The Achilles Heel of Robo-advisors - Wash Sales

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Technology invites innovation, and sometimes revolution.  I sense a revolution coming in the investing space.  Robo-advisors like Betterment and Wealthfront, once scrappy technology startups, now commands billions of assets under management.  When I first signed up for Betterment in 2013, they managed a paltry $100 million.  Today, they manage over $9 Billion in investments!  Unfortunately, one of the best benefits of robo-advisors also happen to be their biggest shortcoming - let's talk about "wash sales".

What is a "Wash Sale"?

Normally when you sell a security at a loss, you can deduct the loss on your income taxes.  Sure it never feels good to lose money, but at least Uncle Sam sympathizes and cuts you a small tax break.  However, the government also doesn't want you to cheat the system by selling losing investments at a loss only to buy them back at the new low price.  The "Wash Sale Rule" defines a wash sale as one that occurs when you sells a security at a loss, and within 30 days before or after this sale, buy a “substantially identical” stock or security, or acquires a contract or option to do so.  If this were to happen, you will not be able to deduct the loss from your income taxes.

For example, say you bought 10 shares of Company A's stock for $100/share and later sold it for $50, you would incur a net loss of $500.  But if you purchased 10 more shares of Company A's stock at $50 within 30 days of that sale, you will NOT be able to claim that $500 net loss.  Rather you get to add that net loss to the cost basis of the new purchase.  So your new cost basis for the 10 shares of Company A stock becomes $50x10+$500=$1,000 or $100/share.

What does this have to do with Robo-advisors?

A whole lot! I've reviewed Betterment before and you may have wondered - how come he doesn't review any other robo-advisors?  I wanted to, but then I discovered the Wash Sales rule.  Turns out one of the biggest advantages of using a robo-advisor also happen to be its Achilles heel.  Take Betterment for example, one of the platform's advertised features is Tax Loss Harvesting (TLH+).  Here is a video describing how it works.

Sounds like a great idea right?  True if you only stick to one robo-advisor.  What happens if you have accounts with multiple robo-advisors?  Turns out they all have their own versions of tax loss harvesting via automated trading. What this means is that you run a real risk of violating the Wash Sales rule.  For example, the 2 largest players Betterment and Wealthfront both include the Vanguard U.S. Total Stock Market Index ETF (VTI), Vanguard FTSE Developed Market Index ETF (VEA) and the Vanguard FTSE Emerging Index ETF (VWO).

Conclusion:

Robo-advisors have taken off recently in both assets under management as well as public mindshare.  However, one of the biggest benefits of using a robo-advisor also serves as a big ball and chain tying you to that one provider.  Beware of the Wash Sales Rule before you sign up for accounts with different robo-advisors.


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Future Proof, MD

Dr. Bo Liu is an aspiring radiologist-in-training and the founder and editor of the White Coat Money Blog.  He has an interest in interventional radiology and helping his medical colleagues get ahead in this mad world of medicine and money.  When he's not crushing the list at the PACS station or typing up your next favorite blog post, you can usually find him at the local badminton club, movie theater or the most recently opened restaurant.