Tax-Coordinated Portfolio: Tax-Smart Investing Using Asset Location

Betterment’s Tax Coordination feature can help shelter retirement investment growth from some taxes.

Hand inserting a coin into a slot

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

allocation-by-aggregate-and-account-tcp-off-03

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

AssetClassesAnimation

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 Locationallocation-by-aggregate-and-account-tcp-on-03

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

TCPaccountsetup

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.