Boris Khentov

Tax-Coordinated Portfolio: Tax-Smart Investing Using Asset Location Betterment’s Tax Coordination feature can help shelter retirement investment growth from some taxes. At Betterment, we’re continually improving our investment advice with the goal of maximizing our customers’ take-home returns. Key to that pursuit is minimizing the amount lost to taxes. Now, we’ve taken a huge step forward with a powerful new service that can increase your after-tax returns, so you can have more money for retirement. Betterment’s Tax Coordination service is our very own, fully automated version of an investment strategy known as asset location. Automated asset location is the latest advancement in tax-smart investing. Introducing Tax Coordination Asset location is widely regarded as the closest thing there is to a “free lunch” in the wealth management industry. If you are saving in more than one type of account, it is a way to increase your after-tax returns without taking on additional risk. align Millions of Americans wind up saving for retirement in some combination of three account types: 1. Taxable, 2. Tax-deferred (Traditional 401(k) or IRA), and 3. Tax-exempt (Roth 401(k) or Roth IRA). Each type of account has different tax treatment, and these rules make certain investments a better fit for one account type over another. Choosing wisely can significantly improve the after-tax value of one’s savings, when more than one account is in the mix. However, intelligently applying this strategy to a globally diversified portfolio is complex. A team of Betterment quantitative analysts, tax experts, software engineers, designers, and product managers have been working for over a year building this powerful service. Today, we are proud to introduce Tax Coordination, the first automated asset location service, now available to all investors. How Does Tax Coordination Work? What is the idea behind asset location? To simplify somewhat: Some assets in your portfolio (bonds) grow by paying dividends. These are taxed annually, and at a high rate, which hurts the take-home return. Other assets (stocks) mostly grow by increasing in value. This growth is called capital gains, and is taxed at a lower rate. Plus, it only gets taxed when you need to make a withdrawal—possibly decades later—and deferring tax is good for the return. Returns in Individual Retirement Accounts (IRAs) and 401(k)s don’t get taxed annually, so they shelter growth from tax better than a taxable account. We would rather have the assets that lose more to tax in these retirement accounts. In the taxable account, we prefer to have the assets that don’t get taxed as much.1 When investing in more than one account, many people select the same portfolio in each one. This is easy to do, and when you add everything up, you get the same portfolio, only bigger. Here’s what an asset allocation with 70% stocks and 30% bonds looks like, held separately in three accounts. The circles represent various asset classes, and the bar represents the allocation for all the accounts combined. Portfolio Managed Separately in Each Account But as long as all the accounts add up to the portfolio we want, each individual account on its own does not have to have that portfolio. Asset location takes advantage of this. Each asset can go in the account where it makes the most sense, from a tax perspective. As long as we still have the same portfolio when we add up the accounts, we can increase after-tax return, without taking on more risk. Here’s a simple animation solely for illustrative purposes: Asset Location in Action Here is the same overall portfolio, except TCP has redistributed the assets unevenly, to reduce taxes. Note that the aggregate allocation is still 70/30. Same Portfolio Overall—with Asset Location The concept of asset location is not new. Advisors and sophisticated do-it-yourself investors have been implementing some version of this strategy for years. But squeezing it for more benefit is very mathematically complex. It means making necessary adjustments along the way, especially after making deposits to any of the accounts. Our software handles all of the complexity in a way that a manual approach just can’t match. We offer this service to all of our customers. Who Can Benefit? To benefit from from Tax Coordination, you must be a Betterment customer with a balance in at least two of the following types of Betterment accounts: Taxable account: If you can save more money for the long-term after making your 401(k) or IRA contributions, that money should be invested in a standard taxable account. Tax-deferred account: Traditional IRA or Betterment for Business 401(k). Investments grow with all taxes deferred until liquidation, and then taxed at the ordinary income tax rate. Tax-exempt account: Roth IRA or Betterment for Business Roth 401(k). Investment income is never taxed—withdrawals are tax-free. Note that you can only include a 401(k) in a goal using Tax Coordination if Betterment for Business manages your company’s 401(k) plan. If you want to learn more about how your employer can start offering a Betterment for Business 401(k), visit Betterment at Work. If you have an old 401(k) with a previous employer, you can still benefit from TCP by rolling it over to Betterment. Higher After-Tax Returns Betterment’s research and rigorous testing demonstrates that accounts managed by Tax Coordination are expected to yield meaningfully higher after-tax returns than uncoordinated accounts. Our white paper presents results for various account combinations. Get Started with Tax Coordination Ready to take advantage of the benefits of Tax Coordination? Here’s how to set it up in your Betterment account. After logging in, go to the top right side of your account in the header of your Summary tab and click "Set up" next to Tax-Coordinated Dividends. Then, follow the steps to set up your new portfolio. Sample Account: Set Up Your New Tax Coordination Once you’ve set up TCP, Betterment will manage your assets as a single portfolio across all accounts, while also looking to increase the after-tax return of the entire portfolio, using every dividend and deposit to optimize the location of the assets. The Tax-Coordinated Dividends module will show you how many dividends were paid in a tax-advantaged account due to TCP, which otherwise would have been paid in your taxable account—and taxed annually. This service is available to all Betterment customers at no additional cost. Learn more about asset location and Betterment’s Tax Coordination feature by reading our white paper. 1All of this is very simplified, actually. Reality is far more complex, and TCP’s algorithms manage that complexity. If you want the whole story, you’ll have to read our white paper. All return examples and return figures mentioned above are for illustrative purposes only. For much more on our TCP research, including additional considerations on the suitability of TCP to your circumstances, please see our white paper. For more information on our estimates and Tax Coordination generally, see full disclosure. When deciding whether to roll over a retirement account, you should carefully consider your personal situation and preferences. The information on this page is being provided for general informational purposes and is not intended to be an individualized recommendation that you take any particular action. Factors that you should consider in evaluating a potential rollover include: available investment options, fees and expenses, services, withdrawal penalties, protections from creditors and legal judgments, required minimum distributions, and treatment of employer stock. Before deciding to roll over, you should research the details of your current retirement account and consult tax and other advisors with any questions about your personal situation.

Addressing Tax Impact with Our Improved Cost Basis Accounting Method Selecting tax lots efficiently can address and reduce the tax impact of your investments.  We use advanced tax accounting methods to help make your transactions more tax-efficient. When choosing which lots of a security to sell, our sophisticated method factors in both cost basis as well as duration held. When you make a withdrawal for a certain dollar amount from an investment account, your broker converts that amount into shares, and sells that number of shares. Assuming you are not liquidating your entire portfolio, there's a choice to be made as to which of the available shares were sold. Every broker has a default method for choosing those shares, and that method can have massive implications for how the sale is taxed. Betterment's default method seeks to reduce your tax impact when you need to sell shares. In the chart below, you can see the tax impact of an actual $150,000 withdrawal made by a Betterment customer with New Jersey listed as their state of residence. The withdrawal sold some of several ETF positions in a $1,000,000+ portfolio. Assuming tax rates consistent with their input income, Betterment saved this customer $11,122 in state and federal taxes, just by having a better default selling method. Betterment saves a customer $11,122   Typical FIFO selling Betterment's TaxMin selling Ticker Gain/Loss Short or Long Term Gain/Loss Short or Long Term VTI $23,639 Long $11,771 Long VEA $10,378 Long $4,410 Long VWO $7,472 Long $2,628 Long MUB $7 Long -$3 Short EMB -$10 Long -$20 Short VTV $6,193 Long $2,130 Long VOE $5,571 Long $2,714 Long VBR $6,704 Long $4,144 Long Total ST Gain/Loss $0   -$22   LT Gain/Loss $59,955   $27,797   Tax Owed: $20,714 $9,592 *Actual customer withdrawal of $150k in April 2021 as a resident of New Jersey, with input annual income of $220,000 and single tax-filing status with no dependents. This calculation assumes that this customer takes the standard deduction when filing taxes, a state capital gains rate of 10.75%, and federal tax rates on short and long term gains of 40.8% and 23.8%, respectively, both inclusive of the net investment income tax of 3.8%. State of residence and other client information may materially affect the outcome or projection of tax minimization technology. The real life scenario listed in this example may not apply to all clients and is not a guarantee of similar results. Tax savings are net of Betterment’s fee of 25 BPS. Basis reporting 101 What's going on here? How can internal accounting result in such a drastic difference? First, some background. The way investment cost basis is reported to the IRS was changed as a result of legislation that followed the financial crisis in 2008. In the simplest terms, your cost basis is what you paid for a security. It’s a key attribute of a so-called “tax lot”—a new one of which is created every time you buy into a security. For example, if you buy $450 of Vanguard Total Stock Market ETF (VTI), and it’s trading at $100, your purchase is recorded as a tax lot of 4.5 shares, with a cost basis of $450 (along with date of purchase.) The cost basis is then used to determine how much gain you’ve realized when you sell (and the date is used to determine whether that gain is short or long term). However, there is more than one way to report cost basis, and it’s worthwhile for the individual investor to know what method your broker is using—as it will impact your taxes. Brokers report your cost basis on Form 1099-B, which Betterment makes available electronically to customers each tax season. Better tax outcomes through advanced accounting When you buy the same security at different prices over a period of time, and then choose to sell some (but not all) of your position, your tax result will depend on which of the shares in your possession you are deemed to be selling. The default method stipulated by the IRS and typically used by brokers is FIFO (“first in, first out”). With this method, the oldest shares are always sold first. This method is the easiest for brokers to manage, since it allows them to go through your transactions at the end of the year and only then make determinations on which shares you sold (which they must then report to the IRS.) FIFO may get somewhat better results than picking lots at random because it avoids triggering short-term gains if you hold a sufficient number of older shares. As long as shares held for more than 12 months are available, those will be sold first. Since short-term tax rates are typically higher than long-term rates, this method can avoid the worst tax outcomes. However, FIFO's weakness is that it completely ignores whether selling a particular lot will generate a gain or loss. In fact, it's likely to inadvertently favor gains over losses; the longer you've held a share, the more likely it's up overall from when you bought it, whereas a recent purchase might be down from a temporary market dip. Clearly, the ability to identify specific lots to sell regardless of when they were purchased could get you a better result, and the rules allow an investor to do so. Yet having to identify specific shares every time you sell is tedious at best, and incomprehensible at worst. Fortunately, the IRS allows brokers to offer investors a different default method in place of FIFO, which selects specific shares by applying a set of rules to whatever lots are available whenever they sell. The problem is that many investors are not even aware there's something they should be overriding, much less which alternative to choose. Upgrading the default method can be a multi-step process through a clunky and confusing interface. While Betterment was initially built to use FIFO as the default method, specific share identification can have such a positive impact on your tax bill that we’ve doubled down to improve our methods. We upgraded our algorithms to support a more sophisticated method of basis reporting, which aims to result in better tax treatment for securities sales in the majority of circumstances. Most importantly, we’ve structured it to replace FIFO as the new default—Betterment customers don’t need to do a thing to benefit from it. Betterment’s TaxMin method When a sale is initiated in a taxable account for part of a particular position, a choice needs to be made about which specific tax lots of that holding will be sold. Our algorithms select which specific tax lots to sell, following a set of rules which we call TaxMin. This method is more granular in its approach, and will improve the tax impact for most transactions, as compared to FIFO. How does this method work? As a general principle, realizing taxable losses instead of gains and allowing short-term gains to mature into long-term gains (which are generally taxed at a lower rate) whenever possible should result in a lower tax liability in the long run. Instead of looking solely at the purchase date of each lot, TaxMin also considers the cost basis of the lot, with the goal of realizing losses before any gains, regardless of when the shares were bought. Lots are evaluated to be sold in the following order: Short-term losses Long-term losses Long-term gains Short-term gains Generally, we sell shares in a way that is intended to prioritize generating short term capital losses, then long term capital losses, followed by long term capital gains and then lastly, short term capital gains. The algorithm looks through each category before moving to the next, but within each category, lots with the highest cost basis are targeted first. With a gain, the higher the basis, the smaller the gain, which results in a lower tax burden. In the case of a loss, the opposite is true: the higher the basis, the bigger the loss (which can be beneficial, since losses can be used to offset gains).1 A simple example If you owned the following lots of the same security, one share each, and wanted to sell one share on July 1, 2021 at the price of $105 per share, you would realize $10 of long term capital gains if you used FIFO. With TaxMin, the same trade would instead realize a $16 short term loss. If you had to sell two shares, FIFO would get you a net $5 long term gain, while TaxMin would result in a $31 short term loss. To be clear, you pay taxes on gains, while losses can help reduce your bill. Purchase Price ($) Purchase Date Gain or Loss ($) FIFO Selling order TaxMin Selling order $95 1/1/20 +10 1 4 $110 6/1/20 -5 2 3 $120 1/1/21 -15 3 2 $100 2/1/21 +5 4 5 $121 3/1/21 -16 5 1 What can you expect? TaxMin automatically works to reduce the tax impact of your investment transactions in a variety of circumstances. Depending on the transaction, the tax-efficiency of various tax-lot selection approaches may vary based on the individual’s specific circumstances (including, but not limited to, tax bracket and presence of other gains or losses.) However, we feel that TaxMin serves the typical Betterment customer far better than FIFO, the default used by most brokers. Note that Betterment is not a tax advisor and your actual tax outcome will depend on your specific tax circumstances—consult a tax advisor for licensed advice specific to your financial situation. This is just one more way we continue to innovate under the hood to maximize your investor returns: net of transaction costs, net of behavior, and net of tax. Footnote 1 Note that when a customer makes a change resulting in the sale of the entirety of a particular holding in a taxable account (such as a full withdrawal or certain portfolio strategy changes), tax minimization may not apply because all lots will be sold in the transaction.

Tax Loss Harvesting+ Methodology Tax loss harvesting is a sophisticated technique to get more value from your investments—but doing it well requires expertise. TABLE OF CONTENTS Navigating the Wash Sale Rule The Betterment Solution TLH+ Model Calibration TLH+ Results Best Practices for TLH+ Conclusion Tax loss harvesting is a sophisticated technique to help you get more value from your investments—but doing it well requires expertise. There are many ways to get your investments to work harder for you—better diversification, downside risk management, and the right mix of asset classes for your risk level. Betterment does all of this automatically via its low-cost index fund ETF portfolio. But there is another way to get even more out of your portfolio—using investment losses to improve your after-tax returns with a method called tax loss harvesting. In this white paper, we introduce Betterment’s Tax Loss Harvesting+™ (TLH+™): a sophisticated, fully automated service for Betterment customers. Betterment’s TLH+ service scans portfolios regularly for opportunities (temporary dips that result from market volatility) to realize losses which can be valuable come tax time. While the concept of tax loss harvesting is not new for wealthy investors, TLH+ utilizes a number of innovations that typical implementations may lack. It takes a holistic approach to tax-efficiency, seeking to optimize every user-initiated transaction in addition to adding value through automated activity, such as rebalances. TLH+ not only improves on this powerful tax-saving strategy, but also makes tax loss harvesting available to more investors than ever before. What is tax loss harvesting? Capital losses can lower your tax bill by offsetting gains, but the only way to realize a loss is to sell the depreciated asset. However, in a well-allocated portfolio, each asset plays an essential role in providing a piece of total market exposure. For that reason, an investor should not want to give up the expected returns associated with each asset just to realize a loss. At its most basic level, tax loss harvesting is selling a security that has experienced a loss—and then buying a correlated asset (i.e. one that provides similar exposure) to replace it. The strategy has two benefits: it allows the investor to “harvest” a valuable loss, and it keeps the portfolio balanced at the desired allocation. How does it lower your tax bill? Capital losses can be used to offset capital gains you’ve realized in other transactions over the course of a year—gains on which you would otherwise owe tax. Then, if there are losses left over (or if there were no gains to offset), you can offset up to $3,000 of ordinary income for the year. If any losses still remain, they can be carried forward indefinitely. Tax loss harvesting is primarily a tax deferral strategy, and its benefit depends entirely on individual circumstances. Over the long run, it can add value through some combination of these distinct benefits that it seeks to provide: Tax deferral: Losses harvested can be used to offset unavoidable gains in the portfolio, or capital gains elsewhere (e.g., from selling real estate), deferring the tax owed. Savings that are invested may grow,  assuming a conservative growth rate of 5% over a 10-year period, a dollar of tax deferred would be worth $1.63. Even after belatedly parting with the dollar, and paying tax on the $0.63 of growth, you’re ahead. Pushing capital gains into a lower tax rate: If you’ve realized short-term capital gains (STCG) this year, they’ll generally be taxed at your highest rate. However, if you’ve harvested losses to offset them, the corresponding gain you owe in the future could be long-term capital gain (LTCG). You’ve effectively turned a gain that would have been taxed up to 50% today into a gain that will be taxed more lightly in the future (up to 30%). Converting ordinary income into long-term capital gains: A variation on the above: offsetting up to $3,000 from your ordinary income shields that amount from your top marginal rate, but the offsetting future gain will likely be taxed at the LTCG rate. Permanent tax avoidance in certain circumstances: Tax loss harvesting provides benefits now in exchange for increasing built-in gains, subject to tax later. However, under certain circumstances (charitable donation, bequest to heirs), these gains may avoid taxation entirely. Navigating the Wash Sale Rule Summary: Wash sale rule management is at the core of any tax loss harvesting strategy. Unsophisticated approaches can detract from the value of the harvest or place constraints on customer cash flows in order to function. If all it takes to realize a loss is to sell a security, it would seem that maintaining your asset allocation is as simple as immediately repurchasing it. However, the IRS limits a taxpayer’s ability to deduct a loss when it deems the transaction to have been without substance. At a high level, the so-called “wash sale rule” disallows a loss from selling a security if a “substantially identical” security is purchased 30 days after or before the sale. The rationale is that a taxpayer should not enjoy the benefit of deducting a loss if he did not truly dispose of the security. The wash sale rule applies not just to situations when a “substantially identical” purchase is made in the same account, but also when the purchase is made in the individual’s IRA/401(k) account, or even in a spouse’s account. This broad application of the wash sale rule seeks to ensure that investors cannot utilize nominally different accounts to maintain their ownership, and still benefit from the loss. A wash sale involving an IRA/401(k) account is particularly unfavorable. Generally, a “washed” loss is postponed until the replacement is sold, but if the replacement is purchased in an IRA/401(k) account, the loss is permanently disallowed. If not managed correctly, wash sales can undermine tax loss harvesting. Handling proceeds from the harvest is not the sole concern—any deposits made in the following 30 days (whether into the same account, or into the individual’s IRA/401(k)) also need to be allocated with care. Avoiding the wash The simplest way to avoid triggering a wash sale is to avoid purchasing any security at all for the 30 days following the harvest, keeping the proceeds (and any inflows during that period) in cash. This approach, however, would systematically keep a portion of the portfolio out of the market. Over the long term, this “cash drag” could hurt the portfolio’s performance. More advanced strategies repurchase an asset with similar exposure to the harvested security that is not “substantially identical” for purposes of the wash sale rule. In the case of an individual stock, it is clear that repurchasing stock of that same company would violate the rule. Less clear is the treatment of two index funds from different issuers (e.g., Vanguard and Schwab) that track the same index. While the IRS has not issued any guidance to suggest that such two funds are “substantially identical,” a more conservative approach when dealing with an index fund portfolio would be to repurchase a fund whose performance correlates closely with that of the harvested fund, but tracks a different index.