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Introducing Tax-Coordinated Portfolio™: Maximize Your Client’s After-Tax Returns

If your clients currently invest in multiple types of accounts with Betterment, a Tax-Coordinated Portfolio™ can help increase their after-tax returns.

Articles by Betterment Editors
By the Editorial Staff Betterment Resource Center Published Sep. 27, 2016
Published Sep. 27, 2016
5 min read

At Betterment, we’re continually improving our investment platform, always with the goal of helping you maximize your clients’ 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 client after-tax returns.

Betterment’s Tax-Coordinated Portfolio (TCP) service is our very own, fully automated version of asset location. Automated asset location is the latest advancement in tax-smart investing.

How Does a Tax-Coordinated Portfolio Work?

As you know, asset location is widely regarded as the closest thing there is to a “free lunch” in wealth management. If your clients are saving in more than one type of account, it is a way to increase their after-tax returns without taking on additional risk.

Taxable, tax-deferred, and tax-exempt accounts all have different tax treatment, and these rules make certain investments a better fit for one account type over another.

Helping your clients choose wisely can significantly improve the after-tax value of their 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-Coordinated Portfolio (TCP), the first automated asset location service, now available to your clients.

Our research estimates that the benefit of TCP could range from 0.10% to 0.82% in annualized after-tax return. Its value will depend on a number of circumstances specific to the client, 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.1

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.

That same $100,000 compounding at 7.48% over the same 30-year period would grow by an estimated $770,622. That’s 15% more for your client—an additional $109,396 for retirement, after all taxes are paid.

How Does Tax-Coordinated Portfolio Work?

You are likely familiar with how asset location adds value, but just in case, here’s a very simplified primer.

Some assets in your client portfolios (bonds) grow by paying dividends. These are taxed annually, and at a high rate, which hurts the return. Other assets (stocks) mostly grow by appreciating in value. Capital gains are taxed at a lower rate. Plus, capital gains only get taxed when clients make withdrawals—possibly decades later—and deferring tax is good for the return.

Returns in Individual Retirement Accounts (IRAs) 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 everything is added up, they 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

Assetlocationgif

Same Portfolio Overall—with Asset Location

Asset location is not new. Advisors 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 when making deposits to any of the accounts.

To optimize asset location, relying on an automated platform such as Betterment for Advisors works best. Our software handles all of the complexity in a way that a manual approach just can’t match. We are the first investment service to offer this powerful service to all of our customers.

Who Can Benefit?

To benefit from from a Tax-Coordinated Portfolio, your client must have a balance in at least two of the following types of Betterment accounts (TCP will work with our additional portfolio strategies in the future):

  • Taxable account: If your client 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 your clients can only include a 401(k) in a Tax-Coordinated Portfolio if Betterment for Business also manages their company’s 401(k) plan. If your clients have an old 401(k) with a previous employer, they 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-Coordinated Portfolio are expected to yield significantly higher after-tax returns than uncoordinated accounts.

Our white paper presents results for various account combinations (as well as higher tax rates). 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 for 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)
50% Stocks 0.82%
70% Stocks 0.48%
90% Stocks 0.27%

Source: TCP White Paper.

Help Your Clients Get Started with a Tax-Coordinated Portfolio

Ready to help your clients take advantage of the benefits of a Tax-Coordinated Portfolio? Here’s how to set it up in Betterment for Advisors.

After logging in, go to the top right side of your clients’ account in the header of your clients’ Summary tab and click Set Up next to Tax-Coordinated Dividends. Then, follow the steps to set up your clients’ new portfolio.

Sample Account: Set Up Your Clients’ New Tax-Coordinated Portfolio

Once you’ve set up TCP for your clients, Betterment will manage their 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 them how many dividends were paid in a tax-advantaged account due to TCP, which otherwise would have been paid in their taxable account—saving annual tax on those dividends.

This service is available to your clients at no additional cost.

Learn more in Betterment’s Tax-Coordinated Portfolio 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-Coordinated Portfolio generally, see full disclosure here.

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