Tax Optimization

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How We Use Your Dividends To Keep Your Tax Bill Low
Every penny that comes into your account is used to rebalance dynamically—and in a tax-savvy ...
How We Use Your Dividends To Keep Your Tax Bill Low Every penny that comes into your account is used to rebalance dynamically—and in a tax-savvy way. There is no doubt that dividends always feel good. It’s not just well-deserved returns from the companies you are funding; it’s also a sweet reminder that investing works while you do other things, like spend time with family or hit the beach. “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” John D. Rockefeller. Here at Betterment, we also use your dividends to keep your tax bill as small as possible. Dividends Boost Your Total Returns There are two opportunities for profit when you buy a share: when the value of the share appreciates, and when the share generates income in the form of dividends. Dividends are your portion of a company’s earnings. Not all companies pay dividends, but as a Betterment investor, you almost always receive some because your money is invested across more than 3,000 companies in the world. Dividends make up a significant proportion of the total return you can expect from investing in those companies. More Opportunities to Rebalance Your Portfolio Your dividends are also an essential ingredient in our tax-efficient rebalancing process. When you receive a dividend into your Betterment account, you are not only making money as an investor—your portfolio is also getting a quick micro-rebalance that helps keep your tax bill down at the end of the year. This is especially crucial after coming through a period of market volatility. Big market changes have a tendency to cause your asset allocation to veer off course. However, in order to better control risk, you want to get back to your correct asset allocation as quickly as possible. Reinvesting dividends helps to get you back on track by allowing us to buy assets that you are underweight in, rather than sell assets you are overweight in. Dividends + Deposits = Tax-Efficient Rebalancing When your account receives any cash—whether through a dividend or deposit—we automatically identify which investments need to be topped up. When market movements cause your portfolio’s actual allocation to drift away from your target allocation, we automatically use any incoming dividends or deposits to buy more shares of the lagging part of your portfolio. This helps to get the portfolio back to its target asset allocation without having to sell off shares. This is a sophisticated financial planning technique that traditionally has only been available to big accounts, but our automation makes it possible to do it with any size account. The Final Puzzle Piece: Fractional Shares The secret is that we can do this because we handle fractional shares. That means every penny that enters your account reinforces full diversification. This contrasts with how many individual investors handle dividends on their own. Some online brokers offer an automatic option, and may reinvest dividends into whatever fund the cash came from. However, this blind reinvesting is often not the most efficient use of dividends, and can very easily lead to a poorly allocated portfolio that requires a sell-off of assets at a gain—with the accompanying capital gains taxes—to rebalance it over time. Instead, our tax-efficient rebalancing helps you avoid such a “hard” rebalance which would require a major sale and expose you to capital gains. For the DIY investor, this automated tax-efficiency is virtually impossible to achieve. At Betterment, it’s included on every dividend and every deposit, every time, for every client. And you do not need to do a thing. -
Tax Loss Harvesting+ Methodology
Tax loss harvesting is a sophisticated technique to get more value from your investments—but ...
Tax Loss Harvesting+ Methodology Tax loss harvesting is a sophisticated technique to get more value from your investments—but doing it well requires expertise. TABLE OF CONTENTS Navigating the Wash Sale Rule The Betterment Solution TLH+ Model Calibration TLH+ Results Best Practices for TLH+ Conclusion Disclosure Tax loss harvesting is a sophisticated technique to help you get more value from your investments—but doing it well requires expertise. There are many ways to get your investments to work harder for you—better diversification, downside risk management, and the right mix of asset classes for your risk level. Betterment does all of this automatically via its low-cost index fund ETF portfolio. But there is another way to get even more out of your portfolio—using investment losses to improve your after-tax returns with a method called tax loss harvesting. In this white paper, we introduce Betterment’s Tax Loss Harvesting+™ (TLH+™): a sophisticated, fully automated service for Betterment customers. Betterment’s TLH+ service scans portfolios regularly for opportunities (temporary dips that result from market volatility) to realize losses which can be valuable come tax time. While the concept of tax loss harvesting is not new for wealthy investors, TLH+ utilizes a number of innovations that typical implementations may lack. It takes a holistic approach to tax-efficiency, seeking to optimize every user-initiated transaction in addition to adding value through automated activity, such as rebalances. TLH+ not only improves on this powerful tax-saving strategy, but also makes tax loss harvesting available to more investors than ever before. What is tax loss harvesting? Capital losses can lower your tax bill by offsetting gains, but the only way to realize a loss is to sell the depreciated asset. However, in a well-allocated portfolio, each asset plays an essential role in providing a piece of total market exposure. For that reason, an investor should not want to give up the expected returns associated with each asset just to realize a loss. At its most basic level, tax loss harvesting is selling a security that has experienced a loss—and then buying a correlated asset (i.e. one that provides similar exposure) to replace it. The strategy has two benefits: it allows the investor to “harvest” a valuable loss, and it keeps the portfolio balanced at the desired allocation. How does it lower your tax bill? Capital losses can be used to offset capital gains you’ve realized in other transactions over the course of a year—gains on which you would otherwise owe tax. Then, if there are losses left over (or if there were no gains to offset), you can offset up to $3,000 of ordinary income for the year. If any losses still remain, they can be carried forward indefinitely. Tax loss harvesting is primarily a tax deferral strategy, and its benefit depends entirely on individual circumstances. Over the long run, it can add value through some combination of these distinct benefits that it seeks to provide: Tax deferral: Losses harvested can be used to offset unavoidable gains in the portfolio, or capital gains elsewhere (e.g., from selling real estate), deferring the tax owed. Savings that are invested may grow, assuming a conservative growth rate of 5% over a 10-year period, a dollar of tax deferred would be worth $1.63. Even after belatedly parting with the dollar, and paying tax on the $0.63 of growth, you’re ahead. Pushing capital gains into a lower tax rate: If you’ve realized short-term capital gains (STCG) this year, they’ll generally be taxed at your highest rate. However, if you’ve harvested losses to offset them, the corresponding gain you owe in the future could be long-term capital gain (LTCG). You’ve effectively turned a gain that would have been taxed up to 50% today into a gain that will be taxed more lightly in the future (up to 30%). Converting ordinary income into long-term capital gains: A variation on the above: offsetting up to $3,000 from your ordinary income shields that amount from your top marginal rate, but the offsetting future gain will likely be taxed at the LTCG rate. Permanent tax avoidance in certain circumstances: Tax loss harvesting provides benefits now in exchange for increasing built-in gains, subject to tax later. However, under certain circumstances (charitable donation, bequest to heirs), these gains may avoid taxation entirely. Navigating the Wash Sale Rule Summary: Wash sale rule management is at the core of any tax loss harvesting strategy. Unsophisticated approaches can detract from the value of the harvest or place constraints on customer cash flows in order to function. If all it takes to realize a loss is to sell a security, it would seem that maintaining your asset allocation is as simple as immediately repurchasing it. However, the IRS limits a taxpayer’s ability to deduct a loss when it deems the transaction to have been without substance. At a high level, the so-called “wash sale rule” disallows a loss from selling a security if a “substantially identical” security is purchased 30 days after or before the sale. The rationale is that a taxpayer should not enjoy the benefit of deducting a loss if he did not truly dispose of the security. The wash sale rule applies not just to situations when a “substantially identical” purchase is made in the same account, but also when the purchase is made in the individual’s IRA/401(k) account, or even in a spouse’s account. This broad application of the wash sale rule seeks to ensure that investors cannot utilize nominally different accounts to maintain their ownership, and still benefit from the loss. A wash sale involving an IRA/401(k) account is particularly unfavorable. Generally, a “washed” loss is postponed until the replacement is sold, but if the replacement is purchased in an IRA/401(k) account, the loss is permanently disallowed. If not managed correctly, wash sales can undermine tax loss harvesting. Handling proceeds from the harvest is not the sole concern—any deposits made in the following 30 days (whether into the same account, or into the individual’s IRA/401(k)) also need to be allocated with care. Avoiding the wash The simplest way to avoid triggering a wash sale is to avoid purchasing any security at all for the 30 days following the harvest, keeping the proceeds (and any inflows during that period) in cash. This approach, however, would systematically keep a portion of the portfolio out of the market. Over the long term, this “cash drag” could hurt the portfolio’s performance. More advanced strategies repurchase an asset with similar exposure to the harvested security that is not “substantially identical” for purposes of the wash sale rule. In the case of an individual stock, it is clear that repurchasing stock of that same company would violate the rule. Less clear is the treatment of two index funds from different issuers (e.g., Vanguard and Schwab) that track the same index. While the IRS has not issued any guidance to suggest that such two funds are “substantially identical,” a more conservative approach when dealing with an index fund portfolio would be to repurchase a fund whose performance correlates closely with that of the harvested fund, but tracks a different index.