¹ Selecting a viable replacement security, however, is just one piece of the accounting and optimization puzzle. Manually implementing a tax loss harvesting strategy is feasible with a handful of securities, little to no cash flows, and infrequent harvests. However, assets will often dip in value but recover by the end of the year, so annual strategies leave many losses on the table. The wash sale management and tax lot accounting necessary to support more frequent (and thus more effective) harvesting quickly become overwhelming in a multi-asset portfolio—especially with regular deposits, dividends, and rebalancing. Software is ideally suited for this complex task. But automation, while necessary, is not sufficient. The problem can get so complex that basic tax loss harvesting algorithms may choose to keep new deposits and dividends in cash for the 30 days following a harvest, rather than tackle the challenge of always maintaining full exposure at the desired allocation. An effective loss harvesting algorithm should be able to maximize harvesting opportunities across a full range of volatility scenarios, without sacrificing the investor’s precisely tuned global asset allocation. It should reinvest harvest proceeds into closely correlated alternate assets, all while handling unforeseen cash inflows from the investor without ever resorting to cash positions. It should also be able to monitor each tax lot individually, harvesting individual lots at an opportune time, which may depend on the volatility of the asset. And most of all, it should do everything to avoid leaving a taxpayer worse off. TLH+ was created because no available implementations seemed to solve all of these problems. Existing strategies and their limitations Every tax loss harvesting strategy shares the same basic goal: to maximize a portfolio’s after-tax returns by realizing built-in losses while minimizing the negative impact of wash sales. Approaches to tax loss harvesting differ primarily in how they handle the proceeds of the harvest to avoid a wash sale. Below are the three strategies commonly employed by manual and algorithmic implementations. After selling a security that has experienced a loss, existing strategies would likely have you… Existing strategy Problem Delay reinvesting the proceeds of a harvest for 30 days, thereby ensuring that the repurchase will not trigger a wash sale. While it’s the easiest method to implement, it has a major drawback: no market exposure—also called cash drag. Cash drag hurts portfolio returns over the long term, and could offset any potential benefit from tax loss harvesting. Reallocate the cash into one or more entirely different asset classes in the portfolio. This method throws off an investor’s desired asset allocation. Additionally, such purchases may block other harvests over the next 30 days by setting up potential wash sales in those other asset classes. Switch back to original security after 30 days from the replacement security. Common manual approach, also used by some automated investing services. A switchback can trigger short-term capital gains when selling the replacement security, reducing the tax benefit of the harvest. Even worse, this strategy can leave an investor owing more tax than if it did nothing. The hazards of switchbacks In the 30 days leading up to the switchback, two things can happen: the replacement security can drop further, or go up. If it goes down, the switchback will realize an additional loss. However, if it goes up, which is what any asset with a positive expected return is expected to do over any given period, the switchback will realize short-term capital gains (STCG)—kryptonite to a tax-efficient portfolio management strategy. To be sure, the harvested loss should offset all (or at least some) of this subsequent gain, but it is easy to see that the result is a lower-yielding harvest. Like a faulty valve, this mechanism pumps out tax benefit, only to let some of it leak back. An algorithm that expects to switch back unconditionally must deal with the possibility that the resulting gain could exceed the harvested loss, leaving the taxpayer worse off. An attempt to mitigate this risk could be setting a higher threshold based on volatility of the asset class—only harvesting when the loss is so deep, that the asset is unlikely to entirely recover in 30 days. Of course, there is still no guarantee that it will not, and the price paid for this buffer is that your lower-yielding harvests will also be less frequent than they could be with a more sophisticated strategy. Examples of negative tax arbitrage Let’s look at how an automatic 30-day switchback can destroy the value of the harvested loss, and even increase tax owed, rather than reduce it. Below is actual performance for Emerging Markets—a relatively volatile asset class that’s expected to offer some of the biggest harvesting opportunities in a global portfolio. We assume a position in VWO, purchased prior to January 1, 2013. With no harvesting, it would have looked like this: No Tax Loss Harvesting Emerging Markets, 1/2/2014 – 5/21/2014 See visual of No Tax Loss Harvesting A substantial drop in February presented an excellent opportunity to sell the entire position and harvest a $331 long-term loss. The proceeds were re-invested into IEMG, a highly correlated replacement (tracking a different index). By March, however, the dip proved temporary, and 30 days after the sale, the asset class more than recovered. The switchback sale results in STCG in excess of the loss that was harvested, and actually leaves the investor owing tax, whereas without the harvest, he would have owed nothing. TLH with 30-day Switchbacks Emerging Markets, 1/2/2014 - 5/21/2014 See TLH with 30-day Switchbacks visual Under certain circumstances, it can get even worse. Due to a technical nuance in the way gains and losses are netted, the 30-day switchback can result in negative tax arbitrage, by effectively pushing existing gains into a higher tax rate. When adding up gains and losses for the year, the rules require netting of like against like first. If any long-term capital gain (LTCG) is present for the year, you must net a long-term capital loss (LTCL) against that first, and only then against any STCG. In the scenario above, the harvested $331 LTCL was used to offset the $360 STCG from the switchback; long can be used to offset short, if we assume no LTCG for the year. Negative tax arbitrage when unrelated long-term gains are present Now let’s assume that in addition to the transactions above, the taxpayer also realized a LTCG of exactly $331 (from selling some other, unrelated asset). If no harvest takes place, the investor will owe tax on $331 at the lower LTCG rate. However, if you add the harvest and switchback trades, the rules now require that the harvested $331 LTCL is applied first against the unrelated $331 LTCG. The harvested LTCL gets used up entirely, exposing the entire $360 STCG from the switchback as taxable. Instead of sheltering the highly taxed gain on the switchback, the harvested loss got used up sheltering a lower-taxed gain, creating far greater tax liability than if no harvest had taken place. Tax Strategy STCG Realized LTCG Realized Taxes Owed No TLH $0 $331 $109 TLH with 30-day switchbacks $360 ($331-$331) $0 net $187 Tax Strategy STCG Realized LTCG Realized Taxes Owed No TLH $0 $331 $109 TLH with 30-day switchbacks $360 ($331-$331) $0 net $187 In the presence of unrelated transactions, unsophisticated harvesting can effectively convert existing LTCG into STCG. Some investors regularly generate significant LTCG (for instance, by gradually diversifying out of a highly appreciated position in a single stock). It’s these investors, in fact, who would benefit the most from effective tax loss harvesting. However, if their portfolios are harvested with unconditional 30-day switchbacks over the years, it’s not a question of “if” the switchbacks will convert some LTCG into STCG, but “when” and “how much.” Negative tax arbitrage with dividends Yet another instance of negative tax arbitrage can result in connection with dividend payments. If certain conditions are met, some ETF distributions are treated as “qualified dividends”, taxed at lower rates. One condition is holding the security for more than 60 days. If the dividend is paid while the position is in the replacement security, it will not get this favorable treatment: under a rigid 30-day switchback, the condition can never be met. As a result, up to 20% of the dividend is lost to tax (the difference between the higher and lower rate). The Betterment Solution Summary: Betterment believes TLH+ can substantially improve upon existing strategies by managing parallel positions within each asset class indefinitely, as tax considerations dictate. It approaches tax-efficiency holistically, seeking to optimize every transaction, including customer activity. The fundamental advance of Betterment’s TLH+ is that tax-optimal decision making should not be limited to the harvest itself—the algorithm should remain vigilant with respect to every transaction. An unconditional 30-day switchback, whatever the cost, is plainly suboptimal, and could even leave the investor owing more tax that year—unacceptable for an automated strategy that seeks to lower tax liability. Intelligently managing a bifurcated asset class following the harvest is every bit as crucial to maximizing tax alpha as the harvest itself. The innovations TLH+ seeks to deliver, include: No exposure to short-term capital gains in an attempt to harvest losses. Through our proprietary Parallel Position Management system, a dual-security asset class approach enforces preference for one security without needlessly triggering capital gains in an attempt to harvest losses, all without putting constraints on customer cash flows. No negative tax arbitrage traps associated with less sophisticated harvesting strategies (e.g., 30-day switchback), making TLH+ especially suited for those generating large long-term capital gains on an ongoing basis. Zero cash drag at all times. With fractional shares and seamless handling of all inflows during wash sale windows, every dollar is invested at the desired allocation risk level. Dynamic trigger thresholds for each asset-class, ensuring that both high- and low-volatility assets can be harvested at an opportune time to increase the chances of large tax offsets. Tax loss preservation logic extended to user-realized losses, not just harvested losses, automatically protecting both from the wash sale rule. In short, user withdrawals always sell any losses first. No disallowed losses through overlap with a Betterment IRA/401(k). We use a tertiary ticker system to eliminate the possibility of permanently disallowed losses triggered by subsequent IRA/401(k) activity.² This makes TLH+ ideal for those who invest in both taxable and tax-advantaged accounts. Harvests also take the opportunity to rebalance across all asset classes, rather than re-invest solely within the same asset class. This further reduces the need to rebalance during volatile stretches, which means fewer realized gains, and higher tax alpha. Through these innovations, TLH+ creates significant value over manually-serviced or less sophisticated algorithmic implementations. TLH+ is accessible to investors —fully automated, effective, and at no additional cost. Parallel securities To ensure that each asset class is supported by optimal securities in both primary and alternate positions, we screened by expense ratio, liquidity (bid-ask spread), tracking error vs. benchmark, and most importantly, covariance of the alternate with the primary.³ While there are small cost differences between the primary and alternate securities, the cost of negative tax arbitrage from tax-agnostic switching vastly outweighs the cost of maintaining a dual position within an asset class. For a 70% stock portfolio composed only of primary securities, the average underlying expense ratio is 0.075%. If each asset class consisted of a 50/50 split between primary and alternate, that cost would be 0.090%—a difference of less than two basis points. Of the 13 asset classes in Betterment’s core taxable portfolio, nine were assigned alternate tickers. Short-term Treasuries (GBIL),Inflation-protected Bonds (VTIP), U.S. Short-term Investment Grade Bonds (JPST), U.S. High Quality Bonds (AGG), and International Developed Bonds (BNDX)  are insufficiently volatile to be viable harvesting candidates. Take a look at the primary and alternate securities in the Betterment portfolio. Additionally, TLH+ features a special mechanism for coordination with IRAs/401(k)s that required us to pick a third security in each harvestable asset class (except in municipal bonds, which are not in the IRA/401(k) portfolio). While these have a higher cost than the primary and alternate, they are not expected to be utilized often, and even then, for short durations (more below in IRA/401(k) protection). Parallel Position Management As demonstrated, the unconditional 30-day switchback to the primary security is problematic for a number of reasons. To fix those problems, we engineered a platform to support TLH+, which seeks to tax-optimize every user and system-initiated transaction: the Parallel Position Management (PPM) system. PPM allows each asset class to be comprised of two closely correlated securities indefinitely, should that result in a better after-tax outcome. Here’s how a portfolio with PPM looks to a Betterment customer. PPM provides several improvements over the switchback strategy. First, unnecessary gains are minimized if not totally avoided. Second, the parallel security (could be primary or alternate) serves as a safe harbor to minimize wash sales—not just from harvest proceeds, but any cash inflows. Third, the mechanism seeks to protect not just harvested losses, but losses realized by the customer as well. PPM not only facilitates effective opportunities for tax loss harvesting, but also extends maximum tax-efficiency to customer-initiated transactions. Every customer withdrawal is a potential harvest (losses are sold first). And every customer deposit and dividend is routed to the parallel position that would minimize wash sales, while shoring up the target allocation. PPM has a preference for the primary security when rebalancing and for all cash flow events—but always subject to tax considerations. This is how PPM behaves under various conditions: Transaction PPM behavior Withdrawals and sales from rebalancing Sales default out of the alternate position (if such a position exists), but not at the expense of triggering STCG—in that case, PPM will sell lots of the primary security first. Rebalancing will always stop short of realizing STCG. Taxable gains are minimized at every decision point—STCG tax lots are the last to be sold on a user withdrawal. Deposits, buys from rebalancing, and dividend reinvestments PPM directs inflows to underweight asset classes, and within each asset class, into the primary, unless doing so incurs greater wash sale costs than buying the alternate. Harvest events TLH+ harvests can come out of the primary into the alternate, or vice versa, depending on which harvest has a greater expected value. After an initial harvest, it could make sense at some point to harvest back into the primary, to harvest more of the remaining primary into the alternate, or to do nothing. Harvests that would cause more washed losses than gained losses are minimized if not totally avoided. PPM eliminates the negative tax arbitrage issues previously discussed, while leaving open significantly more flexibility to engage in harvesting opportunities. TLH+ is able to harvest more frequently, and can safely realize smaller losses, all without putting any constraints on user cash flows. Let’s return to the Emerging Markets example from above, demonstrating how TLH+ harvests the loss, but remains in the appreciated alternate position (IEMG), thereby avoiding STCG. Smarter Harvesting - Avoid the Switchback Emerging Markets, 1/2/2014 - 5/21/2014 See TLH Switchbacks visual Better wash sale management Managing cash flows across both taxable and IRA/401(k) accounts without needlessly washing realized losses is a complex problem. TLH+ operates without constraining the way that customers prefer contributing to their portfolios, and without resorting to cash positions. With the benefit of parallel positions, it weighs wash sale implications of every deposit and withdrawal and dividend reinvestment, and seeks to systematically choose the optimal investment strategy. This system protects not just harvested losses, but also losses realized through withdrawals. IRA/401(k) protection The wash sale rule applies when a “substantially identical” replacement is purchased in an IRA/401(k) account. Taxpayers must calculate such wash sales, but brokers are not required to report them. Even the largest ones leave this task to their customers.⁴ This is administratively complicated for taxpayers and leads to tax issues. At Betterment, we felt we could do more than the bare minimum. Being equipped to perform this calculation, we do it so that our customers don’t have to. Because IRA/401(k) wash sales are particularly unfavorable—the loss is disallowed permanently—TLH+ goes another step further, and seeks to ensure that no loss realized in the taxable account is washed by a subsequent deposit into a Betterment IRA/401(k). In doing so, TLH+ always maintains target allocation in the IRA/401(k), without cash drag. No harvesting is done in an IRA/401(k), so if it weren’t for the potential interaction with taxable transactions, there would be no need for IRA/401(k) alternate securities. However, on the day of an IRA/401(k) inflow, both the primary and the alternate security in the taxable account could have realized losses in the prior 30 days. Accordingly, each asset class supports a third correlated security (tracking a third index). The tertiary security is only utilized to hold IRA/401(k) deposits within the wash window temporarily. Let’s look at an example of how TLH+ handles a potentially disruptive IRA inflow when there are realized losses to protect, using real market data for the Developed Markets asset class. The customer starts with a position in VEA, the primary security, in both the taxable and IRA accounts. We then harvest a loss by selling the entire taxable position, and repurchase the alternate security, SCHF. Loss Harvested in VEA Two weeks pass, and the customer makes a withdrawal from the taxable account (the entire position, for simplicity), intending to fund the IRA. In those two weeks, the asset class dropped more, so the sale of SCHF also realizes a loss. The VEA position in the IRA remains unchanged. Customer Withdrawal Sells SCHF at a Loss A few days later, the customer contributes to his IRA, and $1,000 is allocated to the Developed Markets asset class, which already contains some VEA. Despite the fact that the customer no longer holds any VEA or SCHF in his taxable account, buying either one in the IRA would permanently wash a valuable realized loss. The Tertiary Ticker System automatically allocates the inflow into the third option for developed markets, IEFA. IRA Deposit into Tertiary Ticker Both losses have been preserved, and the customer now holds VEA and IEFA in his IRA, maintaining desired allocation at all times. Because no capital gains are realized in an IRA/401(k), there is no harm in switching out of the IEFA position and consolidating the entire asset class in VEA when there is no danger of a wash sale. The result: Customers using TLH+ who also have their IRA/401(k) assets with Betterment can know that Betterment will seek to protect valuable realized losses whenever they deposit into their IRA/401(k), whether it’s lump rollover, auto-deposits or even dividend reinvestments. Smart rebalancing Lastly, TLH+ directs the proceeds of every harvest to rebalance the entire portfolio, the same way that a Betterment account handles any incoming cash flow (deposit, dividend). Most of the cash is expected to stay in that asset class and be reinvested into the parallel asset, but some of it may not. Recognizing every harvest as a rebalancing opportunity further reduces the need for additional selling in times of volatility, further reducing tax liability. As always, fractional shares allow the inflows to be allocated with perfect precision. TLH+ Model Calibration Summary: To make harvesting decisions, TLH+ optimizes around multiple inputs, derived from rigorous Monte Carlo simulations. The decision to harvest is made when the benefit, net of cost, exceeds a certain threshold. The potential benefit of a harvest is discussed in detail below (“Results”). Unlike a 30-day switchback strategy, TLH+ does not incur the expected STCG cost of the switchback trade. Therefore, “cost” consists of three components: trading expense, execution expense, and increased cost of ownership for the replacement asset (if any). All trades are free for Betterment customers. TLH+ is engineered to factor in the other two components, configurable at the asset level, and the resulting cost approaches negligible. Bid-ask spreads for the bulk of harvestable assets are extremely narrow. Expense ratios for the major primary/alternate ETF pairs are extremely close, and in the case where a harvest back to the primary ticker is being evaluated, that difference is actually a benefit, not a cost. A harder cost to quantify could result from what can be thought of as an “overly itchy TLH trigger finger.” Without the STCG switchback limitation, even very small losses appear to be worth harvesting, but only in a vacuum. Harvesting a loss “too early” could mean passing up a bigger (temporary) loss—made unavailable due to wash sale constraints stemming from the first harvest. This is especially true for more volatile assets, where a static TLH trigger could mean that the asset is being harvested at a fraction of the benefit that could be achieved by harvesting just a few days later, after a larger decline. Optimizing the thresholds to maximize loss yield becomes a statistical problem, ripe for an exhaustive simulation. There are two general approaches to testing a model’s performance: historical backtesting and forward-looking simulation. Optimizing a system to deliver the best results for only past historical periods is relatively trivial, but doing so would be a classic instance of data snooping bias. The maturation of the global ETF market is a relatively recent phenomenon. Relying solely on a historical backtest of a portfolio composed of ETFs that allow for 10 to 20 years of reliable data when designing a system intended to provide 40 to 50 years of benefit would mean making a number of indefensible assumptions about general market behavior. The superset of decision variables driving TLH+ is beyond the scope of this paper—optimizing around these variables required exhaustive analysis. TLH+ was calibrated via Betterment’s rigorous Monte Carlo simulation framework, spinning up thousands of server instances in the cloud to run through tens of thousands of forward-looking scenarios testing model performance. Best Practices for TLH+ Summary: Tax loss harvesting can add some value for most investors, but high earners with a combination of long time horizons, ongoing realized gains, and plans for some charitable disposition will reap the largest benefits. This is a good point to reiterate that tax loss harvesting delivers value primarily due to tax deferral, not tax avoidance. A harvested loss can be beneficial in the current tax year to varying degrees, but harvesting that loss generally means creating an offsetting gain at some point in the future. If and when the portfolio is liquidated, the gain realized will be higher than if the harvest never took place. Let’s look at an example: Year 1: Buy asset A for $100. Year 2: Asset A drops to $90. Harvest $10 loss, repurchase similar Asset B for $90. Year 20: Asset B is worth $500 and is liquidated. Gains of $410 realized (sale price minus cost basis of $90) Had the harvest never happened, we’d be selling A with a basis of $100, and gains realized would only be $400 (assuming similar performance from the two correlated assets.) Harvesting the $10 loss allows us to offset some unrelated $10 gain today, but at a price of an offsetting $10 gain at some point in the future. The value of a harvest largely depends on two things. First, what income, if any, is available for offset? Second, how much time will elapse before the portfolio is liquidated? As the deferral period grows, so does the benefit—the reinvested savings from the tax deferral have more time to grow. While nothing herein should be interpreted as tax advice, examining some sample investor profiles is a good way to appreciate the nature of the benefit of TLH+. Who benefits most? The Bottomless Gains Investor A capital loss is only as valuable as the tax saved on the gain it offsets. Some investors may incur substantial capital gains every year from selling highly appreciated assets—other securities, or perhaps real estate. These investors can immediately use all the harvested losses, offsetting gains and generating substantial tax savings. The High Income Earner Harvesting can have real benefit even in the absence of gains. Each year, up to $3,000 of capital losses can be deducted from ordinary income. Earners in high income tax states (such as New York or California) could be subject to a combined marginal tax bracket of up to 50%. Taking the full deduction, these investors could save $1,500 on their tax bill that year. What’s more, this deduction could benefit from positive rate arbitrage. The offsetting gain is likely to be LTCG, taxed at around 30% for the high earner—less than $1,000—a real tax savings of over $500, on top of any deferral value. The Steady Saver An initial investment may present some harvesting opportunities in the first few years, but over the long term, it’s increasingly unlikely that the value of an asset drops below the initial purchase price, even in down years. Regular deposits create multiple price points, which may create more harvesting opportunities over time. (This is not a rationale for keeping money out of the market and dripping it in over time—tax loss harvesting is an optimization around returns, not a substitute for market exposure.) The Philanthropist In each scenario above, any benefit is amplified by the length of the deferral period before the offsetting gains are eventually realized. However, if the appreciated securities are donated to charity or passed down to heirs, the tax can be avoided entirely. When coupled with this outcome, the scenarios above deliver the maximum benefit of TLH+. Wealthy investors have long used the dual strategy of loss harvesting and charitable giving. Even if an investor expects to mostly liquidate, any gifting will unlock some of this benefit. Using losses today, in exchange for built-in gains, offers the partial philanthropist a number of tax-efficient options later in life. Who benefits least? The Aspiring Tax Bracket Climber Tax deferral is undesirable if your future tax bracket will be higher than your current. If you expect to achieve (or return to) substantially higher income in the future, tax loss harvesting may be exactly the wrong strategy—it may, in fact, make sense to harvest gains, not losses. In particular, we do not advise you to use TLH+ if you can currently realize capital gains at a 0% tax rate. Under 2021 tax brackets, this may be the case if your taxable income is below $40,400 as a single filer or $80,800 if you are married filing jointly. See the IRS website for more details. Graduate students, those taking parental leave, or just starting out in their careers should ask “What tax rate am I offsetting today” versus “What rate can I reasonably expect to pay in the future?” The Scattered Portfolio TLH+ is carefully calibrated to manage wash sales across all assets managed by Betterment, including IRA assets. However, the algorithms cannot take into account information that is not available. To the extent that a Betterment customer’s holdings (or a spouse’s holdings) in another account overlap with the Betterment portfolio, there can be no guarantee that TLH+ activity will not conflict with sales and purchases in those other accounts (including dividend reinvestments), and result in unforeseen wash sales that reverse some or all of the benefits of TLH+. We do not recommend TLH+ to a customer who holds (or whose spouse holds) any of the ETFs in the Betterment portfolio in non-Betterment accounts. You can ask Betterment to coordinate TLH+ with your spouse’s account at Betterment. You’ll be asked for your spouse’s account information after you enable TLH+ so that we can help optimize your investments across your accounts. The Portfolio Strategy Collector Electing different portfolio strategies for multiple Betterment goals may cause TLH+ to identify fewer opportunities to harvest losses than it might if you elect the same portfolio strategy for all of your Betterment goals. The Rapid Liquidator What happens if all of the additional gains due to harvesting are realized over the course of a single year? In a full liquidation of a long-standing portfolio, the additional gains due to harvesting could push the taxpayer into a higher LTCG bracket, potentially reversing the benefit of TLH+. For those who expect to draw down with more flexibility, smart automation will be there to help optimize the tax consequences. The Imminent Withdrawal The harvesting of tax losses resets the one-year holding period that is used to distinguish between LTCG and STCG. For most investors, this isn’t an issue: by the time that they sell the impacted investments, the one-year holding period has elapsed and they pay taxes at the lower LTCG rate. This is particularly true for Betterment customers because our TaxMin feature automatically realizes LTCG ahead of STCG in response to a withdrawal request. However, if you are planning to withdraw a large portion of your taxable assets in the next 12 months, you should wait to turn on TLH+ until after the withdrawal is complete to reduce the possibility of realizing STCG. Other Impacts to Consider Investors with assets held in different portfolio strategies should understand how it impacts the operation of TLH. To learn more, please see Betterment’s SRI disclosures, Flexible portfolio disclosures,  the Goldman Sachs smart beta disclosures, and the BlackRock target income portfolio disclosures for further detail. Clients in Advisor-designed custom portfolios through Betterment for Advisors should consult their Advisors to understand the limitations of TLH with respect to any custom portfolio. Additionally, as described above, electing one portfolio strategy for one or more goals in your account while simultaneously electing a different portfolio for other goals in your account may reduce opportunities for TLH to harvest losses due to wash sale avoidance. Due to Betterment’s new monthly cadence for billing fees for advisory services, through the liquidation of securities, tax loss harvesting opportunities may be adversely affected for customers with particularly high stock allocations, third party portfolios, or flexible portfolios. As a result of assessing fees on a monthly cadence for a customer with only equity security exposure, which tends to be more opportunistic for tax loss harvesting, certain securities may be sold that could have been used to tax loss harvest at a later date, thereby delaying the harvesting opportunity into the future. This delay would be due to avoidance of triggering the wash sale rule, which forbids a security from being sold only to be replaced with a “substantially similar” security within a 30-day period. See Betterment’s TLH disclosures for further detail. Conclusion Summary: Tax loss harvesting can be a highly effective way to improve your investor returns without taking additional downside risk. Tax loss harvesting may get the spotlight, but under the hood, our algorithms labor to minimize taxes on every transaction, in every conceivable way. Historically, tax loss harvesting has only been available to extremely high net worth clients. Betterment is able to take advantage of economies of scale with technology and provide this service to all qualified customers while striving to: Do no harm: we regularly work to avoid triggering short-term capital gains (others often do, through unsophisticated automation). Do it holistically: we don’t just look for opportunities to harvest regularly—we seek to make every transaction tax efficient—withdrawals, deposits, rebalancing, and more. Coordinate wash sale management across both taxable and IRA/401(k) accounts as seamlessly as possible.

