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, always 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.
Our research estimates that the benefit of TCP could range from 0.10% to 0.82% in additional after-tax return. Its value will depend on a number of circumstances specific to the investor, discussed in more detail below. In one generalized scenario, saving in all three types of accounts showed an after-tax benefit of 0.48%, annualized over 30 years.
How would that translate into more concrete terms? A simple example:
Assuming a compounding annual return of 7%, a $100,000 portfolio would grow by $661,226 after 30 years.1
But with Tax Coordination, that same $100,000 compounding at 7.48% over the same 30-year period would grow by $770,622. That’s 15% more—an additional $109,396 for retirement, after all taxes are paid.
Next, let’s look at how asset location, the strategy behind TCP, adds value.
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.2
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 maximum benefit is very mathematically complex. It means making necessary adjustments along the way, especially after making deposits to any of the accounts.
For an optimal asset location strategy, an automated approach works best. Our software handles all of the complexity in a way that a manual approach just can’t match. We are the first automated investment service to 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 for Business. 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. Here, we excerpt the additional “tax alpha” for one generalized case—an identical starting balance of $50,000 in each of three account types, a 30-year horizon, a federal tax rate of 28%, and a state tax rate of 9.3% (CA) both during the period, and during liquidation.
Equal Starting Balance in Three Accounts: Taxable, Traditional IRA, and Roth IRA
|Asset Allocation||Additional Tax Alpha with TCP (Annualized)|
Source: TCP White Paper.
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.
1The estimated additional annualized return of 0.48% assumes that the initial balance is equally distributed across three types of accounts: a taxable account, a tax-deferred account (such as a traditional IRA) and a tax-exempt account (such as a Roth IRA). It also assumes a 70% allocation to stocks across the entire 30-year period, and a California resident in a 28% federal tax bracket both during the entire period, and at liquidation. The incremental return was calculated using the Monte Carlo projection method across more than 1,000 simulated market scenarios. It compared the total after-tax value of all three accounts when managed by TCP to the benchmark, which was the after-tax value of all the accounts under the same market scenarios, but uncoordinated (i.e. managed by Betterment separately, as standalone Betterment portfolios). As such, these projections make no claim about the value of Betterment's service as compared to any particular non-Betterment investing strategy. Instead, they estimate specifically the value of the TCP service, as applied to Betterment's baseline passive investing strategy. There are additional assumptions around these estimates, which are necessarily numerous and complex, due to the nature of this projection method. TCP may not be suitable for taxpayers subject to a Federal tax bracket of 15% or lower. You should not use TCP to coordinate accounts with materially different time horizons. TCP is not optimal for accounts which you rely on for liquidity in case of unforeseen circumstances. For much more on this research, including additional considerations on the suitability of TCP to your circumstances, please see our white paper and our full disclosures.
2All 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.