By Abhishek Singh
Reducing the capital gains tax burden on client investments and maximizing investment returns: these are core challenges that small business advisory firms constantly work to address.
Performing such a balancing act demands that small firms turn to cutting-edge technology: robo-advisors.
In this article, we’ll briefly define robo-advisors and examine how small financial advisory firms can use robo-tax harvesting to reduce clients’ tax burden.
What are robo-advisors?
Robo-advisers are digital investment and financial wealth management tools. At their core, these tools are powered by complex financial algorithms. These algorithms map a client’s financial profile to a specific investment portfolio related to stock market investments, educational savings, retirement accounts, etc.
The main objective of any robo-advisor is to maximize investment return for clients by constantly analyzing market fluctuations. Unlike human financial advisers, robo-advisors offer a dynamic investment portfolio to clients, based on a personality profile.
Also known as digital wealth management software or automated investment applications, robo-advisors are deployed through the cloud and are accessed through web-based applications on multiple devices such as desktops and smartphones.
Robo-tax harvesting: The key to minimizing capital gains tax on investments
With the help of an investment technique known as tax-loss harvesting, robo-advisors automate the selling of investment assets within a portfolio to deliberately result in losses during low market peaks. These losses are made within the IRS guidelines of the wash-sale rule to reduce capital gains taxes.
For example, let’s say you sell a particular investment and get a capital gain of $20,000. Since the value of the capital gain is in the highest tax bracket, you will need to pay 20% of the value gained from the investment to the IRS as a capital gains tax—this comes out to $4,000.
To minimize this capital gains tax, enlist the help of robo-advisors.
Let’s take the example above. Instead of selling an investment for profit, the robo-advisor waits until the market dips, deliberately selling it for a comparative loss of $4,000. In this case, the capital gains tax is lower since the client will only need to pay $3,200—that is, 20% of $16,000 rather than 20% of $20,000. By combining a series of highly profitable and loss-making investments, robo-advisors reduce the amount of capital gains tax in a client’s investment portfolio of a client.
The good news is that tax loss harvesting through robo-advisors is completely legal as long as they are based on IRS’ wash sale rule and capital gains tax guidelines. This rule is one of the main reasons why robo-advisor are algorithmically programmed not to repurchase a similar type of investment within 30 days of the sale of the original investment, based on the IRS’ wash-sale rule.
Compared to robo-advisors, human financial advisers conducting a tax loss harvest for one investment at a time is complicated and expensive. Not to mention that human financial advisers need to look at the nitty-gritty of calculating capital gains tax and identifying investments that could be worth a loss.
In other words, performing a fine balancing act of selling investments for profit and tax loss harvesting involves a lot of manual work for financial human advisers. In contrast, robo-advisors manage high volume investment transactions and managing financial assets in real-time by buying or selling investments based on real-time market fluctuations.
Robo-advisors offer a competitive advantage to small financial advisory firms over their larger competitors in the investment management landscape.
Since small financial advisory firms have a limited operating budget along—especially when considering the cost of hiring financial advisers—deploying robo-advisors tools can be transformative for small financial advisory firms that are embracing digital transformation as part of their overall business strategy.
Abhishek Singh is Team Lead of Content at Gartner Digital Markets. He has been writing extensively on GetApp covering topics related to accounting and finance challenges that small business face and how they can use cloud-based accounting tools to accelerate their digital transformation.