How Tax Impact Preview Works to Help Avoid Surprises Betterment continues to make investing more transparent and tax-efficient, and empowers you to make smarter financial decisions. Two words that don’t belong together: taxes and surprise. But all too often, a transaction made in your investment account has unexpected, costly consequences many months later. Selling securities has tax implications. Typically, these announce themselves the following year, when you get your tax statement.  Today, we are changing that, with Tax Impact Preview. Betterment’s Tax Impact Preview feature provides a real-time tax estimate for a withdrawal or allocation change—before you confirm the transaction. Tax Impact Preview shows you exactly the information you should be focusing on to make an informed decision—potentially lowering your tax bill. Tax-Aware Investors Can Consider: Do the benefits outweigh the costs? Should I wait to avoid short-term capital gains? Is there another source of funds I could use that might have a lower or no tax impact? “Customers can become overly focused on short-term returns and change allocations or make withdrawals in reaction to fluctuations in the market,” says Alex Benke, CFP®, product manager for this new feature, “Tax Impact Preview will help these customers stay focused on the big picture and avoid unpleasant surprises on their tax bill.” Tax Impact Preview: An Industry First Betterment is the only investment platform to offer this kind of real-time tax information—and it joins a suite of tools which already helps investors minimize their taxes, including Tax Coordination™, Tax Loss Harvesting+, TaxMin, and more. Tax Impact Preview is available to all Betterment customers at no additional cost. Learn more about the suite of tax-efficiency features available for your portfolio. How It Works When you initiate a sale of securities (a withdrawal or allocation change), our algorithms first determine which ETFs to sell (rebalancing you in the process, by first selling the overweight components of your portfolio). Within each ETF, our lot selection algorithm, which we call TaxMin, will select the most tax-efficient lots, selling losses first, and short-term gains last. Transaction Timeline Table With Tax Impact Preview, you will now see an “Estimate tax impact” button when you initiate an allocation change or withdrawal, which will give you detailed estimates of expected gains and/or losses, breaking them down by short and long-term. Using this timely information, you can better decide if the tax result makes sense for you.  If your transaction results in a net gain, we estimate the maximum tax you might owe. Why Estimated? The precise tax owed depends on many circumstances specific to you: not just your tax bracket, but also the presence of past and future capital gains or losses for the year across all of your investment accounts. We use the highest applicable rates, to give you an upper-bound estimate. You might ask—why are the gains and losses about to be realized not exact, even if the resulting tax is only an estimate? The gains and losses depend on the exact price that the various ETFs will sell at. If the estimate is done after market close, the prices are sure to move a bit by the time the market opens. Even during the day, a few minutes will pass between the preview and the trades, and prices will shift some, so the estimates will no longer be 100% accurate. Finally, while we are able to factor in wash sale implications from prior purchases in your Betterment account, the estimates could change substantially due to future purchases, and we do not factor in activity in non-Betterment accounts. That is why every number we show you, while useful, is an estimate. Tax Impact Preview is not tax advice, and you should consult a tax professional on how these estimates apply to your individual situation. Why You Should Avoid Short-Term Capital Gains Smart investors take every opportunity to defer a gain from short-term to long-term—it can make a substantive difference in the return from that investment. To demonstrate, let’s assume a long-term rate of 20% and a short-term rate of 40%. A $10,000 investment with a 10% return—or $1,000—will result in a $400 tax if you sell 360 days after you invested. But if you wait 370 days to sell, the tax will be only $200. That’s the difference between a 6% and 8% after-tax return. Until now, making the smart choice meant doing your own calculations for every trade you were about to make. This is the kind of stuff most people hate doing, and automation excels at, so we built it into our product. A Sample Scenario Betterment customer Jenny, 34, has been watching the recent market news and feels nervous about her "Build Wealth" goal, which has a balance of $95,290. She is currently at 90% stocks—the optimal allocation for an investor with more than a 20 year horizon. Jenny decides to temporarily move her allocation to 10% stocks to minimize her exposure to the roller coaster on Wall Street. What Jenny may not realize is that changing allocation will cost her very real money—in the form of a tax bill. And even if she suspects it, she cannot appreciate the extent of the cost. The taxes are abstract, but the anxiety from the rocky market is real. Before finalizing the allocation change, Jenny clicks “Estimate tax impact” and sees that she is about to realize $4,641 in capital gains, with $4,290 of that short-term, which could incur up to $2,304 in taxes if she goes through with the trades. Putting a real dollar cost on knee-jerk reactions to market volatility is exactly what we as investors need at the critical moment when we are about to deviate from our long-term plan. Market timing is not a good idea, and most of us know this. However, emotions can get the better of even the most sophisticated investors, and we can all use some help in making the right decisions. Smarter Design for Better Decisions, Lower Taxes We believe that unhelpful emotion can be mitigated by good product design, which emphasizes the right information at just the right time. For instance, we never show you the individual daily performance of the ETFs in your portfolio—you are more likely to see losses that way, even if your overall portfolio is up. Seeing losses causes stress, which leads to emotional behavior, which can hurt your long-term returns. And yet, every other investment platform shows you individual asset performance front and center. On the other hand, showing you the estimated tax impact of a transaction before you commit to it encourages better decisions, and yet nobody except Betterment shows you this information. This distinction is at the core of our mission. Building the perfect investment service is not just about a pretty web interface, or a slick mobile app (though these are nice too!). It means rethinking every convention from the ground up. We are very excited about Tax Impact Preview, because it’s already helping our customers make better choices, and lessen their tax burden.

How Betterment’s Climate Impact Portfolio Was Born At Betterment, our work is just beginning. Our Climate Impact portfolio is as much a process as it is a product. We see it as a continuation of a conversation with our customers, who told us in no uncertain terms, that climate change matters to them. If climate change somehow wasn’t already front and center of your headspace, 2019 likely changed that. In February, Rep. Alexandria Ocasio-Cortez and Sen. Markey released their Green New Deal resolution. By August, the Amazon rainforest, often referred to as the “Earth’s lungs”, was on fire, as climate activist Greta Thunberg sailed across the Atlantic in a carbon-neutral, solar-powered yacht. In New York, she’d address the United Nations, and go on to be named Time’s youngest ever Person of the Year for sounding “a moral clarion call to those who are willing to act.” Later that fall, inspired by Thunberg, actress Jane Fonda partnered with Greenpeace to kick off “Fire Drill Fridays”, a series of weekly protests through Washington D.C. The final week’s theme was “The Role of Financial Institutions in the Climate Crisis”. Dr. Ayana Elizabeth Johnson, a marine biologist and a friend, extended an invitation to join her at this protest. I never thought of myself as an activist, but I had spent the better part of a decade helping to build a different kind of financial institution at Betterment. I knew this was an opportunity I couldn’t miss and soon found myself aboard an Amtrak headed to D.C. Curbing greenhouse gas emissions from human activity must center on dramatically reducing reliance on fossil fuels across every sector of the global economy. No surprise then, that the rallying cry that weekend was cutting off the flow of capital to the fossil fuel industry. One word reverberated across every speech and conversation: “divestment.” As we marched together towards the Capitol, one phrase ran through my mind: “if only it were that simple.” What did feel simple, however, was that those of us pushing for change within the financial services industry hadn’t come close to channeling the remarkable energy on display. In our goal to bring more American investors off the sidelines and into sustainable investing, we were clearly falling short. Since 2017, Betterment has offered one “Socially Responsible Investing” option, constructed from funds that tilt towards companies which rate highly on a scale that considers each of three pillars: Environmental, Social and Governance (“ESG”). ESG is often embraced as the gold standard for sustainable investing by professionals, but is not tailored to a specific investor’s values. In that moment, seeing the power and conviction of thousands who were mobilized by climate change, our sole ESG offering no longer felt like enough. The Betterment Way Back in NYC at Betterment’s headquarters, it was becoming clear that adding a climate-specific portfolio would better reflect some of our customers’ values even more than our broadly-focused offering could alone. If so, greater adoption would further amplify the signal to the industry that values-based investing, despite its recent growth, was still underserved. For over a decade, Betterment has been working to maximize our customers’ expected returns following the principles of global diversification and low cost. We’ve sought to tackle the complexities behind implementing a sophisticated investing strategy, so that our customers don’t have to, while maintaining transparency around the choices that go into our products. We applied this framework to the challenges of integrating our customers’ values into their investments. We felt well-positioned to make this daunting process simpler, wherever we could. Where some amount of complexity was unavoidable, we would be transparent about how we chose to address it. Broadly speaking, there are three distinct approaches to climate-conscious investing, and all three are integrated into Betterment’s Climate Impact portfolio. Divestment (i.e. excluding companies holding fossil fuel reserves) The equities basket includes SPYX, EEMX, and EFAX, “Fossil Fuel Reserves Free” ETFs tracking US, Developed, and Emerging markets. Low carbon exposure (i.e. overweighting carbon footprint leaders within each industry) The equities basket includes CRBN, a global ETF whose objective is to reduce the carbon footprint of a globally diversified portfolio. Impact (i.e. financing environmentally beneficial activities directly) The fixed income basket includes BGRN, holding “green bonds”, which fund projects across the world, including alternative energy, pollution control, and climate adaptation. The nuances behind how these approaches interact with each other is discussed below. Beyond Divestment What exactly was I going on about, muttering “It’s not that simple”, while surrounded by passionate cries to “divest” from fossil fuels? Like a good student of finance, I was referring back to another mantra: “Capital naturally wants to flow toward where it earns the highest return.” A core argument for divestment is that it “increases the cost of capital”. Less demand for a stock means a lower stock price, which means the company needs to give away more of itself to raise the same amount of money. The problem is that the more successful you are at driving up a company’s cost of capital, the higher the expected return for the financier.  As long as the business you want to starve is engaged in activity that remains both profitable and legal, another investor will come along.  The fewer investors are willing, the more those who remain willing stand to make. The alternative to divestment is engagement. By owning a stock, and using your rights to vote on shareholder resolutions, you can attempt to change the company’s activities from the inside. This path is long and messy. What seems like a victory, often curdles into an empty gesture, as management’s words produce no meaningful action. It’s a grind, and success is far from assured. Engagement is rife with compromise and disappointment. Divestment, on the other hand, feels principled and decisive. It offers immediate action in the face of a crisis that feels unstoppable. Yet its economic impact on the perpetrators of harm is negligible, particularly if it’s applied in a vacuum. Both strategies have their advocates, whose vigorous debates occasionally lose sight of the fact that they are on the same team. Moreover, conflicting appeals to absolutes run the risk of paralyzing millions of their fellow citizens, deeply sympathetic to the cause, but reluctant to wade into the confusion. Can the two approaches be meaningfully reconciled? Michael O’Leary and Warren Valdmanis offer a compelling argument that they can. In their recent book, Accountable: The Rise of Citizen Capitalism, they consider the question through the lens of the Divest Harvard campaign, which took center stage on campus in the spring of 2019. While O’Leary and Valdmanis believe in the effectiveness of engagement, they express great admiration for the campaign’s leaders, which include both students and faculty. By directly examining these leaders’ expressed views, O’Leary and Valdmanis conclude the following: Divestment advocates have done the climate movement a great service, by forcing a broad recognition that “there is no value-neutral way to invest”. These leaders aren’t naive. They view engagement with suspicion—as a fig leaf for complacency. But they also understand the limits of divestment within our existing legal and financial framework. Rather than narrowly fixate on proximate effects, these leaders take a longer view of divestment—as a political act of civic leadership. Under this theory, divestment seeks to impose “a cultural toll, labeling oil and gas companies as morally repugnant … making it easier to pass bold legislation rapidly, with broad political support.” Accordingly, the measure of success for divestment should not anchor on the number of dollars diverted, but on its ability to “center climate change in broader discourse”. Furthermore, if you are able to advance that objective, while also pushing for change via engagement, there is no reason why pursuing both in parallel cannot be a coherent strategy. In other words, if an act of divestment, however great or small, aims to achieve more than a feeling of moral satisfaction, it needs to be heard. It needs to help start conversations, trigger chain reactions, grab headlines. And it doesn’t preclude pushing for change within the shareholder framework, if integrated thoughtfully. It’s a lot to ask of your investment account. Here’s how we approached it at Betterment. Divestment And Engagement In Your Climate Impact Portfolio A divestment strategy is implemented in a globally diversified portfolio by applying a screen to an index of all available stocks, expunging those that hold large fossil fuel reserves, and producing a so-called “ex Fossil Fuels” index. The problem with relying solely on an “ex Fossil Fuels” approach, is that it is both under-inclusive, and over-inclusive. First, let’s look at how it is under-inclusive: An “ex Fossil Fuels” index is highly effective at screening out stocks of companies with familiar logos that we’ve seen plastered on gas stations. But, such indexes generally do not exclude the hundreds of companies that don’t necessarily own reserves, but are integral to the fossil fuel industry (e.g. pipeline operators, and the utilities that actually burn the fuels). Critics of a divestment-only approach refer to this phenomenon as “greenwashing”. There are powerful incentives for investment managers to expunge the familiar fossil fuel companies and call it a day. This goes a long way towards providing an investor with emotional satisfaction, but it ignores the complex enmeshment of fossil fuels throughout every sector of the economy. As for how it is over-inclusive: A handful of energy companies have staked their futures on renewable energy, and are actively diversifying away from fossil fuels. However, these transitions take time and today they qualify for exclusion under a blunt divestment criteria. We believe there is merit to the divestment approach. In Betterment’s Climate Impact portfolio, 50% of the stock basket is allocated to SPYX, EEMX, and EFAX, “Fossil Fuel Reserves Free” equity funds for US, Developed, and Emerging markets. For an act of divestment to be effective, it must be heard, and for most investors, this is uniquely possible by joining with other like-minded investors through index funds. For “ex-Fossil Fuels” funds to grow in assets and stature, sends an increasingly loud message, that the public views the industry as a whole as a pariah. We also believe there is merit for the engagement approach. In Betterment’s Climate Impact portfolio, 50% of the stock basket is allocated to CRBN, a global ETF whose objective is to reduce the carbon footprint of a globally diversified portfolio, with an expense ratio of only 0.20%. CRBN was launched on Earth Day, 2015, seeded with an initial investment from the United Nations Joint Staff Pension Fund. Today, it holds nearly $650mm, and is gaining scale rapidly. By excluding companies holding fossil fuel reserves, ex-Fossil Fuel indexes are effectively concerned only with future, not ongoing emissions. CRBN takes aim at both, with more precision, by assigning every company in every sector a “carbon exposure” score, which incorporates any fossil fuel reserve holdings, but also greenhouse gas emissions from the company’s activities (measured per dollar of revenue). It then uses the scores to minimize carbon exposure across the entire index while maintaining tracking error constraints, by overweighting companies that are managing the lowest carbon footprint within their sphere of activity, including in the energy sector, and underweighting companies that lag their peers, with some of the worst offenders getting dropped from the index entirely. Boosting The Leaders Not surprisingly, a rigorous, quantitative methodology is highly effective in service of a clear objective. When compared to the equity basket of Betterment’s core portfolio, CRBN achieves a 50% reduction in carbon emissions. Perhaps more surprising, is that CRBN’s holdings also emit less carbon than the companies collectively held by the “ex-Fossil Fuels” funds, in spite of the latter’s targeted exclusions. CRBN achieves these results by mathematically expressing preference for “best-in-class” leaders in every sector. In practice, this means that CRBN adds back a handful of energy companies which were screened out by one of the three “ex-Fossil Fuels” funds. An energy company can wind up in the index if it’s shifting out of legacy fossil fuel activities, and driving significant investments in renewables or bio fuels. A couple of illustrative examples held by CRBN as of 1/31/21: Neste is the largest producer of renewable diesel jet fuel, which will significantly reduce aviation emissions (it has two renewable refineries but also two conventional refineries). NextEra Energy Inc is the world’s largest producer of wind and solar energy (but also has generating plants powered by natural gas, nuclear energy, and oil) Generally, “best-in-class” energy leaders are companies where pro-transition management factions have won the internal battles, and have successfully pivoted their roadmaps towards a net zero economy. But such strategic shifts can be fragile. Consider NRG, an enormous American power company, whose CEO, David Crane, wrote to shareholders in 2014: “The day is coming when our children sit us down in our dotage, look us straight in the eye … and whisper to us, ‘You knew … and you didn’t do anything about it. Why?’” NRG announced it would cut its carbon dioxide emissions by 50 percent by 2030 and 90 percent by 2050, and began its transformation. But just three years later, Elliot Management, an activist hedge fund