¹ Selecting a viable replacement security, however, is just one piece of the accounting and optimization puzzle. Manually implementing a tax loss harvesting strategy is feasible with a handful of securities, little to no cash flows, and infrequent harvests. However, assets will often dip in value but recover by the end of the year, so annual strategies leave many losses on the table. The wash sale management and tax lot accounting necessary to support more frequent (and thus more effective) harvesting quickly become overwhelming in a multi-asset portfolio—especially with regular deposits, dividends, and rebalancing. Software is ideally suited for this complex task. But automation, while necessary, is not sufficient. The problem can get so complex that basic tax loss harvesting algorithms may choose to keep new deposits and dividends in cash for the 30 days following a harvest, rather than tackle the challenge of always maintaining full exposure at the desired allocation. An effective loss harvesting algorithm should be able to maximize harvesting opportunities across a full range of volatility scenarios, without sacrificing the investor’s precisely tuned global asset allocation. It should reinvest harvest proceeds into closely correlated alternate assets, all while handling unforeseen cash inflows from the investor without ever resorting to cash positions. It should also be able to monitor each tax lot individually, harvesting individual lots at an opportune time, which may depend on the volatility of the asset. And most of all, it should do everything to avoid leaving a taxpayer worse off. TLH+ was created because no available implementations seemed to solve all of these problems. Existing strategies and their limitations Every tax loss harvesting strategy shares the same basic goal: to maximize a portfolio’s after-tax returns by realizing built-in losses while minimizing the negative impact of wash sales. Approaches to tax loss harvesting differ primarily in how they handle the proceeds of the harvest to avoid a wash sale. Below are the three strategies commonly employed by manual and algorithmic implementations. After selling a security that has experienced a loss, existing strategies would likely have you… Existing strategy Problem Delay reinvesting the proceeds of a harvest for 30 days, thereby ensuring that the repurchase will not trigger a wash sale. While it’s the easiest method to implement, it has a major drawback: no market exposure—also called cash drag. Cash drag hurts portfolio returns over the long term, and could offset any potential benefit from tax loss harvesting. Reallocate the cash into one or more entirely different asset classes in the portfolio. This method throws off an investor’s desired asset allocation. Additionally, such purchases may block other harvests over the next 30 days by setting up potential wash sales in those other asset classes. Switch back to original security after 30 days from the replacement security. Common manual approach, also used by some automated investing services. A switchback can trigger short-term capital gains when selling the replacement security, reducing the tax benefit of the harvest. Even worse, this strategy can leave an investor owing more tax than if it did nothing. The hazards of switchbacks In the 30 days leading up to the switchback, two things can happen: the replacement security can drop further, or go up. If it goes down, the switchback will realize an additional loss. However, if it goes up, which is what any asset with a positive expected return is expected to do over any given period, the switchback will realize short-term capital gains (STCG)—kryptonite to a tax-efficient portfolio management strategy. To be sure, the harvested loss should offset all (or at least some) of this subsequent gain, but it is easy to see that the result is a lower-yielding harvest. Like a faulty valve, this mechanism pumps out tax benefit, only to let some of it leak back. An algorithm that expects to switch back unconditionally must deal with the possibility that the resulting gain could exceed the harvested loss, leaving the taxpayer worse off. An attempt to mitigate this risk could be setting a higher threshold based on volatility of the asset class—only harvesting when the loss is so deep, that the asset is unlikely to entirely recover in 30 days. Of course, there is still no guarantee that it will not, and the price paid for this buffer is that your lower-yielding harvests will also be less frequent than they could be with a more sophisticated strategy. Examples of negative tax arbitrage Let’s look at how an automatic 30-day switchback can destroy the value of the harvested loss, and even increase tax owed, rather than reduce it. Below is actual performance for Emerging Markets—a relatively volatile asset class that’s expected to offer some of the biggest harvesting opportunities in a global portfolio. We assume a position in VWO, purchased prior to January 1, 2013. With no harvesting, it would have looked like this: No Tax Loss Harvesting Emerging Markets, 1/2/2014 – 5/21/2014 See visual of No Tax Loss Harvesting A substantial drop in February presented an excellent opportunity to sell the entire position and harvest a $331 long-term loss. The proceeds were re-invested into IEMG, a highly correlated replacement (tracking a different index). By March, however, the dip proved temporary, and 30 days after the sale, the asset class more than recovered. The switchback sale results in STCG in excess of the loss that was harvested, and actually leaves the investor owing tax, whereas without the harvest, he would have owed nothing. TLH with 30-day Switchbacks Emerging Markets, 1/2/2014 - 5/21/2014 See TLH with 30-day Switchbacks visual Under certain circumstances, it can get even worse. Due to a technical nuance in the way gains and losses are netted, the 30-day switchback can result in negative tax arbitrage, by effectively pushing existing gains into a higher tax rate. When adding up gains and losses for the year, the rules require netting of like against like first. If any long-term capital gain (LTCG) is present for the year, you must net a long-term capital loss (LTCL) against that first, and only then against any STCG. In the scenario above, the harvested $331 LTCL was used to offset the $360 STCG from the switchback; long can be used to offset short, if we assume no LTCG for the year. Negative tax arbitrage when unrelated long-term gains are present Now let’s assume that in addition to the transactions above, the taxpayer also realized a LTCG of exactly $331 (from selling some other, unrelated asset). If no harvest takes place, the investor will owe tax on $331 at the lower LTCG rate. However, if you add the harvest and switchback trades, the rules now require that the harvested $331 LTCL is applied first against the unrelated $331 LTCG. The harvested LTCL gets used up entirely, exposing the entire $360 STCG from the switchback as taxable. Instead of sheltering the highly taxed gain on the switchback, the harvested loss got used up sheltering a lower-taxed gain, creating far greater tax liability than if no harvest had taken place. Tax Strategy STCG Realized LTCG Realized Taxes Owed No TLH $0 $331 $109 TLH with 30-day switchbacks $360 ($331-$331) $0 net $187 Tax Strategy STCG Realized LTCG Realized Taxes Owed No TLH $0 $331 $109 TLH with 30-day switchbacks $360 ($331-$331) $0 net $187 In the presence of unrelated transactions, unsophisticated harvesting can effectively convert existing LTCG into STCG. Some investors regularly generate significant LTCG (for instance, by gradually diversifying out of a highly appreciated position in a single stock). It’s these investors, in fact, who would benefit the most from effective tax loss harvesting. However, if their portfolios are harvested with unconditional 30-day switchbacks over the years, it’s not a question of “if” the switchbacks will convert some LTCG into STCG, but “when” and “how much.” Negative tax arbitrage with dividends Yet another instance of negative tax arbitrage can result in connection with dividend payments. If certain conditions are met, some ETF distributions are treated as “qualified dividends”, taxed at lower rates. One condition is holding the security for more than 60 days. If the dividend is paid while the position is in the replacement security, it will not get this favorable treatment: under a rigid 30-day switchback, the condition can never be met. As a result, up to 20% of the dividend is lost to tax (the difference between the higher and lower rate). The Betterment Solution Summary: Betterment believes TLH+ can substantially improve upon existing strategies by managing parallel positions within each asset class indefinitely, as tax considerations dictate. It approaches tax-efficiency holistically, seeking to optimize every transaction, including customer activity. The fundamental advance of Betterment’s TLH+ is that tax-optimal decision making should not be limited to the harvest itself—the algorithm should remain vigilant with respect to every transaction. An unconditional 30-day switchback, whatever the cost, is plainly suboptimal, and could even leave the investor owing more tax that year—unacceptable for an automated strategy that seeks to lower tax liability. Intelligently managing a bifurcated asset class following the harvest is every bit as crucial to maximizing tax alpha as the harvest itself. The innovations TLH+ seeks to deliver, include: No exposure to short-term capital gains in an attempt to harvest losses. Through our proprietary Parallel Position Management system, a dual-security asset class approach enforces preference for one security without needlessly triggering capital gains in an attempt to harvest losses, all without putting constraints on customer cash flows. No negative tax arbitrage traps associated with less sophisticated harvesting strategies (e.g., 30-day switchback), making TLH+ especially suited for those generating large long-term capital gains on an ongoing basis. Zero cash drag at all times. With fractional shares and seamless handling of all inflows during wash sale windows, every dollar is invested at the desired allocation risk level. Dynamic trigger thresholds for each asset-class, ensuring that both high- and low-volatility assets can be harvested at an opportune time to increase the chances of large tax offsets. Tax loss preservation logic extended to user-realized losses, not just harvested losses, automatically protecting both from the wash sale rule. In short, user withdrawals always sell any losses first. No disallowed losses through overlap with a Betterment IRA/401(k). We use a tertiary ticker system to eliminate the possibility of permanently disallowed losses triggered by subsequent IRA/401(k) activity.² This makes TLH+ ideal for those who invest in both taxable and tax-advantaged accounts. Harvests also take the opportunity to rebalance across all asset classes, rather than re-invest solely within the same asset class. This further reduces the need to rebalance during volatile stretches, which means fewer realized gains, and higher tax alpha. Through these innovations, TLH+ creates significant value over manually-serviced or less sophisticated algorithmic implementations. TLH+ is accessible to investors —fully automated, effective, and at no additional cost. Parallel securities To ensure that each asset class is supported by optimal securities in both primary and alternate positions, we screened by expense ratio, liquidity (bid-ask spread), tracking error vs. benchmark, and most importantly, covariance of the alternate with the primary.³ While there are small cost differences between the primary and alternate securities, the cost of negative tax arbitrage from tax-agnostic switching vastly outweighs the cost of maintaining a dual position within an asset class. For a 70% stock portfolio composed only of primary securities, the average underlying expense ratio is 0.075%. If each asset class consisted of a 50/50 split between primary and alternate, that cost would be 0.090%—a difference of less than two basis points. Of the 13 asset classes in Betterment’s core taxable portfolio, nine were assigned alternate tickers. Short-term Treasuries (GBIL),Inflation-protected Bonds (VTIP), U.S. Short-term Investment Grade Bonds (JPST), U.S. High Quality Bonds (AGG), and International Developed Bonds (BNDX) are insufficiently volatile to be viable harvesting candidates. Take a look at the primary and alternate securities in the Betterment portfolio. Additionally, TLH+ features a special mechanism for coordination with IRAs/401(k)s that required us to pick a third security in each harvestable asset class (except in municipal bonds, which are not in the IRA/401(k) portfolio). While these have a higher cost than the primary and alternate, they are not expected to be utilized often, and even then, for short durations (more below in IRA/401(k) protection). Parallel Position Management As demonstrated, the unconditional 30-day switchback to the primary security is problematic for a number of reasons. To fix those problems, we engineered a platform to support TLH+, which seeks to tax-optimize every user and system-initiated transaction: the Parallel Position Management (PPM) system. PPM allows each asset class to be comprised of two closely correlated securities indefinitely, should that result in a better after-tax outcome. Here’s how a portfolio with PPM looks to a Betterment customer. PPM provides several improvements over the switchback strategy. First, unnecessary gains are minimized if not totally avoided. Second, the parallel security (could be primary or alternate) serves as a safe harbor to minimize wash sales—not just