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 is now vastly superior to the industry standard, expected to reduce your tax bill every time you need to sell shares.

In the chart below, you can see the tax impact of an actual $100,000 withdrawal recently made by a Betterment customer. The withdrawal sold some of every ETF in a $1,000,000+ portfolio. Assuming the highest combined tax rates on short and long term gains (which can get up to 50% and 30% in NYC and California), Betterment saved this customer $3,883 in taxes, just by having a better default selling method.

Betterment saves a customer $3,883

Typical FIFO selling Betterment’s TaxMin selling
Ticker Gain/Loss Short or Long Term Gain/Loss Short or Long Term
VEA $3,334 Long $2,123 Long
AGG $322 Short $108 Short
IVE $3,181 Long -$752 Short
VTI $3,106 Long -$908 Short
BNDX $329 Short $91 Short
LQD $286 Short $83 Short
VWO -$3 Long -$432 Long
VWOB $222 Short $62 Short
IWS $1,162 Long $248 Short
IWN $696 Long -$160 Short
Total
ST Gain/Loss $1,159   -$1,227  
LT Gain/Loss $11,476   $1,690  

Tax Owed:

$4,022

$139

Note: Actual customer withdrawal of $100k in Apr 2014 with tax rate of 30% LT, 50% ST.

Basis reporting 101

What’s going on here? How can internal accounting result in such a drastic difference? First, some background. Over the last several years, the way investment cost basis is reported to the IRS has 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).

Previously, investors had to track and report cost basis for their sales themselves, but today, brokers have taken on the responsibility. (The rules changed in 2011 for stocks, and in 2013 for bonds and options, as part of a staggered roll-out plan).

That’s generally good news for investors (brokers are better equipped to handle such specialized accounting). 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 at the start of 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 used by brokers is typically FIFO (“first in, first out”). 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 recently upgraded our algorithms to support a more sophisticated method of basis reporting, which will result in better tax treatment of sales in the vast 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 new TaxMin method

When Betterment customers sell securities, our algorithms select which specific lots to sell on the fly, 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? Instead of looking solely at the purchase date of each lot, TaxMin also considers the cost basis of the lot, realizing all losses before any gains, regardless of when the shares were bought. Lots are sold in the following order:

  1. Short-term losses
  2. Long-term losses
  3. Long-term gains
  4. Short-term gains

The algorithm exhausts each category before moving to the next, but within each category, lots with the highest cost basis are sold 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 is beneficial, since it can offset gains).

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, 2014 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 1/1/13 +10 1 4
$110 6/1/13 -5 2 3
$120 1/1/14 -15 3 2
$100 2/1/14 +5 4 5
$121 3/1/14 -16 5 1

What you can expect?

This upgrade automatically works to minimize your account’s end-of-year tax bill with every security sale, whether it’s a withdrawal, allocation change, or rebalance. No single selling method is the best in every situation—which method is best suited to a transaction can depend on the individual’s specific circumstances (including, but not limited to, tax bracket and presence of other gains or losses).

However, we strongly feel that every process should be optimized using the information that is available. After carefully analyzing our customer base, we determined that TaxMin would serve the typical Betterment customer better than the alternatives, and far better than FIFO,  the default used by most brokers. Note that your actual tax outcome will depend on your specific tax circumstances—consult a tax advisor.

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.