unhappy with its financial performance, was able to reshuffle the board, depose the CEO, and begin to sell off NRG’s renewable energy assets. One could argue that the climate movement is better served, if the David Cranes of the world not only get control, but stay in control. Elliot was able to reverse the transition while holding just 6.9% of NRG’s shares. If climate-conscious capital held enough of the rest, and used that perch to fight, Crane could have survived. At a systemic level, divestment and engagement are complementary—the stick for companies core to the problem, and the carrot for those who may be part of the solution. Each message has value, and your investments can express both. However, for these messages to actually reach their intended recipients, how you implement these investing strategies becomes important. A globally diversified portfolio calls for exposure to thousands of individual stocks and bonds. Buying index funds, rather than the individual securities directly, is not only a cheaper and simpler way to get this exposure. For most climate-conscious individual investors, it’s also by far the most effective path to have their dollars contribute to the systemic change they want to see. A detour into some general investing plumbing may help to appreciate why. The Power of the Index While passive investing had been steadily gaining popularity over active stock-picking for decades, the 2008 global financial crisis served as an inflection point. Complex strategies seeking to beat the market came under suspicion, and then continued to lose credibility during the relentless bull market that followed. With each year, a transparent buy-and-hold strategy proved harder and harder to beat, particularly net of fees. The spotlight shifted away from chasing alpha, towards lowering expenses, making the continuing rise of passive index fund investing a textbook flywheel in action, where growth begets more growth. Falling fees mean more inflows, and more assets mean more scale, which allows for another round of fee reductions, which pulls the next cohort of fee-conscious investors into the fold. The big fund managers have been engaged in a decade-long “core war”, led by Vanguard, whose flagship equity fund (found in Betterment’s core offering), has ballooned to over a trillion in assets, with its expense ratio down to 0.03%. These pooling dynamics have had an underappreciated second order effect—the anointment of index providers to new heights of authority in global markets. The trillions may be flowing into Vanguard, Blackrock, and State Street, but the investing decisions have been largely delegated to FTSE Russell, MSCI, and S&P DJI. In 2017, the Economist dubbed them “finance’s new kingmakers: arbiters of how investors should allocate their money.” However laborious the process behind constructing and maintaining an index, the finished product is little more than a list of companies, with assigned percentages that add up to 100%. The index-makers take pains to emphasize the rules-based, non-discretionary nature of their work. Nonetheless, because trillions of obedient dollars promptly and faithfully replicate every bureaucratic tweak, these glorified spreadsheets are imbued with at times eye-popping power. Being added to a list has no bearing on a company’s business, and under an efficient markets hypothesis, should have no impact on share price. Yet it is conventional wisdom that membership in the S&P 500 provides some price support. Thus, joining this iconic club can be cause for fanfare befitting a coronation, while removal can be tantamount to a “humiliation”, a symbol of irreversible decline. Some allegedly “rules-based” decisions are inevitably discretionary, and impactful enough to threaten a geopolitical crisis. A rumor that MSCI was considering reassigning Peru from its flagship Emerging Markets Index, to its less prestigious Frontier Markets Index, put the finance minister, leading a senior delegation, on an emergency flight to NYC to avert the demotion. The gradual inclusion of Chinese “A-shares” into the major indexes was a highly political, contentious process with far greater stakes. In early 2019, MSCI announced it would quadruple its exposure, which is estimated to steer $80 billion of investment into China. Throughout the process, MSCI has at times functioned as a quasi-regulator, at one point delisting several Chinese companies that had violated its internal governance standards. Such examples are myriad, ably outlined in a recent paper on “the growing private authority” of index providers. It’s hard not to come away in agreement with the authors, that this backoffice corner of global finance would benefit from more transparency and accountability. But there’s another takeaway: These mechanical, ostensibly value-neutral switchboards for capital have untapped potential as agents of change. But Make It Sustainable 🚀 What would it mean for sustainability-focused indexes to wield this kind of power? Is it crazy to imagine a future in which getting booted from a major ESG index for failing to hit sustainability targets is viewed as irrefutable evidence of corporate management malpractice? Or is that future more likely than not, if we observe the patterns already in motion, some new, some familiar, and play them forward to their logical conclusion? As of Sept. 2020, the top ten equity indexes were directly tracked by over $3.5 trillion. Of course, there is no hint of ESG anywhere near the top, but there are compelling reasons to believe that a secular shift is already in progress, and that the rate of change will be non-linear. None other than the head of ESG at MSCI believes that its sustainable indexes will eventually overtake its traditional offerings, and that trends suggest that the shift will happen “more quickly than most people would expect.” Indeed, while the absolute numbers are relatively small, sustainable funds are seeing scorching, exponential growth. In 2020, investors poured in $50 billion; double that of 2019, and ten times that of 2018. Meanwhile, we’re on the cusp of the greatest generational transfer of wealth in history, to a demographic that bodes well for only more acceleration. According to Morgan Stanley, “nearly 95% of millennials are interested in sustainable investing, while 75% believe that their investment decisions could impact climate change policy.” This story is genuinely new, but one level deeper is a more familiar one. Sustainable investing, until recently still largely the domain of active management, is catching up with the broader industry, and shifting towards passive. 2020 marked the first year that passive sustainable funds (i.e. ones that fully replicate an ESG index) handily beat active sustainable funds. Passive took in 2.5 times more inflows than active, whereas the split was 50/50 just in 2019. Not surprisingly, ETFs, predominantly passive, and favored by investors for their tax efficiency, dominated mutual funds by similar margins. In other words, the defining capital allocation shift of the last two decades is just now starting to play out within the nascent field of sustainable investing, and we know where it leads—the elevation of the index as a behind-the-scenes nexus of power. Neither retail nor institutional investors are likely to reverse course towards more complexity, less transparency, and higher fees. Sustainable or not, investors have been trained to be laser-focused on low fees. We know how the flywheel turns. How do we harness this unstoppable force as a tailwind for real progress on sustainability, and ensure that there’s more to this reallocation than greenwashing deck chairs on the Titanic? “Index Activism”: A Theory Of Change “Index activism”, as any theory of change, faces serious challenges, addressed below. But the structure of index fund investing, as compared to investing in companies’ stocks directly, is uniquely suited to aggregate and amplify the impact of tens of millions of individual portfolios. It represents a form of “collective bargaining”—putting aside lesser differences in favor of progress towards a greater common cause. Index funds will always entail a trade-off between personalization and the benefits of scale. For some investors, trading the underlying securities for a portion of their overall exposure, will make more sense. However, when it comes to effecting broad, systemic change, the prospect of a robust sustainable index fund ecosystem is hard to beat. We can rely on the asset gathering flywheel to carry funds tracking sustainable indexes to the mainstream. Yet asset inflows alone won’t magically teach the passive asset allocators to be the active shareholders that we need them to be. After all, active ownership is a demanding full time affair, requiring specialized expertise. Most of us already have jobs, and ideally, we would empower a team of experts with our dollars, not only to decide what shares to buy, but also how to then leverage those shares in furtherance of a sustainable agenda. What might it look like, if fund managers acted as stewards of sustainable business, pushing their portfolio companies towards a net-zero economy, standing ready to oppose activist shareholders like Elliot, who seek to undermine progress? Boutique managers who have long specialized in shareholder advocacy can offer a glimpse. In 2020, Green Century, which manages ~$1 billion across three mutual funds, used the shares of Procter & Gamble it holds on behalf of investors to introduce a resolution, calling on the company to step up efforts to mitigate deforestation in its supply chain. P&G’s board recommended that shareholders vote “Against”. It passed anyway, with a resounding 67% of votes cast—the first ever deforestation proposal to do so, receiving twice as many votes as any such prior attempt in all of corporate America. Experts believe it will spur other companies targeted with deforestation resolutions in coming months to engage with shareholder proponents. The Work Ahead Now for the reality check—both Blackrock, with 43% of all passively managed sustainable assets, and Vanguard, with 21%, could learn a thing or two from tiny Green Century, to put it mildly. When it comes to steering capital flow, where their expertise is unparalleled, the giants’ commitment to sustainability is tangible. In January 2020, Blackrock made its first ever addition of a sustainable fund, its flagship ESGU, to forty of its non-ESG model portfolios. As a result, ESGU captured nearly a quarter of the $26 billion of net new money that surged into sustainable strategies through August 2020. Yet, there is no denying that active engagement is not in their DNA. That Larry Fink, the head of Blackrock, would call for every corporation to develop a plan for a net zero economy, as he did in his 2021 “Letter to CEOs”, would have been hard to believe just five years ago. Activists may see more posturing than substance to these proclamations, and the facts don’t exactly refute the accusation. While support for shareholder resolutions relevant to climate change from fund managers was generally on the rise in 2020, Blackrock and Vanguard, the perennial largest and second largest shareholder of any major U.S. corporation, were dead last, voting in favor of just 12% and 15% of such resolutions, respectively. Even basic issues of transparency reflect an unacceptable status quo. For instance, how did these giants, who together control about 15% of Procter & Gamble, vote on Green Century’s deforestation resolution? For now, only they know. Blackrock only recently began to disclose their votes on a quarterly basis, and Vanguard may not announce its votes until August 2021. Reading Fink’s letter in a vacuum, one could get the impression that Blackrock confidently leads on environmental and social issues, and corporations are somewhat compelled to actually listen. At best, that model “is not so much true, as it is in the process of becoming true”, as Matt Levine generously put it. As investors, and as citizens, we can and should demand that managers of sustainable funds act like sustainable fund managers. However, one need not infer bad faith. It’s hard to overstate the banal power of inertia. An active posture towards their portfolio companies runs directly counter to decades of institutional muscle memory. Reorienting the highly coordinated efforts of tens of thousands of people will require its own theory of change. At Betterment too, our work is just beginning. Our Climate Impact offering is as much a process, as it is a product. We see it as a continuation of a conversation with our customers, who told us in no uncertain terms, that climate change matters to them. We set out to integrate this mandate alongside the rest: diversify globally, keep costs low, optimize for after-tax return, and automate as much as we can. It's the framework we've been refining for a decade, and continuing to make it better is all we know. Any links provided to other websites are offered as a matter of convenience and are not intended to imply that Betterment or its authors endorse, sponsor, promote, and/or are affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise. Higher bond allocations in your portfolio decreases the percentage attributable to socially responsible ETFs.

Meet $VOTE: Channeling Our Values Through Shareholder Engagement We're adding the new $VOTE ETF to our Socially Responsible Investing portfolios. Here's why it gives investors more power to advocate for their values. Today, we are excited to announce that we will begin integrating the $VOTE ETF, recently launched by Engine No. 1, into all of Betterment’s Socially Responsible Investing portfolios. This new ETF invests in 500 of the largest U.S. companies, weighted according to their size, with a management fee of only .05%. You might think that this sounds a lot like a garden variety index fund tracking the S&P 500—a commodity for many years now. So, why the excitement? In short, $VOTE represents a highly innovative approach to pushing the economy towards sustainability via index fund investing. It may be “passive” in the traditional sense—buying shares in companies purely based on an index—but it is “active” when it comes to engaging with those companies as a shareholder. Beyond Divestment: What’s Shareholder Engagement? Historically, values-aligned investing has often been synonymous with avoiding the purchase of certain stocks—a practice often referred to as “divestment.” The alternative to divestment is “engagement.” By owning a stock, and using your rights to vote on shareholder resolutions, you can attempt to change the company’s activities from the inside. Vanguard, BlackRock, and State Street—the “Big Three” largest fund managers—are collectively the biggest shareholders in most companies, but have historically been reluctant to rock the boat and aggressively challenge management. As a result, when it comes to investing through index funds, the full potential of shareholder engagement to drive change hasn’t been tapped. Engine No. 1’s new $VOTE ETF promises to change that. To understand why, it helps to understand the mechanics of how shareholders can push for change. Proxy Voting Purchasing stock in a company grants you not just a share of its profits, but also the right to influence its decision-making. This process is called “proxy voting,” which can be a powerful tool with the potential to transform the entire economy, company by company. Publicly traded companies operate like quasi-democracies, accountable to their shareholders. They hold annual meetings, where shareholders can vote on a number of topics. Shareholders who disagree with some aspect of how a company’s business is conducted can engage with management, and if they feel they aren’t being heard, can present an alternate course of action by making a “shareholder proposal.” If they can persuade a majority of all shareholders to vote in support of the proposal, they can overrule management. When more drastic change is warranted, such “activist” shareholders can seek to replace management entirely, by nominating their own candidates for the company’s board of directors. Shareholder Activism: Social Change Through Engagement Social change via shareholder activism has a storied history. As early as 1951, in a seminal case, civil rights leader James Peck took the fight to the proxy arena, by filing a shareholder proposal with the Greyhound Corporation, recommending that the bus operator abolish segregated seating in the South. Seventy years later, on May 26, 2021, activist hedge fund Engine No. 1 stunned the corporate world by winning a proxy battle against the current leadership of ExxonMobil, persuading a coalition of shareholders to elect three of its own candidates to the board—the first ever climate-centered case for change. Engine No. 1 argued that Exxon’s share price was underperforming that of its peers because the company was unprepared for the transition away from fossil fuels. It nominated candidates for the board that would push the oil giant to embrace renewable energy. Against all odds, holding just .02% of Exxon’s stock, Engine No. 1 prevailed.  Corporate boardrooms across the entire S&P 500 are buzzing, asking what the Exxon coup means for them. Where will environmentally and socially conscious investors strike next? These questions are warranted: The Exxon campaign was a first, but it surely won’t be the last. “Index Activism”: Bringing Power To The People Individual investors are increasingly aware of proxy voting as a domain by which their portfolios can channel their values. In a recent Morningstar report, 61% of those surveyed said that sustainability should be factored into how votes attributable to their 401(k)s are cast. However, most Americans, including Betterment customers, don’t buy stock of companies like Greyhound or Exxon directly, but through index funds. When you buy a share of an index fund, the index fund manager uses your money to buy stocks of companies on your behalf. As a shareholder of the fund, you benefit financially when these underlying stocks rise in value, but the index fund is technically the shareholder of each individual company, and holds the right to participate in each company’s proxy voting process. As more investors tell the industry that they want their dollars to advance sustainable business practices, the Big Three have been feeling the pressure to work these preferences into their proxy voting practices. This year, they are showing some signs of change. Notably, the Big Three ultimately joined Engine No. 1’s coalition, which could not have prevailed against Exxon without their support. However, even if the Big Three, who manage trillions on behalf of individual investors, continue to side with the activists, what’s missing is a way for individuals to invest their dollars not just to support these campaigns, but to spearhead them as well.   What Makes $VOTE Special Activist shareholder campaigns are generally led by hedge funds, and what happened with Exxon was no exception. However, by launching an ETF that anyone can invest in, Engine No. 1 is looking to break that mold. In 2020, investors poured $50 billion into sustainable index funds—double that of 2019, and ten times that of 2018. The $VOTE ETF should bring even more investors off the sidelines, and into sustainable investing, for two reasons. First, rather than dilute its efforts, $VOTE intends to spearhead a handful of campaigns, pushing companies to improve their environmental and social practices. A focus on the highest impact, and most powerful narratives, will continue to raise awareness for the power of shareholder activism. Second, $VOTE is designed for mass adoption, not as a niche strategy. With a management fee of only .05%, and tracking a market cap weighted index, $VOTE is designed to ensure no trade-off to long-term returns. It is also well-suited for those investing for retirement—and as of today, it will make its way into its first ever 401(k) plan, via Betterment for Business. What Does $VOTE Mean For Investors? We know that many of our customers want to invest for real impact, especially if they can do so without sacrificing their long-term financial goals. If you’re investing through any of Betterment’s three Socially Responsible Investing portfolios, $VOTE will have a target weight equal to 10% of your exposure to the U.S. stocks. With $VOTE in your portfolio, you’ll know that your dollars are directly supporting whatever engagements Engine No. 1 launches next. As their subsequent work unfolds, we will be monitoring their efforts, and updating our customers on the impact their investments are driving. Now that $VOTE exists, anyone—not just Betterment customers—can invest in it, which is a great thing. The bigger it gets, the more it can drive change, and you, as an investor, get to help write the next chapter.