from harvest proceeds, but any cash inflows. Third, the mechanism seeks to protect not just harvested losses, but losses realized by the customer as well. PPM not only facilitates effective opportunities for tax loss harvesting, but also extends maximum tax-efficiency to customer-initiated transactions. Every customer withdrawal is a potential harvest (losses are sold first). And every customer deposit and dividend is routed to the parallel position that would minimize wash sales, while shoring up the target allocation. PPM has a preference for the primary security when rebalancing and for all cash flow events—but always subject to tax considerations. This is how PPM behaves under various conditions: Transaction PPM behavior Withdrawals and sales from rebalancing Sales default out of the alternate position (if such a position exists), but not at the expense of triggering STCG—in that case, PPM will sell lots of the primary security first. Rebalancing will always stop short of realizing STCG. Taxable gains are minimized at every decision point—STCG tax lots are the last to be sold on a user withdrawal. Deposits, buys from rebalancing, and dividend reinvestments PPM directs inflows to underweight asset classes, and within each asset class, into the primary, unless doing so incurs greater wash sale costs than buying the alternate. Harvest events TLH+ harvests can come out of the primary into the alternate, or vice versa, depending on which harvest has a greater expected value. After an initial harvest, it could make sense at some point to harvest back into the primary, to harvest more of the remaining primary into the alternate, or to do nothing. Harvests that would cause more washed losses than gained losses are minimized if not totally avoided. PPM eliminates the negative tax arbitrage issues previously discussed, while leaving open significantly more flexibility to engage in harvesting opportunities. TLH+ is able to harvest more frequently, and can safely realize smaller losses, all without putting any constraints on user cash flows. Let’s return to the Emerging Markets example from above, demonstrating how TLH+ harvests the loss, but remains in the appreciated alternate position (IEMG), thereby avoiding STCG. Smarter Harvesting - Avoid the Switchback Emerging Markets, 1/2/2014 - 5/21/2014 See TLH Switchbacks visual Better wash sale management Managing cash flows across both taxable and IRA/401(k) accounts without needlessly washing realized losses is a complex problem. TLH+ operates without constraining the way that customers prefer contributing to their portfolios, and without resorting to cash positions. With the benefit of parallel positions, it weighs wash sale implications of every deposit and withdrawal and dividend reinvestment, and seeks to systematically choose the optimal investment strategy. This system protects not just harvested losses, but also losses realized through withdrawals. IRA/401(k) protection The wash sale rule applies when a “substantially identical” replacement is purchased in an IRA/401(k) account. Taxpayers must calculate such wash sales, but brokers are not required to report them. Even the largest ones leave this task to their customers.⁴ This is administratively complicated for taxpayers and leads to tax issues. At Betterment, we felt we could do more than the bare minimum. Being equipped to perform this calculation, we do it so that our customers don’t have to. Because IRA/401(k) wash sales are particularly unfavorable—the loss is disallowed permanently—TLH+ goes another step further, and seeks to ensure that no loss realized in the taxable account is washed by a subsequent deposit into a Betterment IRA/401(k). In doing so, TLH+ always maintains target allocation in the IRA/401(k), without cash drag. No harvesting is done in an IRA/401(k), so if it weren’t for the potential interaction with taxable transactions, there would be no need for IRA/401(k) alternate securities. However, on the day of an IRA/401(k) inflow, both the primary and the alternate security in the taxable account could have realized losses in the prior 30 days. Accordingly, each asset class supports a third correlated security (tracking a third index). The tertiary security is only utilized to hold IRA/401(k) deposits within the wash window temporarily. Let’s look at an example of how TLH+ handles a potentially disruptive IRA inflow when there are realized losses to protect, using real market data for the Developed Markets asset class. The customer starts with a position in VEA, the primary security, in both the taxable and IRA accounts. We then harvest a loss by selling the entire taxable position, and repurchase the alternate security, SCHF. Loss Harvested in VEA Two weeks pass, and the customer makes a withdrawal from the taxable account (the entire position, for simplicity), intending to fund the IRA. In those two weeks, the asset class dropped more, so the sale of SCHF also realizes a loss. The VEA position in the IRA remains unchanged. Customer Withdrawal Sells SCHF at a Loss A few days later, the customer contributes to his IRA, and $1,000 is allocated to the Developed Markets asset class, which already contains some VEA. Despite the fact that the customer no longer holds any VEA or SCHF in his taxable account, buying either one in the IRA would permanently wash a valuable realized loss. The Tertiary Ticker System automatically allocates the inflow into the third option for developed markets, IEFA. IRA Deposit into Tertiary Ticker Both losses have been preserved, and the customer now holds VEA and IEFA in his IRA, maintaining desired allocation at all times. Because no capital gains are realized in an IRA/401(k), there is no harm in switching out of the IEFA position and consolidating the entire asset class in VEA when there is no danger of a wash sale. The result: Customers using TLH+ who also have their IRA/401(k) assets with Betterment can know that Betterment will seek to protect valuable realized losses whenever they deposit into their IRA/401(k), whether it’s lump rollover, auto-deposits or even dividend reinvestments. Smart rebalancing Lastly, TLH+ directs the proceeds of every harvest to rebalance the entire portfolio, the same way that a Betterment account handles any incoming cash flow (deposit, dividend). Most of the cash is expected to stay in that asset class and be reinvested into the parallel asset, but some of it may not. Recognizing every harvest as a rebalancing opportunity further reduces the need for additional selling in times of volatility, further reducing tax liability. As always, fractional shares allow the inflows to be allocated with perfect precision. TLH+ Model Calibration Summary: To make harvesting decisions, TLH+ optimizes around multiple inputs, derived from rigorous Monte Carlo simulations. The decision to harvest is made when the benefit, net of cost, exceeds a certain threshold. The potential benefit of a harvest is discussed in detail below (“Results”). Unlike a 30-day switchback strategy, TLH+ does not incur the expected STCG cost of the switchback trade. Therefore, “cost” consists of three components: trading expense, execution expense, and increased cost of ownership for the replacement asset (if any). All trades are free for Betterment customers. TLH+ is engineered to factor in the other two components, configurable at the asset level, and the resulting cost approaches negligible. Bid-ask spreads for the bulk of harvestable assets are extremely narrow. Expense ratios for the major primary/alternate ETF pairs are extremely close, and in the case where a harvest back to the primary ticker is being evaluated, that difference is actually a benefit, not a cost. A harder cost to quantify could result from what can be thought of as an “overly itchy TLH trigger finger.” Without the STCG switchback limitation, even very small losses appear to be worth harvesting, but only in a vacuum. Harvesting a loss “too early” could mean passing up a bigger (temporary) loss—made unavailable due to wash sale constraints stemming from the first harvest. This is especially true for more volatile assets, where a static TLH trigger could mean that the asset is being harvested at a fraction of the benefit that could be achieved by harvesting just a few days later, after a larger decline. Optimizing the thresholds to maximize loss yield becomes a statistical problem, ripe for an exhaustive simulation. There are two general approaches to testing a model’s performance: historical backtesting and forward-looking simulation. Optimizing a system to deliver the best results for only past historical periods is relatively trivial, but doing so would be a classic instance of data snooping bias. The maturation of the global ETF market is a relatively recent phenomenon. Relying solely on a historical backtest of a portfolio composed of ETFs that allow for 10 to 20 years of reliable data when designing a system intended to provide 40 to 50 years of benefit would mean making a number of indefensible assumptions about general market behavior. The superset of decision variables driving TLH+ is beyond the scope of this paper—optimizing around these variables required exhaustive analysis. TLH+ was calibrated via Betterment’s rigorous Monte Carlo simulation framework, spinning up thousands of server instances in the cloud to run through tens of thousands of forward-looking scenarios testing model performance. Best Practices for TLH+ Summary: Tax loss harvesting can add some value for most investors, but high earners with a combination of long time horizons, ongoing realized gains, and plans for some charitable disposition will reap the largest benefits. This is a good point to reiterate that tax loss harvesting delivers value primarily due to tax deferral, not tax avoidance. A harvested loss can be beneficial in the current tax year to varying degrees, but harvesting that loss generally means creating an offsetting gain at some point in the future. If and when the portfolio is liquidated, the gain realized will be higher than if the harvest never took place. Let’s look at an example: Year 1: Buy asset A for $100. Year 2: Asset A drops to $90. Harvest $10 loss, repurchase similar Asset B for $90. Year 20: Asset B is worth $500 and is liquidated. Gains of $410 realized (sale price minus cost basis of $90) Had the harvest never happened, we’d be selling A with a basis of $100, and gains realized would only be $400 (assuming similar performance from the two correlated assets.) Harvesting the $10 loss allows us to offset some unrelated $10 gain today, but at a price of an offsetting $10 gain at some point in the future. The value of a harvest largely depends on two things. First, what income, if any, is available for offset? Second, how much time will elapse before the portfolio is liquidated? As the deferral period grows, so does the benefit—the reinvested savings from the tax deferral have more time to grow. While nothing herein should be interpreted as tax advice, examining some sample investor profiles is a good way to appreciate the nature of the benefit of TLH+. Who benefits most? The Bottomless Gains Investor A capital loss is only as valuable as the tax saved on the gain it offsets. Some investors may incur substantial capital gains every year from selling highly appreciated assets—other securities, or perhaps real estate. These investors can immediately use all the harvested losses, offsetting gains and generating substantial tax savings. The High Income Earner Harvesting can have real benefit even in the absence of gains. Each year, up to $3,000 of capital losses can be deducted from ordinary income. Earners in high income tax states (such as New York or California) could be subject to a combined marginal tax bracket of up to 50%. Taking the full deduction, these investors could save $1,500 on their tax bill that year. What’s more, this deduction could benefit from positive rate arbitrage. The offsetting gain is likely to be LTCG, taxed at around 30% for the high earner—less than $1,000—a real tax savings of over $500, on top of any deferral value. The Steady Saver An initial investment may present some harvesting opportunities in the first few years, but over the long term, it’s increasingly unlikely that the value of an asset drops below the initial purchase price, even in down years. Regular deposits create multiple price points, which may create more harvesting opportunities over time. (This