While Robinhood’s app may glitter, its lack of automated tax-saving options may cause you to lose … [+]
With tax filing season in full swing, many new do-it-yourself investors are dealing with complicated tax issues for the first time. Some are getting caught up in complex IRS policies, like the wash-sale rule, and are now on the hook for hundreds of thousands of dollars. Those who are using new platforms, like Robinhood, are also hamstrung by the lack of critical functionality that helps minimize taxes. These gaps, or the manual band-aid solutions that Robinhood has deployed, could cost new investors thousands in additional taxes. Here’s why.
Robinhood Doesn’t Allow For Automated Tax-Minimizing Strategy
Despite its many bells and whistles, Robinhood makes it extremely difficult for investors to use a tax-strategy known as “specific-lot identification.” As was first reported by The Wall Street Journal, this technique allows investors to reduce their tax bill by specifying what shares to sell, which is especially critical if they bought shares at different times and at different prices.
Selling specific lots allows an investor to smooth out returns and potentially offset other gains or losses. The IRS allows investors to offset up to $3,000 of other income with stock losses and then carry over any additional capital losses to offset future income. The Wall Street Journal used an example of a trader with Tesla shares to show how strategically deploying specific-lot identification could make a significant difference in the end of year tax bills.
Assume an investor has three Tesla shares that were bought at $400, $650, and $850 in the middle of last year. If the trader wanted to sell a single share at the current price of roughly $700, the taxable amount could swing from a huge gain to a loss depending on which share was sold. Specifically, the trader may have a $300 capital gain if she sold the share bought at $400 and a $150 capital loss if she sold the $850 share.
Neither is inherently the wrong move and the best strategy would depend on the rest of the taxable income in the investor’s portfolio. If she had a lot of losses elsewhere, it may be best sell the $400 share and take the gains; however, if she had a lot of gains, she may want to sell the $850 share to offset some of the gains with losses.
Not only does Robinhood not allow for automated lot selection, but it also conveniently omits information that customers do have a way, albeit manual and cumbersome, to sell specific lots. On its website, Robinhood simply states, “Robinhood uses the “First In, First Out” method. This means that your longest-held shares are recorded as having been sold first when you execute a sell order.” But, as The Wall Street Journal notes, “in the fine print of trade confirmations sent to customers after they’ve sold shares, Robinhood does offer the option of specifying lots. But the process is complicated.”
Let’s go back to the Tesla example for a moment. Using the “First In, First Out” approach, Robinhood would sell the trader’s share that was bought for $400 less than a year ago. This means she would be left with a profit taxed at the higher short-term capital gain rate, a potentially sub-optimal outcome.
Robinhood does offer a manual workaround that allows investors to specify lots, but the process is cumbersome and ridiculously slow. Customers need to go through their transaction history and “email customer service with six datapoints, including dates and prices, before the trade settles two days after the trade date. Each request is assigned a case number and handled individually.” It can then take up to 30 days for Robinhood to let you know if your request was successful.
Contrast this experience with what’s available at traditional brokerage firms. Most allow you specific which lots you want to sell and then execute such trades seamlessly. “I think it’s absurd. Taxes are a huge component of investment returns, and it’s an area where investors have some control,” Bill Mulvahill, a CPA and money manager at Trailhead Planners, told The Journal.
Robinhood’s Omission Could Cost You Thousands
The inability to easily specific lots could cost investors different amounts depending on their trading patterns and volume, but it is easy to see how the costs could add up. A recent study, published in The Financial Analysts Journal, found that utilizing tax-loss harvesting strategies increased after-tax returns by 0.82 percent per year.
The Upshot
While Robinhood’s app may glitter, its lack of automated tax-saving options may cause you to lose out on a lot of gold. Free trades sound great, until you realize the price you pay for “free” could be thousands of dollars.