Asset Location Methodology In this paper, we discuss the various factors that must be considered by an optimal asset location strategy. We then present the methodology behind TCP, as well as results from performance simulations. TABLE OF CONTENTS Summary Part I: Asset Location For All: “We Have The Technology!” Part II: After-Tax Return—Deep Dive Part III: Asset Location in Popular Culture Part IV: TCP Methodology Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework Part VI: Who’s Up With TCP? Our Results Part VII: Special Considerations Conclusion Authors Additional References Disclosures Asset location is widely regarded as the closest thing there is to a "free lunch" in the wealth management industry.1 When investments are held in at least two types of accounts (out of three possible types: taxable, tax-deferred and tax-exempt), asset location has been demonstrated to deliver additional after-tax returns, while maintaining the same level of risk. Generally speaking, this benefit is achieved by placing the least tax-efficient assets in the accounts taxed most favorably, and the most tax-efficient assets in the accounts taxed least favorably, all while maintaining the desired asset allocation in the aggregate. However, intelligently applying asset location to a globally diversified portfolio is a complex, mathematically rigorous, and continuous undertaking. Betterment’s Tax-Coordinated Portfolio (TCP) is a dynamic asset location service that automates the process, tailoring its approach to each investor’s personal circumstances. TCP is the first implementation of holistic asset location by an automated investment service, and is a milestone in the rapid advancement of investing technology. It makes this sophisticated strategy accessible to investors who either do not have the desire, expertise, or the time to effectively customize it, and manage it on an ongoing basis. Due to its undeniable value for long-term investors, automated asset location will eventually become table stakes for digital advisors. We believe that its proliferation in the investment management industry will set the stage for the gradual decline of target-date funds, for reasons we discuss below. TCP is seamlessly compatible with Tax Loss Harvesting+ (TLH+), Betterment’s automated tax loss harvesting service. While the latter derives value from the taxable account only, both work in tandem to improve after-tax return without disturbing the desired asset allocation. In this paper, we discuss the various factors that must be considered by an optimal asset location strategy. We then present the methodology behind TCP, as well as results from performance simulations. Part I: Asset Location For All: "We Have The Technology!" Introduction With each year, it is increasingly accepted that most investors are better off following a passive investment strategy, which is best implemented through a diversified portfolio of index funds. As passive investing has grown more popular, focus has shifted away from attempting to beat the market, and toward maximizing the net "take-home" value of the portfolio. This is done by reducing costs, which include fees and taxes, among other things. Maximizing after-tax return on investments can be complex. Still, most investors know that contributing to tax-advantaged (or "qualified") accounts is a relatively straightforward way to pay less tax on their retirement savings. Millions of Americans wind up with some combination of IRAs and 401(k) accounts, both available in two types: traditional or Roth. Investors can see the impact of a deductible contribution when they do their taxes. They may be aware that a Roth contribution makes sense in a year when one’s tax bracket is unusually low. Many will only save in a taxable account once they have maxed out their contribution limits for the qualified accounts. But while tax considerations are paramount when choosing which account to fund, less thought is given to the tax impact of which investments to then purchase across all accounts. Meanwhile, the tax profiles of the three account types (taxable, traditional, and Roth) have implications for what to invest in, once the account has been funded. Choosing wisely can significantly improve the after-tax value of one’s savings, when more than one account is in the mix. Almost universally, such investors can benefit from a properly executed asset location strategy. The idea behind asset location is fairly straightforward. Certain investments generate their returns in a more tax-efficient manner than others. Certain accounts shelter investment returns from tax better than others. Placing, or "locating" less tax-efficient investments in tax-sheltered accounts should increase the after-tax value of the overall portfolio. Allocate First, Locate Second Let’s start with what asset location isn’t. All investors must select a mix of stocks and bonds, finding an appropriate balance of risk and expected return, in line with their goals. One common goal is retirement, in which case, the mix of assets should be tailored to match the investor’s time horizon. This initial determination is known as "asset allocation," and it comes first. When investing in multiple accounts, it is common for investors to simply recreate their desired asset allocation in each account. On a superficial level, this makes sense. If each account, no matter the size, holds the same assets in the same proportions, adding up all the holdings will also match the desired asset allocation. If all these funds, however scattered, are invested towards the same goal, this is the right result. The aggregate portfolio is the one that matters, and it should track the asset allocation selected for the common goal. Portfolio Managed Separately in Each Account However, as long as the desired asset allocation is maintained in the aggregate, each individual account does not necessarily need to reproduce the target portfolio. Enter asset location, which can only be applied once a desired asset allocation is selected. Each asset’s after-tax return is considered in the context of every available account. The assets are then arranged (unequally) across all coordinated accounts to maximize the after-tax performance of the overall portfolio. Same Portfolio Overall—With Asset Location To help conceptualize asset location, consider a team of runners. Some runners compete better on a track than a cross-country dirt path, as compared to their more versatile teammates. Similarly, certain asset classes benefit more than others from the tax-efficient "terrain" of a qualified account. Asset allocation determines the composition of the team, and the overall portfolio’s after-tax return is a team effort. Asset location then seeks to match up asset and environment in a way that maximizes the overall result over time, while keeping the composition of the team intact. Automatic for the People Asset location has theoretically made sense since qualified accounts were introduced in the 1970s. More recently, however, the strategy has gained increasing importance, as financial advice has expanded to cater to a wider demographic. The ultra-wealthy certainly take advantage of qualified accounts. However, due to contribution limits, such accounts typically represent a small percentage of a massive net worth (with exceptions, of course). Planning for such estates is more concerned with generational succession to wealth, rather than liquidation of all or most of a portfolio during one’s life. The rest of us hold a substantial portion of our savings in qualified accounts, and intend for these assets to be our source of income in retirement. These circumstances make asset location particularly valuable. Therefore, a scalable implementation of the strategy is highly desirable for advisors looking to improve outcomes for the average investor. This is easier said than done. Michael Kitces, a leading financial planner who has written extensively about asset location, summarizes both its potential and challenge: Asset location represents one of those unique "free lunch" opportunities for wealth creation—a mechanism by which investment strategies that are already being implemented can simply be done in a more tax-efficient manner that maximizes long-term wealth creation. Yet in practice, the idea of a "free" lunch for asset location may be slightly overstated, in that the complexity of implementing it effectively requires more work, with a far more intensive and proactive process to evaluate investments for their prospective return and tax-efficiency characteristics, establish an asset location priority list to be utilized, and then actually implement it—ostensibly with the assistance of rebalancing/trading software—on an ongoing basis.3 In other words, the theoretical value of asset location is limited by the difficulty of proper execution. Indeed, the difficulty is twofold. First, the initial calculation of a client-specific location requires a mathematically rigorous approach to what is essentially a complex optimization problem. Second, to maximize the benefit, this calculation must be performed continuously, in response to not only market movements and revised return expectations, but also the individual’s cash flows throughout the entire investment period. Deposits, withdrawals, rollovers, distributions, conversions and dividends will all shift the relative balances of the coordinated accounts. These shifts can necessitate location adjustments, big and small. While these challenges can be daunting and cost-prohibitive when performed manually, they are easily handled by software, which is strongest when it comes to mathematically complex, repeatable tasks. Automating these tasks takes far more work than manually solving for a single client. However, once the formulas have been derived, coded into algorithms, and deployed to a production environment, the incremental work required to apply the strategy to additional accounts is minimal. A team of Betterment quantitative analysts, tax experts, software engineers, designers, and product managers have been working for over a year, solving and automating all of these complexities. The result is software that can efficiently apply these calculations to millions of accounts. Betterment’s tightly integrated trading and position tracking systems allow for TCP’s decisions to be seamlessly executed for any individual client’s group of accounts, no matter the mix. RIP, TDF? Automated asset location makes sense for so many investors, that we believe most advice services will eventually have to provide some version of it to protect their value proposition. Seen through that lens, we believe that the release of TCP is the first step toward the eventual decline of the target-date fund (TDF). The primary appeal of a TDF is the "set it and forget it" simplicity with which it allows investors to select and maintain a diversified asset allocation, by purchasing only one fund. That simplicity comes at a price—because each TDF is a single, indivisible security, it cannot unevenly distribute its underlying assets across multiple accounts, and thus cannot deliver the additional after-tax returns of asset location. As soon as managing a single portfolio across multiple accounts becomes as easy as buying a TDF, its popularity should wane. Of course, TDFs are not disappearing any time soon. Disruption takes time—after all, Research In Motion recorded its highest ever profits on the Blackberry in the two years after the iPhone was released, before they started to slide. The structural friction in the investment management industry is an order of magnitude higher, and the transition will be slow. In particular, participants who are locked into 401(k) plans without automated management may find that a cheap TDF is still their best "hands off" option (plus, a TDF’s ability to satisfy the Qualified Default Investment Alternative (QDIA) requirement under ERISA ensures its baseline survival under current law). But change is coming—today, participants in a Betterment for Business plan can already enable TCP to manage a single portfolio across their 401(k), and any IRAs and taxable accounts they individually have with Betterment, squeezing additional after-tax returns from their aggregate long-term savings. Automated asset location (when integrated with automated asset allocation) replicates what makes a TDF so appealing, but effectively amounts to a "TDF 2.0"—an effortless, continuously managed portfolio, but one that can straddle multiple accounts for tax benefits. Next, we dive into the complex dynamics that need to be considered when seeking to optimize after-tax return of a diversified portfolio. Part II: After-Tax Return—Deep Dive The rules governing the taxation of investment income are dense and heavy on detail, but so was Ron Chernow’s "Alexander Hamilton," and look how that turned out. We first define a few key terms, and then dive into specifics. What a Drag It Is Getting Taxed A good starting point for a discussion of investment taxation is the concept of "tax drag." As the name implies, a growing portfolio encounters friction through the years, in the form of annual taxation. Tax drag is the portion of the return that is lost to tax on an annual basis. In particular, funds pay dividends, which are taxed in the year they are received. Gimme Shelter However, there is no annual tax in qualified accounts, also sometimes known as "tax-sheltered accounts." Therefore, placing assets that pay a substantial amount of dividends into a qualified account, rather than a taxable account, "shelters" those dividends, and reduces tax drag. Reducing the tax drag of the overall portfolio is one way that asset location improves the portfolio’s after-tax return. Importantly, investments are also subject to tax at liquidation, both in the taxable account, and in a traditional IRA (where tax is deferred). However, "tax drag", as that term it is commonly used, does not include liquidation tax. So while the concept of "tax drag" is intuitive, and thus a good place to start, it cannot be the sole focus when looking to minimize taxes. What We Talk About When We Talk About "Tax Efficiency" A closely related term is "tax efficiency" and this is one that most discussions of asset location will inevitably focus on. A tax-efficient asset is one that has minimal "tax drag." The less return that is lost to annual taxation, the more tax-efficient the asset generating that return is considered to be. By this definition, tax-efficient assets are typically those that generate most of their return through capital gains (taxed at liquidation), rather than through dividends. It is helpful to think of tax efficiency as a relative concept. An asset is only tax-efficient in the sense that it has less tax drag than another asset in the portfolio. Prioritizing assets on the basis of tax efficiency allows for asset location decisions to be made following a simple, rule-based approach. One goal of this paper is to demonstrate why this approach is too simple to be optimal. Since tax efficiency (as that term is commonly used) is only concerned with reducing annual tax drag, it has nothing to say about eventual liquidation tax. As we shall see, this narrow focus on a subset of the overall tax that must be paid makes tax efficiency an imperfect metric for trying to maximize after-tax return. However, the concept helps facilitate a basic understanding of how asset location adds a substantial amount of its value. Because it is a useful device, tax efficiency is referenced frequently in the discussion that follows. However, it is not worth dwelling too much on whether some asset is truly more or less tax-efficient than another. The ultimate objective is to maximize after-tax return of the portfolio, and tax efficiency is merely one piece of that puzzle. Tax Rates, Timing, and Account Types, Oh My! Both "tax drag" and "tax efficiency" are concepts pertaining to taxation of returns in a taxable account. Therefore, we first consider that account, where the rules are most elaborate. With an understanding of these rules, we can layer on the impact of the two types of qualified accounts. Returns in a Taxable Account There are two types of investment income, and two types of applicable tax rates, but they do not correlate neatly. Their interaction is easier to describe if we define the rates first. Two types of investment tax rates. All investment income in a taxable brokerage account is subject to one of two rate categories (with material exceptions noted). For simplicity, and to keep the analysis universal, this section only addresses federal tax (state tax is considered when testing for performance). Ordinary rate: For most, this rate mirrors the marginal tax bracket applicable to earned income (primarily wages reported on a W-2). For all but the lowest earners, that bracket will range from 25% to 39.6%. Preferential rate: This more favorable rate ranges from 15% to 20% for most investors. For especially high earners, both rates are subject to an additional tax of 3.8%, making the highest possible ordinary and preferential rates 43.4% and 23.8%, respectively. Two types of investment returns. Investments generate returns in two ways: by appreciating in value, and by making cash distributions. Capital gains: When an investment is sold, the difference between the proceeds and the tax basis (generally, the purchase price) is taxed as capital gains. If held for longer than a year, this gain is treated as long-term capital gains (LTCG) and taxed at the preferential rate. If held for a year or less, the gain is treated as short-term capital gains (STCG), and taxed at the ordinary rate. Barring unforeseen circumstances, passive investors should be able to avoid STCG entirely. Betterment’s automated account management avoids STCG,4 and the rest of this paper assumes only LTCG on liquidation of assets. Dividends: Bonds pay interest, which is taxed at the ordinary rate, whereas stocks pay dividends, which are taxed at the preferential rate (both subject to the exceptions below). An exchange-traded fund (ETF) pools the cash generated by its underlying investments, and makes payments that are called dividends, even if some or all of the source was interest. These dividends inherit the tax treatment of the source payments. This means that, generally, a dividend paid by a bond ETF is taxed at the ordinary rate, and a dividend paid by a stock ETF is taxed at the preferential rate. Qualified Dividend Income (QDI): There is an exception to the general rule for stock dividends. Stock dividends enjoy preferential rates only if they meet the requirements of qualified dividend income (QDI). Key among those requirements is that the company issuing the dividend must be a U.S. corporation (or a qualified foreign corporation). A fund pools dividends from many companies, only some of which may qualify for QDI. To account for this, the fund assigns itself a QDI percentage each year, which the custodian uses to determine the portion of the fund’s dividends that are eligible for the preferential rate.For stock funds tracking a U.S. index, the QDI percentage is typically 100%. However, funds tracking a foreign stock index will have a lower QDI percentage, sometimes substantially. For example, VWO, Vanguard’s Emerging Markets Stock ETF, had a QDI percentage of 38% in 2015, which means that 38% of its dividends for the year were taxed at the preferential rate, and 62% were taxed at the ordinary rate. Tax-exempt interest: There is also an exception to the general rule for bonds. Certain bonds pay interest that is exempt from federal tax. Primarily, these are municipal bonds, issued by state and local governments. This means that an ETF which holds municipal bonds will pay a dividend that is subject to 0% federal tax—even better than the preferential rate. The chart below summarizes these interactions. Note that this section does not consider tax treatment for those in a marginal tax bracket of 15% and below. These taxpayers are addressed in "Special Considerations."   Dividends (taxed annually) Capital Gains (taxed when sold) Ordinary Rate Most bonds Non-QDI stocks (foreign) Any security held for a year or less (STCG) Preferential Rate QDI stocks (domestic and some foreign) Any security held for more than a year (LTCG) No Tax Municipal bonds Any security transferred upon death or donated to charity The impact of rates is obvious: The higher the rate, the higher the tax drag. Equally important is timing. The key difference between dividends and capital gains is that the former are taxed annually, contributing to tax drag, whereas tax on the latter is deferred. Tax deferral is a powerful driver of after-tax return, for the simple reason that the savings, though temporary, can be reinvested in the meantime, and compounded. The longer the deferral, the more valuable it is. Putting this all together, we arrive at the foundational piece of conventional wisdom, where the most basic approach to asset location begins and ends: Bond funds are expected to generate their return entirely through dividends, taxed at the ordinary rate. This return benefits neither from the preferential rate, nor from tax deferral, making bonds the classic tax-inefficient asset class. These go in your qualified account. Stock funds are expected to generate their return primarily through capital gains. This return benefits both from the preferential rate, and from tax deferral. Stocks are therefore the most tax-efficient asset class. These go in your taxable account. Tax-Efficient Status: It’s Complicated Reality gets messy rather quickly, however. Over the long term, stocks are expected to grow faster than bonds, causing the portfolio to drift from the desired asset allocation. Rebalancing may periodically realize some capital gains, so we cannot expect full tax deferral on these returns (although if cash flows exist, investing them intelligently can reduce the need to rebalance via selling). Furthermore, stocks do generate some return via dividends. The expected dividend yield varies with more granularity. Small cap stocks pay relatively little (these are growth companies that tend to reinvest any profits back into the business) whereas large cap stocks pay more (as these are mature companies that tend to distribute profits). Depending on the interest rate environment, stock dividends can exceed those paid by bonds. International stocks pay dividends too, and complicating things further, some of those dividends will not qualify as QDI, and will be taxed at the ordinary rate, like bond dividends (especially emerging markets stock dividends). Already, we can see the simple conventional wisdom straining to account for this real-world complexity. How large of a dividend must a stock fund pay before we take the resulting tax drag seriously? Is an emerging markets stock fund really more tax-efficient than a bond fund? If a bond fund is tax-exempt, doesn’t that asset class make the most sense in the taxable account? To have the full framework for addressing these questions, we next consider taxation of investment income in the qualified accounts, to the extent there is any. Returns in a Tax-Deferred Account (TDA) Compared to a taxable account, a TDA is governed by deceptively simple rules. However, earning the same return in a TDA involves trade-offs which are not intuitive. Applying a different time horizon to the same asset can swing our preference between a taxable account and a TDA. Understanding these dynamics is crucial to appreciating why an optimal asset location methodology cannot ignore liquidation tax, time horizon, and the actual composition of each asset’s expected return. In this section, we examine these trade-offs, which are some of the toughest to grasp. Although growth in a traditional IRA or traditional 401(k) is not taxed annually, it is subject to a liquidation tax. All the complexity of a taxable account described above is reduced to two rules. First, all tax is deferred until distributions are made from the account, which should begin only in retirement. Second, all distributions are taxed at the same rate, no matter the source of the return. The rate applied to all distributions is the higher ordinary rate, except that the additional 3.8% tax will not apply to those whose tax bracket in retirement would otherwise be high enough.5 First, we consider income that would be taxed annually at the ordinary rate (i.e. bond dividends and non-QDI stock dividends). The benefit of shifting these returns to a TDA is clear. In a TDA, these returns will eventually be taxed at the same rate, assuming the same tax bracket in retirement. But that tax will not be applied until the end, and compounding due to deferral can only have a positive impact on the after-tax return, as compared to the same income paid in a taxable account.6 The effect on returns that would otherwise be taxed at the preferential rate is more complex. For these returns, tax deferral comes at a price: when it does get taxed, it will be at the higher ordinary rate. There is potential for "negative tax arbitrage"—a conversion of lower-taxed income into higher-taxed income, which can lower the after-tax return. This runs counter to the goal of asset location, and needs to be considered very seriously. In particular, the risk is that LTCG (which we expect plenty of from stock funds) will be taxed like ordinary income. Under the basic assumption that in a taxable account, capital gains tax is already deferred until liquidation, favoring a TDA for an asset whose only source of return is LTCG is plainly harmful. There is no benefit from deferral, which you would have gotten anyway, and only harm from a higher tax rate. This logic supports the conventional wisdom that stocks belong in the taxable account. Not only do bonds benefit more from a TDA, the reasoning goes, but stocks are actually hurt by it! Again, reality is more complex. First, as already discussed, stocks do generate some return via dividends, and that portion of the return will benefit from tax deferral. This is obviously true for non-QDI dividends, already taxed as ordinary income, but QDI can benefit too. If the deferral period is long enough, the value of compounding will offset the hit from the higher rate at liquidation. Second, it is not accurate to assume that all capital gains tax will be deferred