is not a rationale for keeping money out of the market and dripping it in over time—tax loss harvesting is an optimization around returns, not a substitute for market exposure.) The Philanthropist In each scenario above, any benefit is amplified by the length of the deferral period before the offsetting gains are eventually realized. However, if the appreciated securities are donated to charity or passed down to heirs, the tax can be avoided entirely. When coupled with this outcome, the scenarios above deliver the maximum benefit of TLH+. Wealthy investors have long used the dual strategy of loss harvesting and charitable giving. Even if an investor expects to mostly liquidate, any gifting will unlock some of this benefit. Using losses today, in exchange for built-in gains, offers the partial philanthropist a number of tax-efficient options later in life. Who benefits least? The Aspiring Tax Bracket Climber Tax deferral is undesirable if your future tax bracket will be higher than your current. If you expect to achieve (or return to) substantially higher income in the future, tax loss harvesting may be exactly the wrong strategy—it may, in fact, make sense to harvest gains, not losses. In particular, we do not advise you to use TLH+ if you can currently realize capital gains at a 0% tax rate. Under 2021 tax brackets, this may be the case if your taxable income is below $40,400 as a single filer or $80,800 if you are married filing jointly. See the IRS website for more details. Graduate students, those taking parental leave, or just starting out in their careers should ask “What tax rate am I offsetting today” versus “What rate can I reasonably expect to pay in the future?” The Scattered Portfolio TLH+ is carefully calibrated to manage wash sales across all assets managed by Betterment, including IRA assets. However, the algorithms cannot take into account information that is not available. To the extent that a Betterment customer’s holdings (or a spouse’s holdings) in another account overlap with the Betterment portfolio, there can be no guarantee that TLH+ activity will not conflict with sales and purchases in those other accounts (including dividend reinvestments), and result in unforeseen wash sales that reverse some or all of the benefits of TLH+. We do not recommend TLH+ to a customer who holds (or whose spouse holds) any of the ETFs in the Betterment portfolio in non-Betterment accounts. You can ask Betterment to coordinate TLH+ with your spouse’s account at Betterment. You’ll be asked for your spouse’s account information after you enable TLH+ so that we can help optimize your investments across your accounts. The Portfolio Strategy Collector Electing different portfolio strategies for multiple Betterment goals may cause TLH+ to identify fewer opportunities to harvest losses than it might if you elect the same portfolio strategy for all of your Betterment goals. The Rapid Liquidator What happens if all of the additional gains due to harvesting are realized over the course of a single year? In a full liquidation of a long-standing portfolio, the additional gains due to harvesting could push the taxpayer into a higher LTCG bracket, potentially reversing the benefit of TLH+. For those who expect to draw down with more flexibility, smart automation will be there to help optimize the tax consequences. The Imminent Withdrawal The harvesting of tax losses resets the one-year holding period that is used to distinguish between LTCG and STCG. For most investors, this isn’t an issue: by the time that they sell the impacted investments, the one-year holding period has elapsed and they pay taxes at the lower LTCG rate. This is particularly true for Betterment customers because our TaxMin feature automatically realizes LTCG ahead of STCG in response to a withdrawal request. However, if you are planning to withdraw a large portion of your taxable assets in the next 12 months, you should wait to turn on TLH+ until after the withdrawal is complete to reduce the possibility of realizing STCG. Other Impacts to Consider Investors with assets held in different portfolio strategies should understand how it impacts the operation of TLH. To learn more, please see Betterment’s SRI disclosures, Flexible portfolio disclosures, the Goldman Sachs smart beta disclosures, and the BlackRock target income portfolio disclosures for further detail. Clients in Advisor-designed custom portfolios through Betterment for Advisors should consult their Advisors to understand the limitations of TLH with respect to any custom portfolio. Additionally, as described above, electing one portfolio strategy for one or more goals in your account while simultaneously electing a different portfolio for other goals in your account may reduce opportunities for TLH to harvest losses due to wash sale avoidance. Due to Betterment’s new monthly cadence for billing fees for advisory services, through the liquidation of securities, tax loss harvesting opportunities may be adversely affected for customers with particularly high stock allocations, third party portfolios, or flexible portfolios. As a result of assessing fees on a monthly cadence for a customer with only equity security exposure, which tends to be more opportunistic for tax loss harvesting, certain securities may be sold that could have been used to tax loss harvest at a later date, thereby delaying the harvesting opportunity into the future. This delay would be due to avoidance of triggering the wash sale rule, which forbids a security from being sold only to be replaced with a “substantially similar” security within a 30-day period. See Betterment’s TLH disclosures for further detail. Conclusion Summary: Tax loss harvesting can be a highly effective way to improve your investor returns without taking additional downside risk. Tax loss harvesting may get the spotlight, but under the hood, our algorithms labor to minimize taxes on every transaction, in every conceivable way. Historically, tax loss harvesting has only been available to extremely high net worth clients. Betterment is able to take advantage of economies of scale with technology and provide this service to all qualified customers while striving to: Do no harm: we regularly work to avoid triggering short-term capital gains (others often do, through unsophisticated automation). Do it holistically: we don’t just look for opportunities to harvest regularly—we seek to make every transaction tax efficient—withdrawals, deposits, rebalancing, and more. Coordinate wash sale management across both taxable and IRA/401(k) accounts as seamlessly as possible. -
The Benefits of Tax Coordination
Once you’ve set up Tax Coordination for your Retirement goal, we will manage your assets as a ...
The Benefits of Tax Coordination Once you’ve set up Tax Coordination for your Retirement goal, we will manage your assets as a single portfolio across all included legal accounts, using every dividend and deposit to optimize the location of the assets. Betterment’s Tax Coordination service is our fully automated version of an investment strategy known as asset location—and it comes at no extra cost to you. Once you’ve set up Tax Coordination for your Retirement goal, we will manage your assets as a single portfolio across all included legal accounts, using every dividend and deposit to optimize the location of the assets. We’ll also rebalance in order to improve your asset location when we see opportunities to do so—without causing taxes. We’ll generally place assets that we expect to be taxed at higher rates in your tax-advantaged accounts (IRAs and 401(k)s), which have big tax breaks. We’ll generally place assets that we expect to be taxed at lower rates in your taxable account, since you’ll owe taxes on dividends and any realized capital gains each year. You could benefit from Tax Coordination if... You are investing in at least two of the following types of Betterment accounts for retirement: Individual Taxable account (Retirement or General Investing) Tax-deferred account (Traditional IRA, SEP IRA, or Betterment for Business 401(k) plan) Tax-exempt account (Roth IRA or Betterment for Business Roth 401(k) plan) You are investing for the long term and your coordinated goals have the same time horizon. We don’t recommend Tax Coordination if... Your federal marginal tax bracket is 12% or below. The accounts you plan to coordinate have different time horizons. You plan to make a significant withdrawal in the near future from only one of the accounts you are considering including in the goal using Tax Coordination.
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Tax-Coordinated Portfolio: Tax-Smart Investing Using Asset Location
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 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 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 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 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. -
6 Tax Strategies That Will Have You Planning Ahead
6 Tax Strategies That Will Have You Planning Ahead Here are six tax tips you can follow now to help save money on your taxes now—and for years to come. Most people tend to think about taxes just once a year—usually March or April. But investors can save more in taxes each year by thinking ahead and strategizing about their taxes on an ongoing basis. Today, savvy investors aren’t beating the market day-to-day; instead, they’re focused on taking home more of their earnings by lowering taxes and fees across their portfolio. That means thinking about all of your tax-advantaged options—accounts you have now and selections you’ll make in the future—to make every move as tax-efficient as possible. You can think of accounts like IRAs, 401(k)s, 529 accounts, and HSAs as unique opportunities that if implemented strategically, can help you earn more over time. In this article, we’ll introduce six tax strategies that require ongoing planning, but if taken into consideration, can help you keep more of what you earn. 1. Shelter dividends in retirement accounts. By reorganizing your investments, you can shelter many dividends from being taxed. This strategy, called asset location, can not only reduce your annual tax bill, but also help to increase your after-tax investment returns. At Betterment, we have a service called Tax Coordination that does this automatically. It works by placing investments that are taxed more into traditional and Roth IRA accounts, which have big tax advantages. It places investments that are taxed less, such as municipal bonds, in your taxable accounts. This is a great way you can use your current investments to help reduce your taxes. Here’s a simple animation solely for illustrative purposes: Asset Location in Action 2. Start tax loss harvesting earlier. Another way to use your investments to help reduce your taxes is through tax loss harvesting. By selling investments at a loss, you can generate a tax deduction. You can use this deduction to offset other investment gains you earned during the year, or even to decrease your taxable income by up to $3,000. Most investors only view tax loss harvesting as a year-end strategy to get some last-minute deductions, and thus won’t be able to benefit from any other losses throughout the year. A better strategy to consider is monitoring your portfolio throughout the entire year for opportunities to harvest losses. This is especially effective if you are in a high tax bracket or have large capital gains this year. We automatically monitor for you on a daily basis here at Betterment if you use our Tax Loss Harvesting+ feature. 3. Contribute earlier to retirement accounts. It’s true that you have until each year’s tax filing date to contribute to your IRA for the previous year. However, if you’ve already maxed out your the previous year’s IRA contributions, consider maxing out this year’s IRA contributions as early in the year as possible—this can give you up to 15 extra months (January of this year to April of next year) in the market. Waiting until the last minute could cost you more than you think. In fact, funding your IRA in January every year could provide you with an average of $8,800 more over a ten-year period. So if you still haven’t funded your IRA for last year, consider doing it now instead of waiting until mid-April. 