Robo platforms create a new headache for human advisers: wash sales

Most platforms have safeguards, but can't guard against non-platform trading

May 24, 2016 @ 12:01 am

By Jeff Benjamin

As the robo-advice industry continues to expand to a broader universe of investors, financial advisers might have to start watching out for a well-worn obstacle known as wash sales.

The wash sale rule, which prohibits investors from repurchasing the same security or fund within a 60-day window of selling it for tax-loss purposes, could trip up advisers whose clients are doing any business on robo platforms.

“Absolutely, that could become a problem,” said William Trout, senior analyst at Celent's wealth management unit.

“Most robos are only personalized at the asset management level; they're not able to do any sort of tax efficiency on the security level,” he added. “The only saving grace is that most people investing on the robo platforms are not worried about tax losses or wash sales because they don't have enough money to manage outside of those accounts. But it could be a problem as the robos get larger.”

Betterment, the largest robo platform with $4.5 billion under management and 165,000 clients, claims to use algorithms that are “keenly aware of wash sales,” said Alex Benke, director of advice products.

In fact, most robo platforms boast standard safeguards to prevent wash sales on accounts on the platforms.

The trouble starts when an investor sells something for a tax loss in an account separate from the platform, which could be nullified if the robo platform purchased the same security within 30 days before or after the tax-loss sale.

The most common way to work around the wash sale rule, if one doesn't want to wait 30 days to repurchase the same security or fund, is to sell something for a taxable loss and then buy something that provides similar but not identical market exposure.

The advent of a diverse universe of ETFs has made it easier for advisers and investors to deftly navigate the wash sale rule without violating any tax laws.

“We use a strategy we call parallel position management, which will avoid wash sales where possible by using a secondary set of ETFs,” said Mr. Benke. “Let's say we harvest a loss for you. Our algorithm would be potentially buying back that ETF, but we would do that by buying back a secondary ETF for you so you could lock in that loss.”

The wash sale rule is one of the oldest anti-abuse provisions in the Internal Revenue Code, but is still confusing and often misunderstood by some advisers and investors, according to Michael Kitces, director of research at Pinnacle Advisory Group.

“The leading robo advisers like Betterment and Wealthfront already monitor wash sales, and it's included in their algorithms from day one,” he said. “But I don't know that every robo that's ever been created or will be created will do this correctly. Nor, frankly, is it easy for human advisers, who also routinely screw this up.”

Violating the wash sale rule isn't something that triggers a heavy penalty beyond the tax consequences, which might explain why advisers sometimes view it less seriously.

For example, a security purchased for $100 and then sold for $90, could log a $10 tax loss. But if the wash sale is violated, the only penalty is that the investor losses the loss for tax purposes, but the new purchase of the security resets the cost basis to the most recent purchase, effectively banking the loss to be harvested later.

“Wash sales aren't the end of the world; you just don't get to take the loss when it happens,” said Mr. Benke of Betterment. “We'll do everything we can to avoid it, but there are cases when you just can't avoid wash sales.”

The issue of wash sale violations gets a little trickier once you start factoring in qualified retirement accounts, because that can trigger what is known as a permanent wash sale.

“If you harvested something for a tax loss, you can't then make a contribution into an IRA and buy that same security because in an IRA there is no such thing as a cost basis,” Mr. Benke said. “A lot of people don't even realize it, but there's no way to adjust the cost basis in an IRA because everything is taxable when it's withdrawn, so you permanently lose that cost-basis adjustment.”

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