Investing for tax efficiency
Automated Investor’s advanced technology and investing strategy follows these core principles to help you reach your goal over the long-term:
- Minimize investing risk – through regular rebalancing and portfolio diversification
- Maintain low-fees – we’ll construct your portfolio from low-fee ETFs1
- Apply tax-smart strategies – we’ll monitor your portfolio for opportunities for tax-loss harvesting and use tax-efficient investing rules
Here we explain more about our tax-smart investing strategies, tax-loss harvesting, and tax-efficient investing.2 For your particular situation, please consult with your tax advisor regarding the implications of these tax-strategies.
Tax-loss harvesting is a standard strategy used for larger taxable portfolios. The good news is that automated investing algorithms now make it possible to use tax-loss harvesting without the high minimum balance requirement.
- Automated Investor monitors your portfolio daily for tax-loss harvesting opportunities
- Losses are used to realize tax benefits by offsetting taxes on gains from other investments
- Your portfolio will remain on target, as assets sold are replaced with very similar assets
- Losses can be used to offset taxes that you would pay on gains or income. You can also carry forward losses to future tax years
Note: Tax-loss harvesting is not relevant for tax-advantaged accounts such as traditional, Roth, and SEP IRAs, 401(k)s and 529 plans.
How tax-loss harvesting works
Let's say your portfolio consists of $50,000 invested in ETF X. Then, in a down year, the value of that holding decreases to $45,000.
Most investors in this situation would do nothing. However, applying tax-loss harvesting, you would sell the $45,000 holding in ETF X and invest it instead in a similar but not substantially identical fund. By doing this, you have 'harvested' the $5,000 loss for tax purposes, though in reality you still own $45,000 of an ETF in that asset class. (Note that investors must be careful not to buy back ETF X within 30 days, to comply with the IRS' wash sale rule).
Now, because you have a $5,000 capital loss from the sale of ETF X, at tax time, you can apply this loss against capital gains elsewhere in your portfolio, thereby reducing the amount of capital gains tax owed. In a year when your capital losses outweigh gains, the IRS allows you to apply up to $3,000 in losses against your other income, and to carry over the remaining losses to offset income in future years.
This example is for illustration purposes only. Any benefits of tax-loss harvesting could be impacted by activity in other investment accounts, and this does not suggest that Automated Investor’s tax-loss harvesting strategy will have any tax implications.
Advantages of Automated Investor for tax-loss harvesting
Tax-loss harvesting requires diligent tracking of tax lots across a portfolio, as well as frequent monitoring of market movements, since opportunities for tax-loss harvesting could occur at any time. Automated Investor saves you time and effort by monitoring these opportunities daily.
IRS rules related to tax-loss harvesting
Done correctly, tax-loss harvesting is consistent with IRS guidelines. Two key things to avoid are (1) a "wash sale," in which the same investment is repurchased within 30 days of being sold, and (2) the purchase of an investment that is "substantially identical" to the investment being sold. Either of these actions invalidates any potential gains from tax-loss harvesting. Automated Investor takes this into consideration when executing tax-loss harvesting trades on your behalf.
What is tax-efficient asset placement?
Tax-efficient asset placement sets up your portfolio so that assets are put into the right accounts from a tax-savings standpoint:
- Income-producing assets are placed in tax-advantaged accounts such as IRAs or 401(k)s;
- This allows the income to compound and grow over time, deferred from taxation, until withdrawn or distributed
- If you have both tax-advantaged (retirement) and taxable accounts this could potentially have a large impact on your investment returns, especially over the long term
- Tax-efficient asset placement is standard practice in the algorithm that Automated Investor applies to clients’ portfolios
Tax-efficient investing is particularly important for those who expect to be investing for at least a decade, have investments in both taxable (i.e., brokerage) and tax-advantaged accounts (such as Roth or Traditional IRAs), and meet some or all of the following criteria:
- Pay a high marginal income tax rate
- Are in a high income-tax state (such as CA or NY)
- Expect lower income taxes in retirement
- Possess many tax-efficient investments in taxable accounts
Tax-efficient asset placement decisions should also take into account:
- The tax basis of the investment
- Other needs within the portfolio such as ongoing rebalancing decisions
- The potential volatility of an asset class, since assets in a taxable account can be tax-loss harvested, which can also boost post-tax returns
Tax-efficient asset placement is not the only consideration in our investment approach. Our algorithm is designed to balance tax-efficient placement against other factors such as optimizing your stock/bond split or investing new cash. We weigh a number of goals to invest in the instruments that have the largest possible benefit (considering costs, diversification, tax efficiency, transaction costs, etc.) to your expected future returns.
Automated Investor from U.S. Bancorp Investments is exclusively for current customers. Log into usbank.com to open an account today or call 866.758.8655.