4. Execute Roth conversions in January, not December. A Roth conversion moves money from your traditional IRA to your Roth IRA and is sometimes referred to as a backdoor Roth IRA conversion. You may pay taxes when converting, but once inside your Roth IRA, future earnings and qualified withdrawals will be tax-free. You can convert your IRA at any point throughout the year, but most people wait until the last minute. Just like with procrastinating on your retirement account contributions, by waiting until December to convert, you’ll miss out on 11 months of potential tax-free growth. For this reason, consider doing your conversions early in the year to help maximize your tax-free growth. It may be worth speaking with a tax advisor if you’re worried about converting in January because you don’t have a clear enough picture of what your taxes for the year will look like, as the IRS recently removed the ability to undo Roth conversions. The tax code has been updated to reflect this change, which became effective January 1, 2018. This information is for educational purposes only and is not a substitute for the advice of a qualified tax advisor. Roth conversions can have significant tax implications and you should consult a tax professional to discuss any questions about your personal situation and whether a Roth conversion is right for you. 5. Put your tax refund to good use. If you’re like 72% of Americans, you receive a tax refund averaging around $2,825. That refund may sound great, but really that means, in this example, that you overpaid your taxes each month by about $236. That is money that could have been invested and growing for you throughout the year. To adjust how much money is withheld from each paycheck for taxes for the following year, you could consider resubmitting your Form W-4 to your employer. Making the change early in the year will allow it to take full effect, and filling it out properly can ensure the correct amount is taken out. The IRS has provided a Tax Withholding Estimator to help you set or adjust your W-4 to get your refund closer to $0 (meaning you aren’t giving Uncle Sam an interest free loan). Then, consider putting that money to work throughout the year. After adjusting your W-4, consider increasing your 401(k) contribution by that same amount. You won’t notice a difference in your paycheck, and that money will go toward your retirement instead of loaning it to the IRS. 6. Make tax-smart investment switches. You can likely benefit from reviewing your investment portfolio, but it’s important to minimize the tax consequences of making any adjustments. Rebalance your portfolio tax-efficiently. One example of a change you might consider is rebalancing your portfolio. Here’s how it works: As markets move up and down, your portfolio can drift away from its target allocation. Rebalancing allows you to realign the weight of stocks and bonds so that your asset allocation is appropriate for your goal’s time horizon. However, rebalancing by selling existing investments should generally be a last resort because this can cost you in taxes. Instead, consider using cash flows to rebalance; use new deposits, dividends you earn, and proceeds from tax loss harvesting to rebalance your portfolio on an ongoing basis. This will minimize the need to sell investments and thus can help reduce your taxes. At Betterment, we automate this entire process to help keep your portfolio properly balanced with every cash flow. Get out of high-cost investments. Another tax-smart change you might consider is getting out of high-cost investments. Look for losses you can use to offset any gains associated with swapping a high-cost fund for a low-cost one. Even if switching out of the high-cost fund will cause you taxes, consider doing a breakeven analysis to see if it still makes sense. For example, if selling a fund will cost you $1,000 in taxes, but you will save $500/year in fees, you can break even in just two years. If you plan to be invested for longer than that, it can still be a savvy investment move. Our calculator can help you with this decision. Rebalancing and reducing fees are both important, but make sure you don’t ignore taxes while executing these strategies. Think About It Now—And Later We all talk about tax season, but really, taxes are a topic we should think about throughout the year as we invest our savings. Sheltering your tax-inefficient investments in your retirement accounts can reduce dividend taxes and help keep more money in your pocket. Tax loss harvesting throughout the year, not just in December, can reduce your taxes and help increase your after-tax investment returns. Retirement contributions and conversions done early in the year are more effective because they allow your investments to grow for longer. Correcting your tax withholdings can allow you to save more throughout the year, instead of having to wait for your tax refund. Lastly, don’t ignore possible tax implications while rebalancing or adjusting your investment portfolio. Together, these strategies may significantly reduce your tax bill. And by automating them by using a service like Betterment, you can take advantage of these strategies without adding stress during tax season. Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional. -
Addressing Tax Impact with Our Improved Cost Basis Accounting Method
Addressing Tax Impact with Our Improved Cost Basis Accounting Method Selecting tax lots efficiently can address and reduce the tax impact of your investments. We use advanced tax accounting methods to help make your transactions more tax-efficient. When choosing which lots of a security to sell, our sophisticated method factors in both cost basis as well as duration held. 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 seeks to reduce your tax impact when you need to sell shares. In the chart below, you can see the tax impact of an actual $150,000 withdrawal made by a Betterment customer with New Jersey listed as their state of residence. The withdrawal sold some of several ETF positions in a $1,000,000+ portfolio. Assuming tax rates consistent with their input income, Betterment saved this customer $11,122 in state and federal taxes, just by having a better default selling method. Betterment saves a customer $11,122 Typical FIFO selling Betterment's TaxMin selling Ticker Gain/Loss Short or Long Term Gain/Loss Short or Long Term VTI $23,639 Long $11,771 Long VEA $10,378 Long $4,410 Long VWO $7,472 Long $2,628 Long MUB $7 Long -$3 Short EMB -$10 Long -$20 Short VTV $6,193 Long $2,130 Long VOE $5,571 Long $2,714 Long VBR $6,704 Long $4,144 Long Total ST Gain/Loss $0 -$22 LT Gain/Loss $59,955 $27,797 Tax Owed: $20,714 $9,592 *Actual customer withdrawal of $150k in April 2021 as a resident of New Jersey, with input annual income of $220,000 and single tax-filing status with no dependents. This calculation assumes that this customer takes the standard deduction when filing taxes, a state capital gains rate of 10.75%, and federal tax rates on short and long term gains of 40.8% and 23.8%, respectively, both inclusive of the net investment income tax of 3.8%. State of residence and other client information may materially affect the outcome or projection of tax minimization technology. The real life scenario listed in this example may not apply to all clients and is not a guarantee of similar results. Tax savings are net of Betterment’s fee of 25 BPS. Basis reporting 101 What's going on here? How can internal accounting result in such a drastic difference? First, some background. The way investment cost basis is reported to the IRS was 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). 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 each 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 stipulated by the IRS and typically used by brokers is FIFO (“first in, first out”). With this method, 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 upgraded our algorithms to support a more sophisticated method of basis reporting, which aims to result in better tax treatment for securities sales in the 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 TaxMin method When a sale is initiated in a taxable account for part of a particular position, a choice needs to be made about which specific tax lots of that holding will be sold. Our algorithms select which specific tax lots to sell, 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? As a general principle, realizing taxable losses instead of gains and allowing short-term gains to mature into long-term gains (which are generally taxed at a lower rate) whenever possible should result in a lower tax liability in the long run. Instead of looking solely at the purchase date of each lot, TaxMin also considers the cost basis of the lot, with the goal of realizing losses before any gains, regardless of when the shares were bought. Lots are evaluated to be sold in the following order: Short-term losses Long-term losses Long-term gains Short-term gains Generally, we sell shares in a way that is intended to prioritize generating short term capital losses, then long term capital losses, followed by long term capital gains and then lastly, short term capital gains. The algorithm looks through each category before moving to the next, but within each category, lots with the highest cost basis are targeted 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 can be beneficial, since losses can be used to offset gains).1 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, 2021 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 1/1/20 +10 1 4 $110 6/1/20 -5 2 3 $120 1/1/21 -15 3 2 $100 2/1/21 +5 4 5 $121 3/1/21 -16 5 1 What can you expect? TaxMin automatically works to reduce the tax impact of your investment transactions in a variety of circumstances. Depending on the transaction, the tax-efficiency of various tax-lot selection approaches may vary based on the individual’s specific circumstances (including, but not limited to, tax bracket and presence of other gains or losses.) However, we feel that TaxMin serves the typical Betterment customer far better than FIFO, the default used by most brokers. Note that Betterment is not a tax advisor and your actual tax outcome will depend on your specific tax circumstances—consult a tax advisor for licensed advice specific to your financial situation. 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. Footnote 1 Note that when a customer makes a change resulting in the sale of the entirety of a particular holding in a taxable account (such as a full withdrawal or certain portfolio strategy changes), tax minimization may not apply because all lots will be sold in the transaction. -
4 Ways Betterment Can Help Limit the Tax Impact Of Your Investments
