Let the Robots Do Your Taxes

A while ago, I wrote a piece about the opportunities and challenges facing the fast-growing “robo- adviser” industry (which, by the way, really should be called “robo-managers”; the logic of industry buzzwords eludes me). 

In that piece, I claimed that the main advantage of robo- advisers was behavioral. By preventing people from trying to time the market and pick stocks, robo-advisers can bring individual investor performance up to the market average — in other words, a huge improvement. The only problem, I said, was that this improvement might be a tough sell. If investors were smart enough to use a robo-adviser, I asked, might they not eventually get smart enough to simply invest their money themselves, without paying 0.25 percent of their wealth each year (the fee charged by Wealthfront, the industry leader)? 

I still think that robo-advisers will create huge benefits for retail investors by cutting out middlemen and by reducing behavioral biases. But there was one important part of the robo equation that my earlier piece overlooked. 

That piece is good old Uncle Sam. Taxes, it turns out, are a far trickier beast than passive asset allocation. A beast so tricky that only a robot might be able to defeat it. 

Those who work in the finance industry, of course, will already know what tax-loss harvesting is. For the uninitiated, it’s the ability to delay the taxes that you pay on your investments. 

When you sell an investment that went up in value from when you bought it, you owe capital gains taxes. As long as investments generally go up over time, you’d rather pay taxes later instead of now — if you can delay your taxes, the money you would have paid in taxes stays invested, and grows over time. 

This is a problem for investors, who have a number of reasons to sell pieces of their investments in any given year. For instance, suppose you want to rebalance your stock portfolio. You want to keep 60 percent of your money in U.S. stocks and 40 percent in foreign stocks, but since U.S. stocks went down this year and foreign stocks went up, you need to sell some of your foreign stocks and buy U.S. stocks to maintain that 60-40 ratio. 

When you sell the foreign stocks, you’re going to pay capital gains tax. But you can delay that tax with a technique called tax-loss harvesting. Basically, you find some stocks in your portfolio that went down — and since stocks are volatile, there will almost always be some of those — and you sell them. This gives you a tax loss, which you can use to reduce or even eliminate the capital gain that you would have had to pay taxes on. 

Now, selling those losing stocks leaves you with a chunk of cash. You would like to turn right around and buy back the stocks you sold, so that you can restore your old allocation. But the Internal Revenue Service’s “wash sale rule” prohibits you from doing that.