until liquidation in a taxable account. Rebalancing may realize some capital gains "prematurely" and this portion of the return could also benefit from tax deferral. Placing stocks in a TDA is a trade-off—one that must weigh the potential harm from negative rate arbitrage against the benefit of tax deferral. Valuing the latter means making assumptions about dividend yield and turnover. On top of that, the longer the investment period, the more tax deferral is worth. Kitces demonstrates that a dividend yield representing 25% of total return (at 100% QDI), and an annual turnover of 10%, could swing the calculus in favor of holding the stocks in a TDA, assuming a 30-year horizon.7 For foreign stocks with less than perfect QDI, we would expect the tipping point to come sooner. All of the above suggests that we should be wary of overloading a TDA with assets expected to generate substantial capital gains, if the time horizon is relatively short. However, the goal of this section is not to precisely define the circumstances under which stocks perform better in a TDA. Rather, it is to demonstrate that the problem defies a "rule of thumb" approach. Not all stocks are the same, and time horizon matters. The solution must optimize around these trade-offs. Returns in a Tax-Exempt Account (TEA) Investments in a Roth IRA or Roth 401(k) grow tax free, and are also not taxed upon liquidation. Since it eliminates all possible tax, a TEA presents a particularly valuable opportunity for maximizing after-tax return. The trade-off here is managing opportunity cost—every asset does better in a TEA, so how best to use its precious capacity? Clearly, a TEA is the most favorably taxed account. Conventional wisdom thus suggests that if a TEA is available, we use it to first place the least tax-efficient assets. But that approach is wrong. Everything Counts in Large Amounts—Why Expected Return Matters The powerful yet simple advantage of a TEA helps illustrate the limitation of focusing exclusively on tax efficiency when making location choices. Returns in a TEA escape all tax, whatever the rate or timing would have been, which means that an asset’s expected after-tax return equals its expected total return. A tax-inefficient asset is one that loses a relatively large portion of its annual return to taxes, whereas a tax-efficient one loses a relatively small portion. However, ranking assets in this way does not incorporate the absolute size of their returns. A small portion of a large return could benefit from sheltering more than a large portion of a small return. Even the least tax-efficient asset may not be the best candidate for permanent tax-avoidance, if its total return is expected to be relatively low. Savings from avoiding any annual tax do compound, but a small enough number will not amount to much. On the other hand, avoiding all tax on a large expected return may present a larger savings opportunity, even if that return is highly tax-efficient (taxed at liquidation, at the preferential rate). Putting this in concrete terms, when both a taxable account and a TEA are available, it may be worth putting a high-growth, low-dividend stock fund into the TEA, instead of a bond fund, even though the stock fund is vastly more tax-efficient. Not only that, but similar reasoning can apply to placement in a TDA as well, as long as the tax-efficient asset has a large enough expected return, and presents some opportunity for tax deferral (i.e., some portion of the return comes from dividends). In other words, an optimal asset location must consider both tax efficiency and expected return. Tax efficiency has something to say about the degree to which an asset will benefit from a qualified account, but the absolute amount of expected savings is what actually matters. Part III: Asset Location in Popular Culture To be sure, much like tax efficiency, "popular" is a relative concept. Still, much has been publicly written about asset location. The strategy is also (we assume) a topic of frequent rumor, conjecture, and innuendo. In this section, we look at existing approaches to asset location, and consider their advantages and limitations. But before diving into methodology, it is worth clearing up a few popular misconceptions. "The Tax Is Coming From Inside the Account!": Debunking Some Urban Legends Urban Legend 1: Asset location is a one-time process. Just set it and forget it. While an initial location may add some value, doing it properly is a continuous process, and will require adjustments in response to changing conditions. Note that overlaying asset location is not a deviation from a passive investing philosophy, because optimizing for location does not mean changing the overall asset allocation (the same goes for tax loss harvesting). Rick Ferri, a financial analyst and respected investing expert, has this to say: The problem with asset location is that nothing is static. Tax rates change, tax brackets change, tax preferences change, and on and on. What was a logical tax location one year may turn out to be a lousy one a few years later, but you're stuck in the one you have.8 Other things that will change, all of which should factor into an optimal methodology: expected returns (both the risk-free rate, and the excess return), dividend yields, QDI percentages, and most importantly, relative account balances. Contributions, rollovers, and conversions can increase qualified assets relative to taxable assets, continuously providing more room for additional optimization. Ferri is also making the point that future location adjustments may be limited if the assets we want to relocate out of the taxable account have appreciated substantially (and adjusting our asset location would not be worth the tax cost of realizing those gains). This is a legitimate consideration, but should not prevent us from optimizing around what we know today. A rigorous strategy should weigh the costs and benefits of a potential future adjustment. In particular, during one’s working years, a steady stream of deposits (as well as dividends) will provide constant opportunities to move closer to whatever the optimal location is at that time. Urban Legend 2: Taking advantage of asset location means you should contribute more to a particular qualified account than you otherwise would. Definitely not! Asset location should play no role in deciding which accounts to fund. It optimizes around account balances as it finds them, and is not concerned with which accounts should be funded in the first place. Just because the presence of a TEA makes asset location more valuable, does not mean you should contribute to a TEA, as opposed to a TDA. That decision is primarily a bet on how your tax rate today will compare to your tax rate in retirement. To hedge, some may find it optimal to make contributions to both a TDA and TEA (this is called "tax diversification"). While these decisions are out of scope for this paper, Betterment’s retirement planning tools can help clients with these choices. Urban Legend 3: Asset location has very little value if one of your accounts is relatively small. It depends. Asset location will not do much for investors with a very small taxable balance and a relatively large balance in only one type of qualified account, because most of the overall assets are already sheltered. However, a large taxable balance and a small qualified account balance (especially a TEA balance) presents a better opportunity. Under these circumstances, there may be room for only the least tax-efficient, highest-return assets in the qualified account. Sheltering a small portion of the overall portfolio can deliver a disproportionate amount of value. Urban Legend 4: Asset location has no value if you are investing in both types of qualified accounts, but not in a taxable account. Not so. A TEA offers significant advantages over a TDA. Zero tax is better than a tax deferred until liquidation. While tax efficiency (i.e. annual tax drag) plays no role in these location decisions, expected returns and liquidation tax do. The assets we expect to grow the most should be placed in a TEA, and doing so will plainly increase the overall after-tax return. There is an additional benefit as well. Required minimum distributions (RMDs) apply to TDAs but not TEAs. Shifting expected growth into the TEA, at the expense of the TDA, will mean lower RMDs, giving the investor more flexibility to control taxable income down the road. In other words, a lower balance in the TDA can mean lower tax rates in retirement, if higher RMDs would have pushed the retiree into a higher bracket. This potential benefit is not captured in our results. Urban Legend 5: Enough with the fancy talk. Bonds always go in the IRA, and that’s all there is to it. Possibly, but not necessarily. This commonly asserted rule is a simplification, and will not be optimal under all circumstances. It is discussed at more length below. Existing Approaches to Asset Location: Advantages and Limitations Optimizing for After-Tax Return While Maintaining Separate Portfolios One approach to increasing after-tax return on retirement savings is to maintain a separate, standalone portfolio in each account with roughly the same level of risk-adjusted return, but tailoring each portfolio somewhat to take advantage of the tax profile of the account. Effectively, this means that each account separately maintains the desired exposure to stocks, while substituting certain asset classes for others. Generally speaking, managing a fully diversified portfolio in each account means that there is no way to avoid placing some assets with the highest expected return in the taxable account. Based on the discussion above, it should be obvious that a strategy which completely rules out the possibility of sheltering such assets cannot be optimal. The presence of a TEA, which is unambiguously best for the highest growth assets, only underscores this limitation. This approach does include a valuable tactic, which is to differentiate the high-quality bonds component of the allocation, depending on the account they are held in. The allocation to the component is the same in each account, but in a taxable account, it is represented by municipal bonds which are exempt from federal tax (MUB), and in a qualified account, by taxable investment grade bonds (AGG). This variation is effective because it takes advantage of the fact that these two asset classes have very similar characteristics (expected returns, covariance and risk exposures) allowing them to play roughly the same role from an asset allocation perspective. Municipal bonds, however, are highly tax-efficient, and are very compelling in a taxable account. Taxable investment grade bonds have significant tax drag, and work best in a qualified account. Betterment has applied this substitution since 2014. As we shall see, this MUB/AGG substitution is incorporated into TCP’s methodology. The Basic Priority List For those looking to unevenly distribute a single portfolio across multiple account types with no help from software, a rule-based approach has obvious appeal. The presence of multiple assets, and a highly personal ratio of account balances make for a complex problem. Most DIY investors and professional advisors are not mathematicians, so tackling the optimization with maximum precision is not viable. In other words, when implemented manually, this is a strategy crying for a heuristic—a simple set of rules that will produce an asset location which is hopefully "good enough." The easiest way to determine "what goes where" is to have confidence that at least with respect to certain assets, "this goes there first." Armed with such conviction, the casual locator can start "filling up" the qualified account, prioritizing those assets which are perceived to benefit most from sheltering. Moving down the list requires only basic arithmetic—subtract the dollar amount allocated to an asset from the available balance, look to the next asset, and repeat until the qualified account is full (and what’s left goes in the taxable). That list, more often than not, is a ranking of assets based solely on tax efficiency. At one extreme you may have say, high-yield bonds, which generate all of their returns as dividends, taxed annually at the ordinary rate (high tax drag). At the other extreme would be say, U.S. small cap stocks—mostly capital gains, and the few dividends they do generate are QDI, taxed at the preferential rate (very little tax drag). Everything else goes in between, with bonds and stocks clustering together on opposite ends. This basic prioritization is the source for the conventional wisdom that "bonds go in the IRA." As one would expect, the desire to reduce complexity, if taken too far, eventually leads to suboptimal results. One immediately obvious exception is that municipal bonds are maximally tax-efficient, and belong in a taxable account. Still, other bonds are, in fact, highly tax-inefficient. Yet, as many have pointed out, in the current low-yield environment, bonds just do not return that much, so the potential savings are low. Is there a hidden opportunity cost to blindly prioritizing bonds in the qualified accounts, no matter what? "Smile" Like You Mean It Numerous experts have published research on how to best navigate the complex trade-offs discussed so far. The conclusion is more often than not: "It just depends." However, manual asset locators need an approach that is more sophisticated than prioritization by tax efficiency, while still being rule-based and thus easy to implement. Gobind Daryanani and Chris Cordaro sought to balance considerations around tax efficiency and expected return, and illustrated that when both are very low, location decisions with respect to those assets have very limited impact.9 That study inspired Michael Kitces, who leverages its insights into a more sophisticated approach to building a priority list.10 To visually capture the relationship between the two considerations, Kitces bends the one-dimensional list into a "smile." Asset Location Priority List The rendering is both effective, and delightfully simple. Assets with a high expected return that are also very tax-efficient go in the taxable account. Assets with a high expected return that are also very tax-inefficient go in the qualified accounts, starting with the TEA. The "smile" guides us in filling the accounts from both ends simultaneously, and by the time we get to the middle, whatever decisions we make with respect to those assets just "don’t matter" much. It’s clear why this heuristic is better than a straight ranking—plotting the assets in two dimensions allows the location decisions to factor in the interaction between two independent variables, both of which are important. Prioritizing with a "smile" means that the valuable real estate in the qualified accounts will not be occupied by assets that may have high tax drag, but very little to actually drag. However, Kitces augments the graph in short order, recognizing that the basic "smile" does not capture a third key consideration—the impact of liquidation tax. Because capital gains will eventually be realized in a taxable account, but not in a TEA, even a highly tax-efficient asset might be better off in a TEA, if its expected return is high enough. The next iteration of the "smile" illustrates this preference. Asset Location Priority List With Limited High Return Inefficient Assets A two-dimensional representation of a relationship between three variables immediately raises questions. Just how high must its return be, for a tax-efficient asset to bump a tax-inefficient asset out of the TEA? How high must its tax drag be, for that tax-inefficient asset to retain its tax-exempt perch? Unlike at the bottom of the smile, these are decisions that "matter," but the rules are no longer clear. Two dimensions are not enough! To push the optimization further, we need to revisit the limitation of "tax efficiency" as a metric. It is a poor measure for what we are actually seeking to maximize, which is after-tax return. Tax efficiency, as it is used in asset location discussions, is only concerned with annual tax drag in the taxable account. However, "liquidation tax drag" also exists, and varies across all accounts (moderate in the taxable, highest in a TDA, and absent in a TEA). In other words, we must also attempt to quantify "liquidation tax efficiency," but doing so is complex, because it involves all three accounts, whereas the accepted definition of tax efficiency described the taxable account only. We would need to derive an annualized after-tax return for each asset, in each account. This metric is driven by the expected return, but also incorporates both annual and liquidation tax, and is sensitive to time horizon. Suddenly, we are quite far from rules of thumb, lists, and graphs. This is not to say that investors taking advantage of a sophisticated heuristic, whether through their own efforts, or with the help of a skilled advisor, will not select a beneficial asset location. Far from it. As Kitces summarizes, nailing the corners of his "smile" and not worrying about the middle will undoubtedly add value: "Just get those two right and you’ve done yourself a ton of good."11 We wholeheartedly agree. With automation, we should be able to do even better. Too many important factors cannot be accounted for with a prioritization approach. However many rules we devise, we'll land on "good enough" when the answer is not apparent. Only a mathematical optimization can squeeze maximum benefit from a given set of inputs. Part IV: TCP Methodology By now, it should be clear that there is no one-size-fits-all asset location for every set of inputs. Some circumstances apply to all investors, but shift through time—the expected return of each asset class (which combines separate assumptions for the risk-free rate and the excess return), as well as dividend yields, QDI percentages, and tax laws. Other circumstances are personal—which accounts the client has, the relative balance of each account, and the client’s time horizon. Solving for multiple variables while respecting defined constraints is a problem that can be effectively solved by linear optimization. This method is used to maximize some value, which is represented by a formula called an "objective function." What we seek to maximize is the after-tax value of the overall portfolio at the end of the time horizon. We get this number by adding together the expected after-tax value of every asset in the portfolio, but because each asset can be held in more than one account, each portion must be considered separately, by applying the tax rules of that account. We must therefore derive an account-specific expected after-tax return for each asset. Deriving Account-Specific After-Tax Return To define the expected after-tax return of an asset, we first need its total return (i.e., before any tax is applied). The total return is the sum of the risk-free rate (same for every asset) and the excess return (unique to every asset). Betterment derives excess returns using the Black-Litterman model as a starting point. This common industry method involves analyzing the global portfolio of investable assets and their proportions, and using them to generate forward-looking expected returns for each asset class. Next, we must reduce each total return into an after-tax return.12 The immediate problem is that for each asset class, the after-tax return can be different, depending on the account, and for how long it is held. In a TEA, the answer is simple—the after-tax return equals the total return—no calculation necessary. In a TDA, we project growth of the asset by compounding the total return annually. At liquidation, we apply the ordinary rate to all of the growth.13 We use what is left of the growth after taxes to derive an annualized return, which is our after-tax return. In a taxable account, we need to consider the dividend and capital gain component of the total return separately, with respect to both rate and timing. We project growth of the asset by taxing the dividend component annually at the ordinary rate (or the preferential rate, to the extent that it qualifies as QDI) and adding back the after-tax dividend (i.e., we reinvest it). Capital gains are deferred, and the LTCG is fully taxed at the preferential rate at the end of the period. We then derive the annualized return based on the after-tax value of the asset.14 Note that for both the TDA and taxable calculations, time horizon matters. More time means more value from deferral, so the same total return can result in a higher annualized after-tax return. Additionally, the risk-free rate component of the total return will also depend on the time horizon, which affects all three accounts. William Reichenstein and William Meyer express a key insight into what this really means: "The same asset, whether stock or bond, is effectively a different asset when held in a TDA or taxable account."15 Because we are accounting for the possibility of a TEA, as well, we actually have three distinct after-tax returns, and thus each asset effectively becomes three assets, for any given time horizon (which is specific to each Betterment customer). The Objective Function To see how this comes together, we first consider an extremely simplified example. Let’s assume we have a taxable account, both a traditional and Roth account, with $50,000 in each one, and a 30-year horizon. Our allocation calls for only two assets: 70% equities (stocks) and 30% fixed income (bonds). With a total portfolio value of $150,000, we need $105,000 of stocks and $45,000 of bonds. 1. These are constants whose value we already know (as derived above). req,tax is the after-tax return of stocks in the taxable account, over 30 years req,trad is the after-tax return of stocks in the traditional account, over 30 years req,roth is the after-tax return of stocks in the Roth account, over 30 years rfi,tax is the after-tax return of bonds in the taxable account, over 30 years rfi,trad is the after-tax return of bonds in the traditional account, over 30 years rfi,roth is the after-tax return of bonds in the Roth account, over 30 years 2. These are the values we are trying to solve for (called "decision variables". xeq,tax is the amount of stocks we will place in the taxable account xeq,trad is the amount of stocks we will place in the traditional account xeq,roth is the amount of stocks we will place in the Roth account xfi,tax is the amount of bonds we will place in the taxable account xfi,trad is the amount of bonds we will place in the traditional account xfi,roth is the amount of bonds we will place in the Roth account 3. These are the constraints which must be respected. All positions for each asset must add up to what we have allocated to the asset overall. All positions in each account must add up to the available balance in each account. xeq,tax + xeq,trad + xeq,roth = 105,000 xfi,tax + xfi,trad + xfi,roth = 45,000 xeq,tax + xfi,tax = 50,000 xeq,trad + xfi,trad = 50,000 xeq,roth + xfi,roth = 50,000 4. This is the objective function, which uses the constants and decision variables to express the after-tax value of the entire portfolio, represented by the sum of six terms (the after-tax value of each asset in each of the three accounts). maxx req,taxxeq,tax + req,tradxeq,trad + req,rothxeq,roth + rfi,taxxfi,tax + rfi,tradxfi,trad + rfi,rothxfi,roth Linear optimization turns all of the above into a complex geometric representation, and mathematically closes in on the optimal solution. It assigns values for all decision variables in a way that maximizes the value of the objective function, while respecting the constraints. Accordingly, each decision variable is a precise instruction for how much of which asset to put in each account. If a variable comes out as zero, then that particular account will contain none of that particular asset. An actual Betterment portfolio can have up to twelve asset classes,16 depending on the allocation. That means TCP must effectively handle up to 36 "assets", each with its own after-tax return. However, the full complexity behind TCP goes well beyond increasing assets from two to twelve. Updated constants and constraints will trigger another part of the optimization, which determines what TCP is allowed to sell, in order to move an already coordinated portfolio toward the newly optimal asset location, while minimizing taxes. Reshuffling assets in a TDA or TEA is "free" in the sense that no capital gains will be realized.17 In the taxable account, however, TCP will attempt to move as close as possible towards the optimal asset location without realizing capital gains. The full optimization on an actual set of accounts must solve for hundreds of variables subject to hundreds of constraints, and reproducing the full objective function would take many pages. Good news! The computer will do it. Even better news: Because the calculation is automated, it can run every time any of our constants or constraints change, using every opportunity to either maintain, or move closer to the optimal asset location. Expected returns will periodically be updated, either because the risk-free rate has been adjusted, or because new excess returns have been derived via Black-Litterman. Future cash flows may be even more material. Additional funds in one or more of the accounts could significantly alter the constraints which define the size of each account, and the target dollar allocation to each asset class. Such events (including dividend payments, subject to a de minimis threshold) will trigger a recalculation, and potentially a reshuffling of the assets. Cash flows, in particular, can be a challenge for those managing their asset location manually. Inflows to just one account (or to multiple accounts in unequal proportions) create a tension between optimizing asset location and maintaining asset allocation, which is hard to resolve without mathematical precision. To maintain the overall asset allocation, each position in the portfolio must be increased pro-rata. However, some of the additional assets we need to buy "belong" in other accounts from an asset location perspective, even though new cash is not available in those accounts. If the taxable account can only be partially reshuffled due to built-in gains, we must choose either to move farther away from the target allocation, or the target location.18 With linear optimization, our preferences can be expressed through additional constraints, weaving these considerations into the overall problem. When solving for new cash flows, TCP penalizes allocation drift higher than it does location drift—another complexity not represented by the simplified objective function above. All the Math in the World Cannot Predict the Future We can reason our way into these choices, though some may be less intuitive than others. We can debate the many assumptions discussed above—changing any of them may impact these decisions. Linear optimization is only as good as its inputs, but extremely effective within that framework. Still, even linear optimization may not land on what will turn out to have been the optimal asset location, in retrospect. Events nobody can predict make this improbable, especially over a long horizon. But that is no reason not to select an optimized asset location based on what is known today, adjusting when new information becomes available. When asset location is automated, these adjustments are made centrally, and seamlessly propagated across all accounts. This makes the ongoing component of location management extremely efficient and consistent. However, it cannot be emphasized enough that expected returns (the key input into TCP, and portfolio management generally) are educated guesses at best. No matter how airtight the math, reasonable people will disagree on the "correct" way to derive them. The future may not cooperate, making a mockery of our best-laid plans, especially in the short-term. There is no guarantee that any particular asset location will add the most value, or even any value at all. But given decades, our certainty in the outcome grows. Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework To test the output of the linear optimization method, we turned to a rigorous Monte Carlo testing framework,19 built entirely in-house by Betterment’s experts. The forward-looking simulations model the behavior of the TCP strategy down to the individual lot level. We simulate the paths of these lots, accounting for dividend reinvestment, rebalancing, and taxation. As far as we are aware, this level of analysis for an asset location strategy has never been made public in the investment management industry. The forward market scenarios were derived from parametric sampling of a multivariate Gaussian distribution, where the mean was estimated using an equilibrium forecast method. Each set of assumptions was subject to at least 1,000 market scenarios. The covariance matrix was generated from historical returns. Forward dividends were simulated by sampling from a univariate Gaussian distribution, with the first and second moments derived from historical data, and with the same current dividend frequency. For QDI, we assumed the percentages reported by funds for 2015, over the whole period. The simulations applied Betterment’s rebalancing methodology, which corrects drift from the target asset allocation in excess of 3%, but stops short of ever realizing STCG. Betterment’s management fees were assessed in all accounts, and ongoing taxes were paid annually from the taxable account. All taxable sales first realized available losses before touching LTCG. The simulations assumed no additional cash flows other than dividends. This is not because we do not expect them to happen. Rather, it is because making assumptions around these very personal circumstances does nothing to isolate the benefit of TCP specifically. Asset location is driven by the relative sizes of the accounts, and cash flows will change these ratios, but the timing and amount is highly specific to the individual.20 Avoiding the need to make specific assumptions here helps keep the analysis more universal. We used equal starting balances for the same reason.21 R&D in the Cloud: Harder, Better, Faster, Stronger Betterment is hosted by Amazon Web Services (AWS), which allows us to dynamically increase or decrease the computing power available to our software in response to variable demand. The purpose of this infrastructure is to provide a consistently robust experience to customers in a scalable and efficient manner. However, an added benefit is that our R&D team has access to a platform that can temporarily support an extremely demanding computing load. Tracking positions at the tax lot level means accounting for basis on the fly, even for small trades, which Betterment executes using fractional shares. Each taxable sale is processed through our TaxMin lot selection algorithm, and all transactions (including purchases in qualified accounts) are run through our wash sale avoidance algorithms, which are described in our TLH+ white paper. All of this means that a 30-year simulation runs for multiple hours. AWS allows us to spin up thousands of servers simultaneously, each running a different market scenario in parallel. Each set of assumptions (combination of accounts, stock allocation) was tested under at least 1,000 market scenarios. The research presented here is the product of over 150,000 computer-hours, at times running on up to 3,000 AWS servers simultaneously. For every set of assumptions, we ran each market scenario while managing each account as a standalone (uncoordinated) Betterment portfolio as the benchmark.22 We then ran the same market scenarios with TCP enabled. In both cases, we calculated the after-tax value of the aggregate portfolio after full liquidation at the end of the period.23 Then, for each market scenario, we calculated the after-tax annualized internal rates of return (IRR) and subtracted the benchmark IRR from the TCP IRR. That delta represents the incremental tax alpha of TCP for that scenario. The median of those deltas across all market scenarios is the estimated tax alpha we present below for each set of assumptions. It is important to note that these results do not express the value of Betterment’s management vis-à-vis some particular non-Betterment investing strategy. Rather, they measure the incremental tax alpha of TCP, as compared to Betterment’s management of its uncoordinated portfolios in the same accounts. Still, these results are a reasonable measure of the effectiveness of Betterment’s implementation of asset location as applied to a passive investing strategy. Part VI: Who’s Up With TCP? Our Results If you have read this far, you are truly a tax management paladin, and our hats are off to you. We should hang out sometime. If you skipped ahead to get here, that’s okay too, as long as you promise to read the "Special Considerations" section, and the disclosures. All of the following projections assume a 30-year horizon, with an initial balance of $50,000 in each account. However, the specific tax rates matter when actually calculating tax alpha. We use the following assumptions, with deductibility of state taxes incorporated into the federal rate: "Moderate" tax rate: 28% federal tax bracket, the capital gains rates corresponding that bracket, and a state tax rate of 9.3% (the CA bracket corresponding to the 28% federal bracket). "High" tax rate: assumes 39.6%, the highest federal bracket, the capital gains rates corresponding to that bracket, and a state tax rate of 13.3% (the highest bracket in CA). Asset location for taxpayers in a 15% federal bracket or lower is driven by substantially different considerations, which are discussed below under "Special Considerations." The first set of results assumes a taxpayer subject to the Moderate tax rate both during the period, and in liquidation. 1. Three Accounts: TAX/TRAD/ROTH (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.82% 70% Stocks 0.48% 90% Stocks 0.27% 2. Two Accounts: TAX/TRAD (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.51% 70% Stocks 0.22% 90% Stocks 0.10% 3. Two Accounts: TAX/ROTH (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.69% 70% Stocks 0.43% 90% Stocks 0.29% In the next set, we project tax alpha for a taxpayer subject to the highest rates. However, in this case, we want to use different rates for accumulation and liquidation, for a more realistic scenario. It is unlikely that a taxpayer in the 39.6% bracket during the working years will not be able to structure their taxable income in retirement to reduce the bracket substantially. We assume a Moderate rate in retirement, which applies on up to $230,000 of taxable income for a married couple filing jointly. 4. TAX/TRAD/ROTH (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.77% 70% Stocks 0.49% 90% Stocks 0.34% 5. Two Accounts: TAX/TRAD (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.54% 70% Stocks 0.27% 90% Stocks 0.20% 6. Two Accounts: TAX/ROTH (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.71% 70% Stocks 0.46% 90% Stocks 0.38% More Bonds, More Alpha The clearest pattern is that a higher allocation to bonds leads to a dramatically higher benefit across the board. This makes sense—the heavier your allocation to tax-inefficient assets, the more asset location can do for you. To be extremely clear: this is not a reason to select a lower allocation to stocks! Over the long-term, we expect a higher stock allocation to return more (because it’s riskier), both before, and after tax. These are measurements of the additional return due to TCP, which say nothing about the absolute return of the asset allocation itself. Conversely, a very high allocation to stocks shows a smaller (though still real) benefit. However, younger customers invested this aggressively should gradually reduce risk as they get closer to retirement (to something more like 50% stocks). Looking to the 70% stock allocation is therefore an imperfect but reasonable way to generalize the value of the strategy over a 30-year period. More Roth, More Alpha Another pattern is that the presence of a Roth makes the strategy more valuable. This also makes sense—a taxable account and a TEA are on opposite ends of the "favorably taxed" spectrum, and having both presents the biggest opportunity for TCP’s "account arbitrage." But again, this benefit should not be interpreted as a reason to contribute to a TEA over a TDA, or to shift the balance between the two via a Roth conversion. These decisions are driven by other considerations. TCP’s job is to optimize the relative balances as it finds them. Enabling TCP On Existing Taxable Accounts All of these results assume that TCP is enabled before the taxable account is funded, meaning that the initial location can be optimized without the need to sell potentially appreciated assets. A Betterment customer with an existing taxable account who enables TCP should not expect the full incremental benefit we project here, to the extent that assets with built-in capital gains need to be sold to achieve the optimal location. This is because TCP conservatively prioritizes avoiding a certain tax today, over potentially reducing tax in the future. However, the optimization is performed every time there is a deposit (or dividend) to any account. With future cash flows, the portfolio will move closer to whatever the optimal location is determined to be at the time of the deposit. Part VII: Special Considerations Low Bracket Taxpayers: Beware Taxation of investment income is substantially different for those who qualify for a marginal tax bracket of 15% or below. To illustrate, we have modified the chart from Part II to apply to such low bracket taxpayers.   Dividends Capital Gains Ordinary Rate N/A Any security held for a year or less (STCG) Preferential Rate N/A N/A No Tax Qualified dividends from any security are not taxed Any security held for a year or more is not taxed (LTCG) TCP is not designed for these investors. Optimizing around this tax profile would reverse many assumptions behind TCP’s methodology. Municipal bonds no longer have an advantage over other bond funds. The arbitrage opportunity between the ordinary and preferential rate is gone. In fact, there’s barely tax of any kind. It is quite likely that such investors would not benefit much from TCP, and may even reduce their overall after-tax return. If the low tax bracket is temporary, TCP over the long-term may still make sense.  Also note that some combinations of account balances can, in certain circumstances, still add tax alpha for investors in low tax brackets. One example is when an investor only has traditional and Roth IRA accounts, and no taxable accounts being tax coordinated. Low bracket investors should very carefully consider whether TCP is suitable for them. As a general rule, we do not recommend it. Potential Problems with Coordinating Accounts Meant for Different Time Horizons We began with the premise that asset location is sensible only with respect to accounts that are generally intended for the same purpose. This is crucial, because unevenly distributing assets will result in asset allocations in each account that are not tailored towards the overall goal (or any goal at all). This is fine, as long as we expect that all coordinated accounts will be available for withdrawals at roughly the same time (e.g. at retirement). Only the aggregate portfolio matters in getting there. However, uneven distributions are less diversified. Temporary drawdowns (e.g., the 2008 financial crisis) can mean that a single account may drop substantially more than the overall coordinated portfolio. If that account is intended for a short-term goal, it may not have a chance to recover by the time you need the money. Likewise, if you do not plan on depleting an account during your retirement, and instead plan on leaving it to be inherited for future generations, arguably this account has a longer time horizon than the others and should thus be invested more aggressively. In either case, We do not recommend managing accounts with materially different time horizons as a single portfolio. For a similar reason, you should avoid applying asset location to an account that you expect will be long-term, but one that you may look to for emergency withdrawals. For example, a Safety Net Goal should never be managed by TCP. Large Upcoming Transfers/Withdrawals If you know you will be making large transfers in or out of your tax-coordinated accounts, you may want to delay enabling our tax coordination tool until after those transfers have occurred. This is because large changes in the balances of the underlying accounts can necessitate rebalancing, and thus may cause taxes. With incoming deposits, we can intelligently rebalance your accounts by purchasing asset classes that are underweight. But when large withdrawals or transfers out are made, despite Betterment’s intelligent management of executing trades, some taxes can be unavoidable when rebalancing to your overall target allocation. The only exception to this rule is if the large deposit will be in your taxable account instead of your IRAs. In that case, you should enable tax-coordination before depositing money into the taxable account. This is so our system knows to tax-coordinate you immediately. The goal of tax coordination is to reduce the drag taxes have on your investments, not cause additional taxes. So if you know an upcoming withdrawal or outbound transfer could cause rebalancing, and thus taxes, it would be prudent to delay enabling tax coordination until you have completed those transfers. Mitigating Behavioral Challenges Through Design There is a broader issue that stems from locating assets with different volatility profiles at the account level, but it is behavioral. Uncoordinated portfolios with the same allocation move together. Asset location, on the other hand, will cause one account to dip more than another, testing an investor’s stomach for volatility. Those who enable TCP across their accounts should be prepared for such differentiated movement. Rationally, we should ignore this—after all, the overall allocation is the same—but that is easier said than done. Rick Ferri has an interesting example of how this played out during the last big downturn: "[T]here is a hidden risk with having different allocations in taxable versus non-taxable, and we saw this risk turn into reality during 2008 and early 2009. A few clients terminated their higher risk taxable portfolio because that specific portfolio was losing more money than the more conservative non-taxable portfolio. In other words, they separated their portfolios in their mind and compared returns rather than looking at the big picture."24 This is an important consideration, and should not be ignored. A good advisor should seek to maximize a client’s returns net of tax, fees, and behavior. So while this effect is real, we believe that intelligent product design can mitigate it somewhat for the modern investor. Clients using a digital investment service can access their balance and returns in real-time, and in our experience, rely far less on traditional statements, which are account-specific. Generally, this is behaviorally undesirable: an unavoidable cost of online investing. In this case, however, it presents an opportunity. App design has more latitude in presenting information than a statement does. A well-designed interface can surface aggregate performance only, nudging the client towards the "big picture," and deprioritizing counterproductive information.25 So while a client can still access each account’s balance and infer account-level performance, behaviorally sensitive UX can make an impact on what clients focus on. How TCP Interacts with Tax Loss Harvesting+ Asset location is highly compatible with tax loss harvesting. While the latter derives value from the taxable account only, both work in tandem to improve after-tax return. The reason they work well together is that both derive their benefit without disturbing the desired asset allocation. Operational Compatibility Betterment’s implementations of both strategies are especially compatible, because of certain design decisions made when building TLH+, Betterment’s automated tax loss harvesting service. For that strategy, effective wash sale management was paramount. Special attention was paid to avoiding a type of wash sale that permanently disallows a realized loss. This can happen when a security is sold at a loss in a taxable account, and a substantially identical security is purchased in a qualified account within the wash sale window. TLH+ was designed around a "tertiary ticker" system, which ensures that no purchase in an IRA or 401(k) managed by Betterment will interfere with a harvested loss in a Betterment taxable account. A sale in a taxable account, and a subsequent repurchase of the same asset class in a qualified account would be incidental for accounts managed as separate portfolios. Under TCP, however, we expect this to occasionally happen by design. When "relocating" assets, either during initial setup, or as part of ongoing optimization, TCP will sell an asset class in one account, and immediately repurchase it in another. The tertiary ticker system allows this reshuffling to happen seamlessly, while protecting any tax losses that are realized in the process. Conceptualizing Blended Performance Estimating the benefit of TCP and TLH on a standalone basis already requires making many generalized assumptions. However, modeling their combined benefit is even more difficult to generalize. Simulations of both strategies must be at the tax lot level, and combined performance is highly path dependent. They are expected to add more value together than either one would on its own, but simply adding up the two standalone estimates is clearly inaccurate, and a better answer is elusive. TCP will affect the composition of the taxable account in ways that are hard to predict, because its decisions will be driven by changes in relative balances among the accounts. Meanwhile, the weight of specific asset classes in the taxable account is a material predictor of the potential value of TLH (more volatile assets should offer more harvesting opportunities). The precise interaction between the two strategies is far more dependent on personal circumstances, such as today’s account balance ratios and future cash flow patterns, than on generally applicable inputs like asset class return profiles and tax rules. These dynamics are best understood as a hierarchy. Asset allocation comes first, and determines what mix of asset classes we should stick to overall. Asset location comes second, and continuously generates tax alpha across all coordinated accounts, within the constraints of the overall portfolio. Tax loss harvesting comes third, and looks for opportunities to generate tax alpha from the taxable account only, within the constraints of the asset mix dictated by asset location for that account. Decision logic at each tier is encapsulated, following the architectural principle of "information hiding." To illustrate in concrete terms: TCP knows only that the overall allocation must be 70% stocks, but should not be concerned with what drove that determination. Similarly, TLH does not need to know why the taxable account must hold (for example) municipal bonds and domestic equities only. Both seek to optimize after-tax return within their domain, playing the hand they are dealt. To sum up, it is worth highlighting why asset location sets the parameters for tax loss harvesting, and not the other way around. TLH is most effective in the first several years after an initial deposit to a taxable account. Over decades, however, we expect it to generate value only from subsequent deposits and dividend reinvestments. Eventually, even a substantial dip is unlikely to bring the market price below the purchase price of the older tax lots. Meanwhile, TCP continues to deliver tax alpha over the entire balance of all three accounts for the entire holding period. Conclusion An investment strategy intended to maximize the after-tax value of a portfolio should focus on increasing annualized after-tax return. Traditional approaches to asset location are concerned with prioritizing assets in certain accounts based on their relative "tax efficiency", with the objective of sheltering income from annual tax. This narrow focus ignores numerous factors which affect annualized after-tax return, but are hard to account for without a mathematically rigorous approach. To reach its potential, an optimal asset location methodology must incorporate these realities, which include liquidation tax, time horizon, expected total return, and the actual composition of each expected return. Automation provides us with an opportunity to tackle these complexities. Betterment’s TCP considers both generally applicable inputs and customer-specific circumstances when optimizing an asset location for each set of accounts. TCP’s reliance on linear optimization makes it a "living implementation" of asset location. As material assumptions change, TCP can be easily adjusted across the entire customer base, without the need to rewrite its fundamental rules. Accordingly, the service can optimize after-tax returns for Betterment’s customers based on today’s expectations, without sacrificing operational flexibility, which will be utilized in the years to come. Addendum As of May 2020, for customers who indicate that they’re planning on using a Health Savings Account (HSA) for long-term savings, we allow the inclusion of their HSA in their Tax-Coordinated Portfolio. If an HSA is included in a Tax-Coordinated Portfolio, we treat it essentially the same as an additional Roth account. This is because funds within an HSA grow income tax-free, and withdrawals can be made income tax-free for medical purposes. With this assumption, we also implicitly assume that the HSA will be fully used to cover long-term medical care spending. The tax alpha numbers presented above have not been updated to reflect the inclusion of HSAs, but remain our best-effort point-in-time estimate of the value of TCP at the launch of the feature. As the inclusion of HSAs allows even further tax-advantaged contributions, we contend that the inclusion of HSAs is most likely to additionally benefit customers who enable TCP. 1"Boost Your After-Tax Investment Returns." Susan B. Garland. Kiplinger.com, April 2014. 3Pg. 13, The Kitces Report. March/April 2014. 4This does not include withdrawals or customer-directed allocation changes. If these are substantial enough, realizing STCG may be unavoidable. In such cases, Betterment customers are notified before they confirm their instruction, via Tax Impact Preview. 5But see "How IRA Withdrawals In The Crossover Zone Can Trigger The 3.8% Medicare Surtax," Michael Kitces, July 23, 2014. 6It is worth emphasizing that asset location optimizes around account balances as it finds them, and has nothing to say about which account to fund in the first place. Asset location considers which account is best for holding a specified dollar amount of a particular asset. However, contributions to a TDA are tax-deductible, whereas getting a dollar into a taxable account requires more than a dollar of income. 7Pg. 5, The Kitces Report. January/February 2014. 8 "Problems with Reichenstein's "Asset Location Decision Revisted." Bogleheads.org. Nov. 10, 2013. 9Daryanani, Gobind, and Chris Cordaro. 2005. "Asset Location: A Generic Framework for Maximizing After-Tax Wealth." Journal of Financial Planning (18) 1: 44–54. 10The Kitces Report, March/April 2014. 11 "Minimizing the Tax Drag on Your Investments," By Carla Fried. The New York Times, Feb. 7, 2014. 12While the significance of ordinary versus preferential tax treatment of income has been made clear, the impact of an individual’s specific tax bracket has not yet been addressed. Does it matter which ordinary rate, and which preferential rate is applicable, when locating assets? After all, calculating the after-tax return of each asset means applying a specific rate. It is certainly true that different rates should result in different after-tax returns. However, we found that while the specific rate used to derive the after-tax return can and does affect the level of resulting returns for different asset classes, it makes a negligible difference on resulting location decisions. The one exception is when considering using very low rates as inputs (the implication of which is discussed under "Special Considerations"). This should feel intuitive: Because the optimization is driven primarily by the relative size of the after-tax returns of different asset classes, moving between brackets moves all rates in the same direction, generally maintaining these relationships monotonically. The specific rates do matter a lot when it comes to estimating the benefit of the asset location chosen, so rate assumptions are laid out in the "Results" section. In other words, if one taxpayer is in a moderate tax bracket, and another in a high bracket, their optimal asset location will be very similar and often identical, but the high bracket investor may benefit more from the same location. 