4 Ways Betterment Can Help Limit the Tax Impact Of Your Investments Betterment has a variety of processes in place to help limit the impact of your investments on your tax bill, depending on your situation. Let’s demystify these powerful strategies. In the US, approximately 33% of households have a taxable investment account—often referred to as a brokerage account—and approximately 50% of households also have at least one retirement account, like an IRA or an employer-sponsored retirement account. We know that the medley of account types can make it challenging for you to decide which account to contribute to or withdraw from at any given time. Let’s dive right in to get a further understanding of: What accounts are available and why you might choose them. The benefits of receiving dividends. Betterment’s powerful tax-sensitive features. How Are Different Investment Accounts Taxed? Taxable Accounts Taxable investment accounts are typically the easiest to set up and have the least amount of restrictions. Although you can easily contribute and withdraw at any time from the account, there are trade-offs. A taxable account is funded with after-tax dollars, and any capital gains you incur by selling assets, as well as any dividends you receive, are taxable on an annual basis. While there is no deferral of income like in a retirement plan, there are special tax benefits only available in taxable accounts such as reduced rates on long-term gains, qualified dividends, and municipal bond income. Key Considerations You would like the option to withdraw at any time with no IRS penalties. You already contributed the maximum amount to all tax-advantaged retirement accounts. Traditional Accounts Traditional accounts include Traditional IRAs, Traditional 401(k)s, Traditional 403(b)s, Traditional 457 Governmental Plans, and Traditional Thrift Savings Plans (TSPs). Traditional investment accounts for retirement are generally funded with pre-tax dollars. The investment income received is deferred until the time of distribution from the plan. Assuming all the contributions are funded with pre-tax dollars, the distributions are fully taxable as ordinary income. For investors under age 59.5, there may be an additional 10% early withdrawal penalty unless an exemption applies. Key Considerations You expect your tax rate to be lower in retirement than it is now. You recognize and accept the possibility of an early withdrawal penalty. Roth Accounts Includes Roth IRAs, Roth 401(k)s, Roth 403(b)s, Roth 457 Governmental Plans, and Roth Thrift Saving Plans (TSPs) Roth type investment accounts for retirement are always funded with after-tax dollars. Qualified distributions are tax-free. For investors under age 59.5, there may be ordinary income taxes on earnings and an additional 10% early withdrawal penalty on the earnings unless an exemption applies. Key Considerations You expect your tax rate to be higher in retirement than it is right now. You expect your modified adjusted gross income (AGI) to be below $140k (or $208k filing jointly). You desire the option to withdraw contributions without being taxed. You recognize the possibility of a penalty on earnings withdrawn early. Beyond account type decisions, we also use your dividends to keep your tax impact as small as possible. Four Strategies Betterment Uses To Help You Limit Your Tax Impact 1. We use any additional cash to rebalance your portfolio. When your account receives any cash—whether through a dividend or deposit—we automatically identify how to use the money to help you get back to your target weighting for each asset class. Dividends are your portion of a company’s earnings. Not all companies pay dividends, but as a Betterment investor, you almost always receive some because your money is invested across thousands of companies in the world. Your dividends are an essential ingredient in our tax-efficient rebalancing process. When you receive a dividend into your Betterment account, you are not only making money as an investor—your portfolio is also getting a quick micro-rebalance that helps keep your tax bill down at the end of the year. And, when market movements cause your portfolio’s actual allocation to drift away from your target allocation, we automatically use any incoming dividends or deposits to buy more shares of the lagging part of your portfolio. This helps to get the portfolio back to its target asset allocation without having to sell off shares. This is a sophisticated financial planning technique that traditionally has only been available to larger accounts, but our automation makes it possible to do it with any size account. Beyond dividends, Betterment also has a number of features to help you optimize for taxes. Let’s demystify these three powerful strategies. Performance of S&P 500 With Dividends Reinvested Source: Bloomberg. Performance is provided for illustrative purposes to represent broad market returns for the U.S. Stock Market. The performance is not attributable to any actual Betterment portfolio nor does it reflect any specific Betterment performance. As such, it is not net of any management fees. The performance of specific U.S. Stock Market funds in the Betterment portfolio will differ from the performance of the broad market returns reflected here. 2. Tax loss harvesting. Tax loss harvesting can lower your tax bill by “harvesting” investment losses for tax reporting purposes while keeping you fully invested. When selling an investment that has increased in value, you will owe taxes on the gains, known as capital gains tax. Fortunately, the tax code considers your gains and losses across all your investments together when assessing capital gains tax, which means that any losses (even in other investments) will reduce your gains and your tax bill. In fact, if losses outpace gains in a tax year you can eliminate your capital gains bill entirely. Any losses leftover can be used to reduce your taxable income by up to $3,000. Finally, any losses not used in the current tax year can be carried over indefinitely to reduce capital gains and taxable income in subsequent years. How do I do it? When an investment drops below its initial value—something that is very likely to happen to even the best investment at some point during your investment horizon—you sell that investment to realize a loss for tax purposes and buy a related investment to maintain your market exposure. Ideally, you would buy back the same investment you just sold. After all, you still think it’s a good investment. However, IRS rules prevent you from recognizing the tax loss if you buy back the same investment within 30 days of the sale. So, in order to keep your overall investment exposure, you buy a related but different investment. Think of selling Coke stock and then buying Pepsi stock. Overall, tax loss harvesting can help lower your tax bill by recognizing losses while keeping your overall market exposure. At Betterment, all you have to do is turn on Tax Loss Harvesting+ in your account. 3. Asset location. Asset location is a strategy where you put your most tax-inefficient investments (usually bonds) into a tax-efficient account (IRA or 401k) while maintaining your overall portfolio mix. For example, an investor may be saving for retirement in both an IRA and taxable account and has an overall portfolio mix of 60% stocks and 40% bonds. Instead of holding a 60/40 mix in both accounts, an investor using an asset location strategy would put tax-inefficient bonds in the IRA and put more tax-efficient stocks in the taxable account. In doing so, interest income from bonds—which is normally treated as ordinary income and subject to a higher tax rate—is shielded from taxes in the IRA. Meanwhile, qualified dividends from stocks in the taxable account are taxed at a lower rate, capital gains tax rates instead of ordinary income tax rates. The entire portfolio still maintains the 60/40 mix, but the underlying accounts have moved assets between each other to lower the portfolio’s tax burden. Here’s what asset location looks like in action: 4. We use ETFs instead of mutual funds. Have you ever paid capital gain taxes on a mutual fund that was down over the year? This frustrating situation happens when the fund sells investments inside the fund for a gain, even if the overall fund lost value. IRS rules mandate that the tax on these gains is passed through to the end investor, you. While the same rule applies to exchange traded funds (ETFs), the ETF fund structure makes such tax bills much less likely. In fact, most of the largest stock ETFs have not passed through any capital gains in over 10 years. In most cases, you can find ETFs with investment strategies that are similar or identical to a mutual fund, often with lower fees. We go the extra mile for your money. Following these four strategies can help eliminate or reduce your tax bill, depending on your situation. At Betterment, we’ve automated these and other tax strategies, which means tax loss harvesting and asset location are as easy as clicking a button to enable it. We do the work, and your wallet can stay a little fuller. Learn more about how Betterment helps you maximize your after-tax returns. -
3 Simple Ways You Could Pay Fewer Taxes If You Have An Investment Account
3 Simple Ways You Could Pay Fewer Taxes If You Have An Investment Account Tax loss harvesting, asset location, and utilizing ETFs instead of mutual funds can eliminate or reduce your tax bill, depending on your situation. Here’s why. If you have investments, you might be paying Uncle Sam more than you need to come tax time. Thankfully, there are three things you can do to help keep more of your money in your own pocket. Many investors may not know these strategies are available, or may have heard about them but do not use them. If while you’re reading this you start to think that these strategies are difficult to implement, you’re not wrong. Before we get started, it’s important to note that when you’re a Betterment customer, we can do these things for you (all you have to do is opt-in through your account). Now, onto the good stuff: Let’s demystify these three powerful strategies. 1. Tax loss harvest. Tax loss harvesting can lower your tax bill by “harvesting” investment losses for tax reporting purposes while keeping you fully invested. When selling an investment that has increased in value, you will owe taxes on the gains, known as capital gains tax. Fortunately, the tax code considers your gains and losses across all your investments together when assessing capital gains tax, which means that any losses (even in other investments) will reduce your gains and your tax bill. In fact, if losses outpace gains in a tax year you can eliminate your capital gains bill entirely. Any losses leftover can be used to reduce your taxable income by up to $3,000. Finally, any losses not used in the current tax year can be carried over indefinitely to reduce capital gains and taxable income in subsequent years. How do I do it? For example, sell Coke, buy Pepsi. When an investment drops below its initial value—something that is very likely to happen to even the best investment at some point during your investment horizon—you sell that investment to realize a loss for tax purposes and buy a related investment to maintain your market exposure. Ideally, you would buy back the same investment you just sold. After all, you still think it's a good investment. However, IRS rules prevent you from recognizing the tax loss if you buy back the same investment within 30 days of the sale. So, in order to keep your overall investment exposure, you buy a related but different investment. Think of selling Coke stock and then buying Pepsi stock. Here’s an example of tax loss harvesting: Overall, tax loss harvesting can help lower your tax bill by recognizing losses while keeping your overall market exposure. At Betterment, all you have to do is see if it’s right for you and turn on Tax Loss Harvesting+ in your account. 2. Asset locate. Asset location is a strategy where you put your most tax-inefficient investments (usually bonds) into a tax-efficient account (IRA or 401k) while maintaining your overall portfolio mix. For example, an investor may be saving for retirement in both an IRA and taxable account and has an overall portfolio mix of 60% stocks and 40% bonds. Instead of holding a 60/40 mix in both accounts, an investor using an asset location strategy would put tax-inefficient bonds in the IRA and put more tax-efficient stocks in the taxable account. In doing so, interest income from bonds, which is normally treated as ordinary income and subject to a higher tax rate, is shielded from taxes in the IRA. Meanwhile, qualified dividends from stocks in the taxable account are taxed at a lower rate. The entire portfolio still maintains the 60/40 mix, but the underlying accounts have moved assets between each other to lower the portfolio’s tax burden. Asset location in action. 3. Use ETFs instead of mutual funds. Have you ever paid capital gain taxes on a mutual fund that was down over the year? This frustrating situation happens when the fund sells investments inside the fund for a gain, even if the overall fund lost value. IRS rules mandate that the tax on these gains is passed through to the end investor, you. While the same rule applies to exchange traded funds (ETFs), the ETF fund structure makes such tax bills much less likely. In fact, most of the largest stock ETFs have not passed through any capital gains in over 10 years. In most cases, you can find ETFs with investment strategies that are similar or identical to a mutual fund, often with lower fees. Following these three strategies can help eliminate or reduce your tax bill, depending on your situation. At Betterment, we’ve automated these and other tax strategies, which means tax loss harvesting and asset location are as easy as clicking a button to enable it. We do the work, and your wallet can stay a little fuller. Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional. -
Video: How Can Tax Loss Harvesting Help?
Video: How Can Tax Loss Harvesting Help? Tax loss harvesting (TLH) can be a silver lining in bad markets. In this video, Dan Egan, explains how it works at Betterment. -
What Should I Know About Taxes on My Investment Accounts?
