment.

Who Benefits The Most From Tax Loss Harvesting?

Betterment’s report includes some nice profiles of individuals who would benefit the most from tax loss harvesting. They identify four particular profiles:

1. The bottomless gains investor. For certain investors who regularly sell assets such as stocks or real estate that have greatly increased in value, they can utilize the losses they incurred to offset those gains, thereby greatly reducing their tax liability.
2. The high income earner. Higher earners without other capital gains can still benefit from tax loss harvesting, since up to $3,000 in losses can be deducted from ordinary income each year, which could save investors with a 50% marginal tax rate up to $1,500. Because these gains would commonly be converted into long-term capital gains, it’s likely the ultimate tax rate applied would also be lower.
3. The steady saver. Saving on an ongoing basis provides multiple entry points into the market that provides greater opportunity to potentially experience losses. Even though investments made 10 years ago are less likely to encounter losses going forward, new contributions made today are more likely to encounter losses.
4. The philanthropist. As noted above, gifting securities to charity and avoiding capital gains taxes entirely only further increases the benefits of tax loss harvesting.

Who Benefits The Least From Tax Loss Harvesting?

Betterment’s report also includes some nice profiles of individuals who would benefit the least from tax loss harvesting. They identify five particular profiles:

1. The aspiring tax bracket climber. Someone who expects their income to increase significantly may not want to tax loss harvest. Particularly for anyone in the 0% capital gains tax bracket, it is often better to harvest gains rather than losses.
2. The scattered portfolio. Investors who have assets spread across multiple third-party providers are far more likely to run into wash sale issues. If Robo Advisor A is managing someone’s IRA and Robo Advisor B is managing their taxable brokerage account, mistakes can easily happen that trigger wash sales that disallow losses come tax time. Consolidating with one high-quality provider is almost always better than keeping assets spread across institutions.
3. The portfolio strategy collector. Even within one institution, someone who has assets spread across many different strategies may be creating disadvantages for tax-efficient investing. Sticking with one core portfolio is generally best.
4. The rapid liquidator. Liquidating all of a portfolio at one time can have negative tax consequences pushing someone into higher capital gains brackets. While this can often be avoided with good planning, if someone does know they will need to liquidate rapidly, avoiding harvesting losses or even harvesting gains over time may be more beneficial.
5. The imminent withdrawal. Similar to the rapid liquidator, if someone has (large) imminent withdrawals they plan to make, delaying the start of a tax loss harvesting strategy until after those withdrawals have been made may be wise.

Conclusion

In conclusion, tax loss harvesting can be a valuable tool for improving investor returns without increasing risk. While putting a number to the value of tax loss harvesting has historically been difficult, Boris Khentov’s 2014 report for Betterment provides some of the best estimates I have come across for actually computing the long-term value of tax loss harvesting. Particularly when it is done well and wash sales and other nuances are managed appropriately, tax loss harvesting can have great potential to enhance wealth.