How to Make a Tax-Smart Investment Switch
Calculate the value of realizing gains to move to a potentially better investment.
It can be worth paying tax on an embedded gain to move to a potentially better investment.
Use our Investment Switch Calculator to decide if it's worth it for you.
It's likely that you can expect better investor returns and lower fees at Betterment.
A customer once called us to discuss moving significant assets from another provider to Betterment. He asked if he would have to pay a one-time tax cost to liquidate, and considering that cost, would the switch still be worth it? We thought we’d share with everyone a way to figure out the cost and benefits of switching.
Depending on your particular circumstances, the answer is likely yes to both questions—selling off a long-established portfolio may trigger taxes, but in the long term, it can be worth it.
As an example, you might want to move out of an actively managed mutual fund. Research has shown that a portfolio of actively managed funds is expected to underperform by 1.01% a year on average, after fees, compared to an all index-fund portfolio. Or perhaps you’re interested in lowering your fees over the long term or diversifying your investments from a single stock to a multi-asset class portfolio.
While nothing in this piece should be construed as tax advice, since individual circumstances can vary greatly, the following should serve as a general illustration of the cost and benefit of transitioning to a potentially better investment.
The key here is making an informed trade-off—you may trigger a tax bill today by selling your current holdings, but if you’re in it for the long haul, moving to a better portfolio consisting of all index ETFs should make up for that tax cost.
The real question to ask yourself when looking to move your investments to Betterment is: How long do I intend to hold this investment for?
If you’re a short-term investor and plan to hold assets for a couple of years, or less, there’s not much to gain from transitioning to a more efficient portfolio (although it should be noted that under this scenario, you’ll realize the capital gains very soon in any case.) And as a general rule, you should only consider moving appreciated investments that you’ve held for more than a year in order to qualify for long-term capital gains on liquidation. If your investments have not appreciated since you bought them, or if they are held in an IRA or 401(k), you can generally transition them tax-free.¹
Tax Cost vs. Excessive Fees
The process by which we pay tax versus fees on our investments subtly biases us to overestimate the impact of taxes, and underestimate the impact of fees. Fees are generally taken out of returns before they ever hit our accounts—it’s money we never even see. Tax on realized capital gains is assessed for an entire year, and results in a clear and visible liability, paid out of funds that are already in your possession. It’s no wonder that irrational tax aversion is a well-documented, widespread phenomenon, whereas millions of people unwittingly go on paying unnecessarily high fees year after year.
Your key decision boils down to comparing the long-term benefit of switching to a potentially better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something). It’s also important to keep in mind that unless you gift or bequeath your portfolio, you will one day pay tax on these built-in gains. Tax deferral is worth something, but how much?
You can assess the break-even point of switching with our investment switching costs calculator. The graph plots staying in the current investment and paying taxes on liquidation versus liquidating now, reinvesting, and liquidating again at the end of the time period.
Switching Cost Calculator
Calculate the value of realizing gains to move to a potentially better investment
To see the calculator, please follow this link.
The 3 Key Financial Drivers to Consider
1. You could be invested in better assets. Take a hard look at your investor returns in your current investments. Could they be better? If you’re invested in actively managed funds, you may be losing, on average, 1.01% in returns, compared to an all index-fund portfolio, research shows. Betterment’s portfolio is made up entirely of index-tracking ETFs.
2. Automation and good behavior drive returns. We automatically take care of maintaining your investments for you—including rebalancing, dividend reinvestment, diversifying, tax efficiency, free trades and more. If you’re handling your own investments, consider what you’re missing (and also how you’re spending your time.) We perform automatic, regular rebalancing, which is expected to add 0.4% to returns, on average; a global, diversified portfolio is expected to add 1.44% in returns as compared to a basic two-fund portfolio and the average Betterment customer has enjoyed a behavior gap that’s narrower by 1.25% as compared to the average investor. All told, including the demonstrated benefit of index funds—these advantages are expected to contribute, on average, 1.48% to investor returns over the long run: see here for details.
3. If you’re paying what a typical mutual fund charges, you could be paying much less in fees. The average expense ratio for a hybrid (stock and bond) mutual fund is 0.79%.². Betterment’s underlying ETF portfolios have an average expense ratio of 0.06% to 0.17%, depending on your allocation. Note that the range is subject to change depending on current fund prices.
Our management fee is either .25% or .40%, depending on your plan. Your all-in cost at Betterment is between 0.31% and 0.57%. As smart investors know, every basis point matters.3
Taxes are a cost, but generally a cost you’ll eventually pay anyway. Meanwhile, the cost of being in a sub-optimal investment over the years can far outweigh any benefit of tax deferral.
Need a second opinion?
If you’re still not sure if transferring your taxable portfolio is worth the upfront costs, we can weigh in. If your taxable portfolio holds more than $250,000 in assets, stop stressing and simply reach out to our licensed transfer specialists at firstname.lastname@example.org. The team can review the specifics of your portfolio and provide you with a recommendation on how to best move—or not move—your assets to Betterment.
¹The discussion here only applies to taxable investment accounts. All types of IRAs (traditional and Roth) and 401(k)s don’t typically trigger taxes when rolling over from one provider to another. (An exception is converting from a traditional IRA to a Roth, which will trigger taxes. However, there are smart ways to lower these, too.)
3We’ve updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
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