What Should I Know About Taxes on My Investment Accounts? An informed and educated investor can make better decisions if they know the unique tax attributes of each type of investment account. In the US, 33% of households have a taxable investment account—often referred to as a brokerage account—and 89% of those households also have at least one retirement account, like an IRA or an employer-sponsored retirement account. We know that the medley of account types can make it challenging for the average investor to decide which account to contribute to or withdraw from at any given time. Further, the factors that might inform this decision don’t necessarily align with a straightforward, black-and-white rubric. Taxable Accounts Taxable investment accounts are typically the easiest to set up and have the least amount of restrictions. Although you can easily contribute and withdraw at any time from the account, there are trade-offs. A taxable account is funded with after-tax dollars and any capital gains your incur by selling assets, as well as any dividends you receive, are taxable on an annual basis. While there is no deferral of income like a retirement plan, there are special tax benefits only available in taxable accounts. Any gains avoid taxation until they are realized, or in other words, sold. Investments held for over one year qualify for long-term capital gains treatment, so those gains are taxed at a lower rate than investments that have been sold before being held for a year. There is an additional exception for an investor who holds investment assets until death: their cost basis is “stepped-up” (reset) to the market value on the date of their death. This means that the original cost of the assets is now considered to be the current value, and gains on any growth during their lifetime are avoided. Note too that inherited assets, when sold, are always taxed at the lower capital gains tax rate for long-term gains. The term dividend is frequently used in a broad sense but can ultimately be referring to distributions from a variety of investment activities. Qualified dividends paid from the the earnings and profits of corporations are taxable at the reduced long-term capital gains rates. Foreign taxes paid on dividends from non-US investments may be eligible for a foreign tax credit—to partially or fully offset taxation in the US so you aren’t paying double taxes. Dividends paid from taxable bond investments are taxed at ordinary income tax rates. Dividends paid from municipal bond investments are generally tax-free. Main Considerations for Choosing a Taxable Retirement Account You would like the option to withdraw at any time with no penalties. You have already contributed the maximum amount to all tax-advantaged retirement accounts. Traditional Accounts Includes Traditional IRAs, Traditional 401(k)s, Traditional 403(b)s, Traditional 457 Governmental Plans, and Traditional Thrift Savings Plans (TSPs) Traditional type investment accounts for retirement are generally funded with pre-tax dollars. The investment income received is deferred until the time of distribution from the plan. Assuming all the contributions are funded with pre-tax dollars, the distributions are fully taxable as ordinary income. For investors under age 59.5, there may be an additional 10% early withdrawal penalty unless an exemption applies. There are a number of possible 10% penalty exemptions, such as death, disability, or taking distributions as an annuity stream—refer to IRS.gov for more information. Unlike a taxable account, retirement plans do not receive a step-up in cost basis upon death. Foreign taxes paid on retirement account investments are not eligible to be claimed as a tax credit. Main Considerations for Choosing a Traditional Retirement Account You expect your tax rate to be lower in retirement than it is now. You recognize and accept the possibility of an early withdrawal penalty. Roth Accounts Includes Roth IRAs, Roth 401(k)s, Roth 403(b)s, Roth 457 Governmental Plans, and Roth Thrift Saving Plans (TSPs) Roth type investment accounts for retirement are always funded with after-tax dollars. Qualified distributions are tax-free. For investors under age 59.5, there may be ordinary income taxes on earnings and an additional 10% early withdrawal penalty on the earnings unless an exemption applies. While there is no step-up in cost basis upon death, distributions made to beneficiaries after the account has been open for five years are automatically tax-free. Foreign taxes paid on retirement account investments are not eligible to be claimed as a tax credit. Main Considerations for Choosing a Roth Retirement Account You expect your tax rate to be higher in retirement than it is right now. You desire the option to withdraw contributions without being taxed. You recognize the possibility of penalty on earnings withdrawn early. Summary of Key Considerations Are the retirement account contributions pre-tax or post-tax? Are the retirement account distributions expected to be tax-free? Is there a 10% early withdrawal penalty from a retirement distribution? Is there potential for long-term capital gain tax rates and qualified dividend rates? Going the Extra Mile With Additional Tax Efficiencies Betterment can help you be a smarter investor, because we offer additional features — at no extra cost — to help you minimize taxes so that you can maximize your money. Tax Coordination can help increase your overall returns if you are investing in multiple types of investment accounts, because it allocates your assets within each account type as tax-efficiently as possible. Tax Loss Harvesting+ can be used to capture losses during market declines so that you can use them to help offset future gains or even lower your tax bracket. Learn more about how Betterment helps you maximize your after-tax returns. Betterment is a financial advisor, not a tax advisor—consult a tax advisor or IRS resources for additional guidance. Getting Started Within a Betterment account, we can provide additional advice regarding which accounts you should be funding and in what order. You can even sync up your 401(k)s and other accounts to see an overall picture your finances. Get started or log in to complete your retirement plan and see personalized savings advice. -
The Benefits of Tax Loss Harvesting+
The Benefits of Tax Loss Harvesting+ We’ve automated tax loss harvesting which can help you save on taxes over time. Learn about the benefits of TLH+. Tax loss harvesting is the practice of selling an asset that has experienced a loss. The sold asset is replaced by a similar one, helping to maintain your risk level and your expected returns. By realizing, or "harvesting" a loss, you can: Offset taxes on realized capital gains. Reduce tax liability by reducing your income. Realized losses on investments can offset gains and reduce ordinary taxable income by as much as $3,000 per year. We do this all for you—at no additional cost—with our automated Tax Loss Harvesting+ feature. You could benefit from Tax Loss Harvesting+ if... You are investing in a taxable investment account. You plan to donate to charity or leave your assets to your heirs. The IRS allows you to offset your realized capital gains with realized capital losses. The IRS allows you to reduce up to $3,000 from your ordinary income. We don’t recommend Tax Loss Harvesting+ if... Your future tax bracket will be higher than your current tax bracket. You can currently realize capital gains at a 0% tax rate. Under current law, this may be the case if your taxable income is below $39,375 as a single filer or $78,750 if you are married filing jointly. You are planning to withdraw a large portion of your taxable assets in the next 12 months. You risk causing wash sales due to having substantially identical investments elsewhere. -
Asset Location Methodology
Asset Location Methodology In this paper, we discuss the various factors that must be considered by an optimal asset location strategy. We then present the methodology behind TCP, as well as results from performance simulations. TABLE OF CONTENTS Summary Part I: Asset Location For All: “We Have The Technology!” Part II: After-Tax Return—Deep Dive Part III: Asset Location in Popular Culture Part IV: TCP Methodology Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework Part VI: Who’s Up With TCP? Our Results Part VII: Special Considerations Conclusion Authors Additional References Disclosures Asset location is widely regarded as the closest thing there is to a "free lunch" in the wealth management industry.1 When investments are held in at least two types of accounts (out of three possible types: taxable, tax-deferred and tax-exempt), asset location has been demonstrated to deliver additional after-tax returns, while maintaining the same level of risk. Generally speaking, this benefit is achieved by placing the least tax-efficient assets in the accounts taxed most favorably, and the most tax-efficient assets in the accounts taxed least favorably, all while maintaining the desired asset allocation in the aggregate. However, intelligently applying asset location to a globally diversified portfolio is a complex, mathematically rigorous, and continuous undertaking. Betterment’s Tax-Coordinated Portfolio (TCP) is a dynamic asset location service that automates the process, tailoring its approach to each investor’s personal circumstances. TCP is the first implementation of holistic asset location by an automated investment service, and is a milestone in the rapid advancement of investing technology. It makes this sophisticated strategy accessible to investors who either do not have the desire, expertise, or the time to effectively customize it, and manage it on an ongoing basis. Due to its undeniable value for long-term investors, automated asset location will eventually become table stakes for digital advisors. We believe that its proliferation in the investment management industry will set the stage for the gradual decline of target-date funds, for reasons we discuss below. TCP is seamlessly compatible with Tax Loss Harvesting+ (TLH+), Betterment’s automated tax loss harvesting service. While the latter derives value from the taxable account only, both work in tandem to improve after-tax return without disturbing the desired asset allocation. In this paper, we discuss the various factors that must be considered by an optimal asset location strategy. We then present the methodology behind TCP, as well as results from performance simulations. Part I: Asset Location For All: "We Have The Technology!" Introduction With each year, it is increasingly accepted that most investors are better off following a passive investment strategy, which is best implemented through a diversified portfolio of index funds. As passive investing has grown more popular, focus has shifted away from attempting to beat the market, and toward maximizing the net "take-home" value of the portfolio. This is done by reducing costs, which include fees and taxes, among other things. Maximizing after-tax return on investments can be complex. Still, most investors know that contributing to tax-advantaged (or "qualified") accounts is a relatively straightforward way to pay less tax on their retirement savings. Millions of Americans wind up with some combination of IRAs and 401(k) accounts, both available in two types: traditional or Roth. Investors can see the impact of a deductible contribution when they do their taxes. They may be aware that a Roth contribution makes sense in a year when one’s tax bracket is unusually low. Many will only save in a taxable account once they have maxed out their contribution limits for the qualified accounts. But while tax considerations are paramount when choosing which account to fund, less thought is given to the tax impact of which investments to then purchase across all accounts. Meanwhile, the tax profiles of the three account types (taxable, traditional, and Roth) have implications for what to invest in, once the account has been funded. Choosing wisely can significantly improve the after-tax value of one’s savings, when more than one account is in the mix. Almost universally, such investors can benefit from a properly executed asset location strategy. The idea behind asset location is fairly straightforward. Certain investments generate their returns in a more tax-efficient manner than others. Certain accounts shelter investment returns from tax better than others. Placing, or "locating" less tax-efficient investments in tax-sheltered accounts should increase the after-tax value of the overall portfolio. Allocate First, Locate Second Let’s start with what asset location isn’t. All investors must select a mix of stocks and bonds, finding an appropriate balance of risk and expected return, in line with their goals. One common goal is retirement, in which case, the mix of assets should be tailored to match the investor’s time horizon. This initial determination is known as "asset allocation," and it comes first. When investing in multiple accounts, it is common for investors to simply recreate their desired asset allocation in each account. On a superficial level, this makes sense. If each account, no matter the size, holds the same assets in the same proportions, adding up all the holdings will also match the desired asset allocation. If all these funds, however scattered, are invested towards the same goal, this is the right result. The aggregate portfolio is the one that matters, and it should track the asset allocation selected for the common goal. Portfolio Managed Separately in Each Account However, as long as the desired asset allocation is maintained in the aggregate, each individual account does not necessarily need to reproduce the target portfolio. Enter asset location, which can only be applied once a desired asset allocation is selected. Each asset’s after-tax return is considered in the context of every available account. The assets are then arranged (unequally) across all coordinated accounts to maximize the after-tax performance of the overall portfolio. Same Portfolio Overall—With Asset Location To help conceptualize asset location, consider a team of runners. Some runners compete better on a track than a cross-country dirt path, as compared to their more versatile teammates. Similarly, certain asset classes benefit more than others from the tax-efficient "terrain" of a qualified account. Asset allocation determines the composition of the team, and the overall portfolio’s after-tax return is a team effort. Asset location then seeks to match up asset and environment in a way that maximizes the overall result over time, while keeping the composition of the team intact. Automatic