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For decades tax-loss harvesting was an obscure tool used to minimize taxes that was only available to the ultra wealthy. That all changed when Wealthfront launched its tax-loss harvesting service in October 2012. Many pundits and industry professionals who were unfamiliar with its benefits thought it couldn’t add much value. One of our competitors even referred to the concept as a “joke.” Well, times have changed, and now just about every automated investment service offers a version of tax-loss harvesting.
However, there are still many misperceptions of how and when tax-loss harvesting creates value, even among very intelligent investors. Here’s our Top 10 list of things you probably didn’t know about tax-loss harvesting:
1. Tax-loss harvesting derives its benefit from the combination of the difference in tax rates applicable to ordinary income, long-term and short-term capital gains and the compounding of your annual tax savings.
Many people mistakenly believe tax-loss harvesting provides no benefit because you must ultimately pay a tax on the gain that results from the lowered cost basis achieved through tax-loss harvesting. What they fail to realize is the tax rate you pay on the ultimate gain is almost always lower than the rate at which you can benefit from your harvested loss. That’s because your loss creates value at the short-term capital loss rate and the ultimate gain is taxed at the much lower long-term capital gains rate. Our typical Wealthfront client’s combined short term federal and state tax rate is 33% vs. 24% for the long term rate. In addition, the savings you create from tax-loss harvesting can be reinvested and compounded until you withdraw all your money from your investment account. Partial withdrawals can first be taken from investments with low gains, which results in minimal taxes.