13In reality, the ordinary rate is applied to the entire value of the TDA, both the principal (i.e., the deductible contributions) and the growth. However, this will happen to the principal whether we use asset location or not. Therefore, we are measuring here only that which we can optimize. 14TCP today does not account for the potential benefit of a foreign tax credit (FTC). The FTC is intended to mitigate the potential for double taxation with respect to income that has already been taxed in a foreign country. The scope of the benefit is hard to quantify and its applicability depends on personal circumstances. All else being equal, we would expect that incorporating the FTC may somewhat increase the after-tax return of certain asset classes in a taxable account—in particular developed and emerging markets stocks. If maximizing your available FTC is important to your tax planning, you should carefully consider whether TCP is the optimal strategy for you. 15Note that Reichenstein and Meyer develop this concept to optimize asset allocation—an approach known as "after-tax asset allocation." They stress that pre-tax contributions to TDAs are "partnerships", and the government is effectively a minority partner, with an interest in part of the return and principal. This view has implications for what the asset allocation should be, when factoring in liquidation tax. After-tax asset location prioritizes allocation over after-tax return, and is not without its detractors. TCP today does not optimize for after-tax allocation. 16One component of the portfolio gets special treatment, as previewed in an earlier section. The overall asset allocation treats high-quality bonds as one asset class. However, when solving for this asset class, the optimizer uses MUB’s return for the after-tax return in the taxable account, and AGG’s return for the after-tax return in the qualified accounts. The resulting decision variables tell us the dollar value of high-quality bonds that goes in each account, but the actual purchases follow the same split—MUB in the taxable, AGG in the qualified. The sum of the MUB position and AGG positions will equal the overall allocation to high-quality bonds. 17Standard market bid-ask spread costs will still apply. These are relatively low, as Betterment considers liquidity as a factor in its investment selection process. Betterment customers do not pay for trades. 18Additionally, in the interest of making interaction with the tool maximally responsive, certain computationally demanding aspects of the methodology were simplified for purposes of the tool only. This could result in a deviation from the target asset location imposed by the TCP service in an actual Betterment account. 19Another way to test performance is with a backtest on actual market data. One advantage of this approach is that it tests the strategy on what actually happened. Conversely, a forward projection allows us to test thousands of scenarios instead of one, and the future is unlikely to look like the past. Another limitation of a backtest in this context—sufficiently granular data for the entire Betterment portfolio is only available for the last 15 years. Because asset location is fundamentally a long-term strategy, we felt it was important to test it over 30 years, which was only possible with Monte Carlo. Additionally, Monte Carlo actually allows us to test tweaks to the algorithm with some confidence, whereas adjusting the algorithm based on how it would have performed in the past is effectively a type of "data snooping". 20In simulations, as in the actual product, Betterment uses cash flows to purchase underweight assets first, helping reduce portfolio drift and reducing the likelihood that a taxable sale will be required to rebalance. This will increase the after-tax return both for TCP, and for uncoordinated accounts baseline. However, note that when accounts are coordinated, there is a higher likelihood that taxable sales can be avoided. Because we are now managing a single portfolio, TCP will make whatever use it can of the qualified accounts to reduce overall drift, and to the extent that the overweight asset is available in a qualified account, it will sell that position. For all transactions, the algorithms have a preference for correcting allocation drift first, but will attempt to optimize for location as part of the same transaction, if possible. 21That said, the strategy is expected to change the relative balances dramatically over the course of the period, due to unequal allocations. We expect a Roth balance in particular to eventually outpace the others, since the optimization will favor assets with the highest expected return for the TEA. This is exactly what we want to happen. 22For the uncoordinated taxable portfolio, we assume an allocation to municipal bonds (MUB) for the high-quality bonds component, but use investment grade taxable bonds (AGG) in the uncoordinated portfolio for the qualified accounts. While TCP makes use of this substitution, Betterment has offered it since 2014, and we want to isolate the additional tax alpha of TCP specifically, without conflating the benefits. 23Full liquidation of a taxable or TDA portfolio that has been growing for 30 years will realize income that is guaranteed to push the taxpayer into a higher tax bracket. We assume this does not happen, because in reality, a taxpayer in retirement will make withdrawals gradually. The strategies around timing and sequencing decumulation from multiple account types in a tax-efficient manner are out of scope for this paper. 24https://www.bogleheads.org/forum/viewtopic.php?t=98662 25Since inception, Betterment has never displayed daily performance of individual ETFs in a portfolio, and has generally de-emphasized daily performance of a portfolio, since focusing on short-term volatility is not productive, and instead increases the probability of suboptimal investor behavior. Instead, the interface was designed to emphasize information that an investor can and should act on—such as an indication of whether the portfolio is on track to reaching its specified goal, and if not, what can be done to put it back on track. Authors Boris Khentov, J.D., is VP of Operations and Legal Counsel at Betterment. He has a B.A. in Computer Science from Harvard University and a J.D. from Northwestern University School of Law. Prior to Betterment, Boris was a software engineer at Antenna Software, and practiced tax and capital markets law at Cleary Gottlieb Steen & Hamilton LLP. Boris helped oversee the development of Tax-Coordinated Portfolio, and wrote so very many words. No capital gains were realized in the writing of this paper. Rukun Vaidya is a Product Manager at Betterment. He has a degree in Operations Research from Cornell University. Prior to Betterment, Ruk spent five years performing risk research at Highbridge Capital, where he focused on statistical arbitrage, quantitative macro, and quantitative commodities. As the lead Product Manager for Tax-Coordinated Portfolio, Ruk conceived its methodology and led the implementation team. Ruk had a joke in here, but it did not make it through compliance. Lisa Huang, Ph.D., is Head of Quantitative Analysis & Research at Betterment. She holds a degree in mathematics and biochemistry from UCLA, and a Ph.D. in theoretical physics from Harvard University. Prior to Betterment, Lisa was a quantitative strategist at Goldman Sachs, leading research collaborations and building models for fixed income strategies. She is the brains behind the "Cloud Ferrari" that is Betterment’s Monte Carlo performance testing framework. Lisa is always right, especially when the problem is so hard that everyone else barely has a clue. Additional References Berkin. A. "A Scenario Based Approach to After-Tax Asset Allocation." 2013. Journal of Financial Planning. Jaconetti, Colleen M., CPA, CFP®. Asset Location for Taxable Investors, 2007. https://personal.vanguard.com/pdf/s556.pdf. Poterba, James, John Shoven, and Clemens Sialm. "Asset Location for Retirement Savers." November 2000. https://faculty.mccombs.utexas.edu/Clemens.Sialm/PSSChap10.pdf. Reed, Chris. "Rethinking Asset Location - Between Tax-Deferred, Tax-Exempt and Taxable Accounts." Accessed 2015. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2317970. Reichenstein, William, and William Meyer. "The Asset Location Decision Revisited." 2013. Journal of Financial Planning 26 (11): 48–55. Reichenstein, William. 2007. "Calculating After-Tax Asset Allocation is Key to Determining Risk, Returns, and Asset Location." Journal of Financial Planning (20) 7: 44–53. Disclosures The value provided by Tax-Coordinated Portfolio (TCP) will vary depending on each investor’s personal circumstances. Investors who have a short time horizon may get little to no value from the asset location strategy employed by TCP. Under certain circumstances, investors could conceivably even decrease their after-tax returns by enabling TCP. As a general matter, asset location strategies like the one implemented by TCP distribute assets unevenly across multiple accounts based on the varying return profiles of each asset (separately considering the potential for capital appreciation and dividend yield). These figures are "expected returns"—projections for what future returns might be. While these figures are empirically derived (using the Black-Litterman method as a starting point) they are still speculative, and actual returns will differ year-to-year, often substantially. Therefore, while the reasonable expectation may be that asset A will pay more dividends than asset B (and/or appreciate more than asset B), the opposite could happen in any given year, or across a number of years, such that asset location decisions based on differing expectations do not maximize after-tax returns. The longer the investing period, the more likely it is that the relative performance of the various assets in the portfolio will converge on what is expected. Shorter periods, however, are more likely to produce unexpected results. Asset location seeks to place assets with higher expected returns into tax-advantaged accounts. Therefore, toward the end of the accumulation phase, an investor should expect his or her tax-advantaged accounts to have a higher balance than they otherwise would have had (and the taxable retirement account to have a lower balance than it would have had, had an asset location strategy not been deployed). While under most circumstances, more growth in a tax-advantaged account (in exchange for less growth in a taxable account) is desirable, there are potential trade-offs which should be considered. For instance, tax-advantaged accounts incur penalties for early withdrawal, so to the extent that access to funds prior to retirement becomes necessary, liquidity may come at a higher cost for a portion of funds that might otherwise be accessible penalty-free (had that appreciation taken place in the taxable account instead). If the tax-advantaged assets are primarily or exclusively tax-deferred, rather than tax-exempt (e.g., a traditional IRA vs. a Roth IRA), then additional considerations should be weighed. Because all distributions from a tax-deferred account are taxed at ordinary rates, including amounts that would be taxed as long-term capital gains when realized in a taxable account, shifting such appreciation could amount to a conversion of lower taxed income into higher taxed income. Over a long enough period, the tax deferral (i.e., the ability to continually reinvest the tax savings and compound that growth, before eventually paying the tax) is expected to be valuable enough to justify such a conversion. This is especially likely when the taxpayer expects to be in a lower income tax bracket in retirement than during the accumulation phase (often, though not always the case). However, when asset location is practiced over a short period (years, not decades) and the taxpayer maintains a high income tax bracket at the time of distribution, conversion of some capital gains into ordinary income may dominate the after-tax return, thereby rendering the asset location strategy counterproductive. As a separate matter, a higher tax-deferred balance could mean higher required minimum distributions (RMDs) in retirement, which could be an important consideration for those seeking to minimize their RMDs. No performance estimates are based on actual client trading history, and actual Betterment clients may experience different results. Factors which will determine the actual benefit of TCP include, but are not limited to, market performance, the relative size of each account included in TCP, the equity exposure of the portfolio, the frequency and size of deposits into the various accounts, the tax rates applicable to the investor in a given tax year and in future years, and the time elapsed before liquidation of any of the accounts becomes necessary. Nothing herein should be interpreted as tax advice, and Betterment does not represent in any manner that the tax consequences described herein will be obtained, or that any Betterment product will result in any particular tax consequence. Please consult your personal tax advisor as to whether TCP is a suitable strategy for you, given your particular circumstances. The tax consequences of asset location are complex and uncertain. You and your tax advisor are responsible for how transactions conducted in your account are reported to the IRS on your personal tax return. Betterment assumes no responsibility for the tax consequences to any client of any transaction.

How Betterment Protects Your Investments Your investments with Betterment are protected by SIPC. History suggests that even if you had millions of dollars invested with a brokerage firm that became insolvent, it is extremely likely that you would be made whole. Insurance is meant to provide a safety net in the case of an emergency. Health insurance covers the cost of a broken limb; dental insurance covers a root canal; homeowners insurance covers leaky plumbing. The Securities Investor Protection Corporation (SIPC) provides insurance that protects your investments, including those held by our broker, Betterment Securities. It covers up to $500,000 of missing assets, including a maximum of $250,000 for cash claims.1 But the difference between SIPC and some other types of insurance is that there’s a very good chance you’ll never have to use it. Since the inception of SIPC in 1971, fewer than 1% of all SIPC member broker-dealers have been subject to a SIPC insolvency proceeding.2 During those proceedings, 99% of total assets distributed to investors came directly from the insolvent broker-dealer’s assets, and not from SIPC.3 Of all the claims ever filed (625,200), less than one-tenth of a percent (352) exceeded the limit of coverage.4 History suggests that even if you had millions of dollars invested with a brokerage firm that became insolvent, it is extremely likely that you would be made whole. How SIPC Insurance Works All brokers are required to be SIPC members. The $500,000 coverage limit applies to each legally distinct account. For example, if you have a taxable account, an IRA, and a trust, each is eligible for its own $500,000 of coverage. The limit applies only to the value of missing securities, not losses due to market volatility. If there are securities identified as belonging to the customer, these (or their equivalent value) will be returned regardless of account size, and the $500,000 limit will apply only to the difference. Some investors mistakenly think that they should never have more than $500,000 in a single brokerage account, but the coverage applies to what’s missing, not to the overall balance. Let’s walk through an example to see how it works. You have an account with three different brokers, and each account holds $2 million in assets. Each of those accounts is covered separately by SIPC, up to $500,000. If one of those brokerage firms were to go bankrupt, a judge would appoint a trustee to sort through the broker’s books and distribute assets back to you and other clients. Here are some possible outcomes, with specific numbers just to illustrate: The trustee recovers your original assets—that’s your $2 million—from the insolvent broker-dealer, and you are made whole. You would experience zero loss on your account. (Since the inception of SIPC in 1971, 99% of total assets distributed have come directly from the insolvent broker-dealer, not from SIPC.)5 If the trustee can only recover $1.5 million of your assets, the remaining $500,000 would be covered by SIPC insurance, and you’d be made whole. If the trustee can only recover $1 million, you would still be covered for $500,000 on the missing amount, but you would incur a partial loss for the remaining $500,000. Historical data shows how extremely rare this is: Over the 46 years that SIPC has existed, there have only been 352 people who have ever had a loss where SIPC wasn’t able to make them whole.6 Three Illustrative Outcomes for an Investor After Brokerage Failure While SIPC is sometimes compared to the Federal Deposit Insurance Corporation (FDIC), it is neither a government agency nor a regulatory body. It’s a private nonprofit group funded by the brokerage industry (every member pays semi-annual dues). It’s not completely on its own, however. SIPC is allowed to borrow from the U.S. Treasury if its own resources are strained—so there is very little chance that SIPC would not meet its coverage obligations. It’s also important to note that FDIC guarantees your principal up to its coverage limit, whereas SIPC does not cover market fluctuations, only missing assets. Insurance That Is Rarely Invoked Why is SIPC insurance so rarely called upon? Because an elaborate set of guardrails around a broker-dealer’s financial operations makes SIPC an absolute last resort. There is a vast framework of regulatory safety checks and audits that custodian broker-dealers undergo on a daily, weekly, monthly, and annual basis. For example, the requirement to segregate client assets from those of the broker greatly increases the likelihood that account holders can be made whole without having to use SIPC funds. If this segregation is properly maintained, account holders should be made whole in case of firm insolvency, no matter the account size. Close monitoring of a broker’s net capital cushion serves a similar purpose. Again, adherence to these safeguards is a foremost focus of a custodian broker-dealer—every single day a custodian broker-dealer is required to perform applicable safety-checks and immediately report problems to its regulators. Of course, there are outliers when an institution fails under more nefarious circumstances. In the most notorious example, the Bernard Madoff Ponzi scheme, some investors could not be compensated when it turned out they didn’t own the securities they thought they did. Madoff just lied and said that they owned them. (Additional rules were enacted post-Madoff, which are discussed in more detail below.) Betterment Securities holds only publicly traded ETFs in client portfolios, allowing for complete transparency. All of our clients can track their assets and returns on a daily basis. High-profile cases such as Madoff are exceptions, overshadowing the fact that SIPC proceedings are very rare. As shown in the chart below, there have been just 328 proceedings since the organization was set up in 1971, out of more than 39,600 brokers who have been SIPC members over that period. There were 109 proceedings initiated in the first four years, and since then, no year has had more than 13. In fact, in the 10 years through 2013, a tumultuous time for the financial markets and the financial-service industry, no year has seen more than five proceedings initiated. In 2014, there were none. Customer Protection Claims, 1971-2014 Be Proactive: How to Protect Your Investments SIPC is important when it comes to protecting your investments, but it’s also necessary for you to consider these key safety points when choosing a brokerage firm: Your assets are never commingled with the brokerage’s operational funds. Your holdings are completely transparent at all times. You should be able to review publicly available audits of your firm. If you are being promised something “too good to be true,” there is reason to be cautious. Never Allow Your Assets to Be Commingled With any brokerage you use, your money and the firm’s operational funds (e.g., what the firm uses to pay its bills) should never be mixed. With Betterment Securities, operational funds and customer funds live not only in different accounts, but in separate universes—separated by numerous digital (and human-supervised) firewalls. Regulators require us to file our detailed financials on a monthly basis; we must report both firm capital and any customer cash that we hold. As Betterment Securities is the custodian of our customers’ assets, we must also maintain substantially higher levels of net capital than an introducing firm, which is a broker that delegates custody to a third party. Another guideline is to avoid brokers that engage in proprietary trading for their own account, while also handling yours. On occasion, such a broker might “blow up” over some failed exotic trade made in the house account. As a result, the need to cover a shortfall can create the temptation to “temporarily” borrow funds that are off limits, such as those from customer accounts. Betterment Securities never does any proprietary trading for its own account. That is not our business, and never will be. Always Be Able to Verify Your Assets One of the great pitfalls for Madoff investors was that they could not verify their assets—in fact, Madoff lied about their existence. With Betterment, you have full visibility into your exact positions at any time. You can follow your performance over any time period, directly from your account (on mobile or on the Web). We believe in complete transparency—on any day, after every trade, we disclose the precise number of shares of every ETF in which you’re invested. That differentiates us from many portfolio and fund managers who do not openly share this information with their clients. Look at the Public Record You don’t need to take your broker’s word at face value—you can and should verify regulatory audits to ensure you’re in good hands. The U.S. Securities and Exchange Commission (SEC) issued an amendment in 2010 (post-Madoff) that applies to investment advisors who custody their clients' assets, or who use a related party to do so. We are the latter case. Betterment LLC, the investment advisor, is an affiliate of Betterment Securities, the custodian. Under rule 206(4)-2 of the Investment Advisers Act of 1940, the investment advisor must be subject to an annual surprise exam from an independent public accountant. We don't know when the surprise exam will happen. The accountants just show up in the office one day. The auditors verify the internal books and records of the affiliate custodian. They reconcile every share, and every dollar we say we have, against our actual holdings. They spot check several hundred random customer accounts. They contact customers directly, and verify that the account statements we issue to them match our internal records for these accounts. They ask questions if something doesn't add up by even a penny. Ernst & Young LP, one of the Big Four accounting firms, performs our annual surprise exam. The firm then issues a report to summarize its findings, and this report must be filed with the SEC. Learn more by reviewing our past reports. Trust Your Instincts: There Are No Shortcuts to Investing Not all brokers deserve your caution in equal measure. It is not a coincidence that Madoff’s fund handily beat the market year after year after year. If something seems “too good to be true,” it probably is. Similarly, be wary of overly complex, exotic strategies that you cannot understand. At best, such complexity creates circumstances for you to be overcharged, on account of perceived sophistication. At worst, it’s a red flag for smoke and mirrors. Betterment is designed for market returns over time, and we make no promises we cannot keep. We buy global index fund ETFs on your behalf, and charge you a small management fee. It’s that simple, and when it comes to assessing risk, simplicity is your friend. While SIPC insurance and regulatory oversight can help protect you from mismanagement by all but the most devious frauds, it can’t save you from yourself. President Richard Nixon, of all people, made that clear when he signed into law the Securities Investor Protection Act, the bill that created the SIPC. “Just as the FDIC protects the user of banking services from the danger of bank failure, so will the SIPC protect the user of investment services from the danger of brokerage firm failure, he said. “It does not cover the equity risk that is always present in stock market investment.” Of course, all investing comes with risk, but that risk is the price you pay for return. Fortunately, you can take only the risk necessary to achieve your goals, by staying properly diversified to smooth out volatility and cushion the impact of bear markets as you invest for the long haul. That is what Betterment is designed for. All blog posts and investment advice are produced by Betterment LLC. 1SIPC insurance does not cover commodity futures, fixed annuities, foreign currency—none of which are part of the Betterment portfolio. SIPC also does not cover losses associated with market fluctuations. You can learn more at www.sipc.org. 2SIPC Annual Report 2014, page 8  3 SIPC Annual Report 2014, page 30 4 SIPC Annual Report 2014, page 9  5SIPC Annual Report 2014, page 30 6SIPC Annual Report 2014, page 9