for the People Asset location has theoretically made sense since qualified accounts were introduced in the 1970s. More recently, however, the strategy has gained increasing importance, as financial advice has expanded to cater to a wider demographic. The ultra-wealthy certainly take advantage of qualified accounts. However, due to contribution limits, such accounts typically represent a small percentage of a massive net worth (with exceptions, of course). Planning for such estates is more concerned with generational succession to wealth, rather than liquidation of all or most of a portfolio during one’s life. The rest of us hold a substantial portion of our savings in qualified accounts, and intend for these assets to be our source of income in retirement. These circumstances make asset location particularly valuable. Therefore, a scalable implementation of the strategy is highly desirable for advisors looking to improve outcomes for the average investor. This is easier said than done. Michael Kitces, a leading financial planner who has written extensively about asset location, summarizes both its potential and challenge: Asset location represents one of those unique "free lunch" opportunities for wealth creation—a mechanism by which investment strategies that are already being implemented can simply be done in a more tax-efficient manner that maximizes long-term wealth creation. Yet in practice, the idea of a "free" lunch for asset location may be slightly overstated, in that the complexity of implementing it effectively requires more work, with a far more intensive and proactive process to evaluate investments for their prospective return and tax-efficiency characteristics, establish an asset location priority list to be utilized, and then actually implement it—ostensibly with the assistance of rebalancing/trading software—on an ongoing basis.3 In other words, the theoretical value of asset location is limited by the difficulty of proper execution. Indeed, the difficulty is twofold. First, the initial calculation of a client-specific location requires a mathematically rigorous approach to what is essentially a complex optimization problem. Second, to maximize the benefit, this calculation must be performed continuously, in response to not only market movements and revised return expectations, but also the individual’s cash flows throughout the entire investment period. Deposits, withdrawals, rollovers, distributions, conversions and dividends will all shift the relative balances of the coordinated accounts. These shifts can necessitate location adjustments, big and small. While these challenges can be daunting and cost-prohibitive when performed manually, they are easily handled by software, which is strongest when it comes to mathematically complex, repeatable tasks. Automating these tasks takes far more work than manually solving for a single client. However, once the formulas have been derived, coded into algorithms, and deployed to a production environment, the incremental work required to apply the strategy to additional accounts is minimal. A team of Betterment quantitative analysts, tax experts, software engineers, designers, and product managers have been working for over a year, solving and automating all of these complexities. The result is software that can efficiently apply these calculations to millions of accounts. Betterment’s tightly integrated trading and position tracking systems allow for TCP’s decisions to be seamlessly executed for any individual client’s group of accounts, no matter the mix. RIP, TDF? Automated asset location makes sense for so many investors, that we believe most advice services will eventually have to provide some version of it to protect their value proposition. Seen through that lens, we believe that the release of TCP is the first step toward the eventual decline of the target-date fund (TDF). The primary appeal of a TDF is the "set it and forget it" simplicity with which it allows investors to select and maintain a diversified asset allocation, by purchasing only one fund. That simplicity comes at a price—because each TDF is a single, indivisible security, it cannot unevenly distribute its underlying assets across multiple accounts, and thus cannot deliver the additional after-tax returns of asset location. As soon as managing a single portfolio across multiple accounts becomes as easy as buying a TDF, its popularity should wane. Of course, TDFs are not disappearing any time soon. Disruption takes time—after all, Research In Motion recorded its highest ever profits on the Blackberry in the two years after the iPhone was released, before they started to slide. The structural friction in the investment management industry is an order of magnitude higher, and the transition will be slow. In particular, participants who are locked into 401(k) plans without automated management may find that a cheap TDF is still their best "hands off" option (plus, a TDF’s ability to satisfy the Qualified Default Investment Alternative (QDIA) requirement under ERISA ensures its baseline survival under current law). But change is coming—today, participants in a Betterment for Business plan can already enable TCP to manage a single portfolio across their 401(k), and any IRAs and taxable accounts they individually have with Betterment, squeezing additional after-tax returns from their aggregate long-term savings. Automated asset location (when integrated with automated asset allocation) replicates what makes a TDF so appealing, but effectively amounts to a "TDF 2.0"—an effortless, continuously managed portfolio, but one that can straddle multiple accounts for tax benefits. Next, we dive into the complex dynamics that need to be considered when seeking to optimize after-tax return of a diversified portfolio. Part II: After-Tax Return—Deep Dive The rules governing the taxation of investment income are dense and heavy on detail, but so was Ron Chernow’s "Alexander Hamilton," and look how that turned out. We first define a few key terms, and then dive into specifics. What a Drag It Is Getting Taxed A good starting point for a discussion of investment taxation is the concept of "tax drag." As the name implies, a growing portfolio encounters friction through the years, in the form of annual taxation. Tax drag is the portion of the return that is lost to tax on an annual basis. In particular, funds pay dividends, which are taxed in the year they are received. Gimme Shelter However, there is no annual tax in qualified accounts, also sometimes known as "tax-sheltered accounts." Therefore, placing assets that pay a substantial amount of dividends into a qualified account, rather than a taxable account, "shelters" those dividends, and reduces tax drag. Reducing the tax drag of the overall portfolio is one way that asset location improves the portfolio’s after-tax return. Importantly, investments are also subject to tax at liquidation, both in the taxable account, and in a traditional IRA (where tax is deferred). However, "tax drag", as that term it is commonly used, does not include liquidation tax. So while the concept of "tax drag" is intuitive, and thus a good place to start, it cannot be the sole focus when looking to minimize taxes. What We Talk About When We Talk About "Tax Efficiency" A closely related term is "tax efficiency" and this is one that most discussions of asset location will inevitably focus on. A tax-efficient asset is one that has minimal "tax drag." The less return that is lost to annual taxation, the more tax-efficient the asset generating that return is considered to be. By this definition, tax-efficient assets are typically those that generate most of their return through capital gains (taxed at liquidation), rather than through dividends. It is helpful to think of tax efficiency as a relative concept. An asset is only tax-efficient in the sense that it has less tax drag than another asset in the portfolio. Prioritizing assets on the basis of tax efficiency allows for asset location decisions to be made following a simple, rule-based approach. One goal of this paper is to demonstrate why this approach is too simple to be optimal. Since tax efficiency (as that term is commonly used) is only concerned with reducing annual tax drag, it has nothing to say about eventual liquidation tax. As we shall see, this narrow focus on a subset of the overall tax that must be paid makes tax efficiency an imperfect metric for trying to maximize after-tax return. However, the concept helps facilitate a basic understanding of how asset location adds a substantial amount of its value. Because it is a useful device, tax efficiency is referenced frequently in the discussion that follows. However, it is not worth dwelling too much on whether some asset is truly more or less tax-efficient than another. The ultimate objective is to maximize after-tax return of the portfolio, and tax efficiency is merely one piece of that puzzle. Tax Rates, Timing, and Account Types, Oh My! Both "tax drag" and "tax efficiency" are concepts pertaining to taxation of returns in a taxable account. Therefore, we first consider that account, where the rules are most elaborate. With an understanding of these rules, we can layer on the impact of the two types of qualified accounts. Returns in a Taxable Account There are two types of investment income, and two types of applicable tax rates, but they do not correlate neatly. Their interaction is easier to describe if we define the rates first. Two types of investment tax rates. All investment income in a taxable brokerage account is subject to one of two rate categories (with material exceptions noted). For simplicity, and to keep the analysis universal, this section only addresses federal tax (state tax is considered when testing for performance). Ordinary rate: For most, this rate mirrors the marginal tax bracket applicable to earned income (primarily wages reported on a W-2). For all but the lowest earners, that bracket will range from 25% to 39.6%. Preferential rate: This more favorable rate ranges from 15% to 20% for most investors. For especially high earners, both rates are subject to an additional tax of 3.8%, making the highest possible ordinary and preferential rates 43.4% and 23.8%, respectively. Two types of investment returns. Investments generate returns in two ways: by appreciating in value, and by making cash distributions. Capital gains: When an investment is sold, the difference between the proceeds and the tax basis (generally, the purchase price) is taxed as capital gains. If held for longer than a year, this gain is treated as long-term capital gains (LTCG) and taxed at the preferential rate. If held for a year or less, the gain is treated as short-term capital gains (STCG), and taxed at the ordinary rate. Barring unforeseen circumstances, passive investors should be able to avoid STCG entirely. Betterment’s automated account management avoids STCG,4 and the rest of this paper assumes only LTCG on liquidation of assets. Dividends: Bonds pay interest, which is taxed at the ordinary rate, whereas stocks pay dividends, which are taxed at the preferential rate (both subject to the exceptions below). An exchange-traded fund (ETF) pools the cash generated by its underlying investments, and makes payments that are called dividends, even if some or all of the source was interest. These dividends inherit the tax treatment of the source payments. This means that, generally, a dividend paid by a bond ETF is taxed at the ordinary rate, and a dividend paid by a stock ETF is taxed at the preferential rate. Qualified Dividend Income (QDI): There is an exception to the general rule for stock dividends. Stock dividends enjoy preferential rates only if they meet the requirements of qualified dividend income (QDI). Key among those requirements is that the company issuing the dividend must be a U.S. corporation (or a qualified foreign corporation). A fund pools dividends from many companies, only some of which may qualify for QDI. To account for this, the fund assigns itself a QDI percentage each year, which the custodian uses to determine the portion of the fund’s dividends that are eligible for the preferential rate.For stock funds tracking a U.S. index, the QDI percentage is typically 100%. However, funds tracking a foreign stock index will have a lower QDI percentage, sometimes substantially. For example, VWO, Vanguard’s Emerging Markets Stock ETF, had a QDI percentage of 38% in 2015, which means that 38% of its dividends for the year were taxed at the preferential rate, and 62% were taxed at the ordinary rate. Tax-exempt interest: There is also an exception to the general rule for bonds. Certain bonds pay interest that is exempt from federal tax. Primarily, these are municipal bonds, issued by state and local governments. This means that an ETF which holds municipal bonds will pay a dividend that is subject to 0% federal tax—even better than the preferential rate. The chart below summarizes these interactions. Note that this section does not consider tax treatment for those in a marginal tax bracket of 15% and below. These taxpayers are addressed in "Special Considerations." Dividends (taxed annually) Capital Gains (taxed when sold) Ordinary Rate Most bonds Non-QDI stocks (foreign) Any security held for a year or less (STCG) Preferential Rate QDI stocks (domestic and some foreign) Any security held for more than a year (LTCG) No Tax Municipal bonds Any security transferred upon death or donated to charity The impact of rates is obvious: The higher the rate, the higher the tax drag. Equally important is timing. The key difference between dividends and capital gains is that the former are taxed annually, contributing to tax drag, whereas tax on the latter is deferred. Tax deferral is a powerful driver of after-tax return, for the simple reason that the savings, though temporary, can be reinvested in the meantime, and compounded. The longer the deferral, the more valuable it is. Putting this all together, we arrive at the foundational piece of conventional wisdom, where the most basic approach to asset location begins and ends: Bond funds are expected to generate their return entirely through dividends, taxed at the ordinary rate. This return benefits neither from the preferential rate, nor from tax deferral, making bonds the classic tax-inefficient asset class. These go in your qualified account. Stock funds are expected to generate their return primarily through capital gains. This return benefits both from the preferential rate, and from tax deferral. Stocks are therefore the most tax-efficient asset class. These go in your taxable account. Tax-Efficient Status: It’s Complicated Reality gets messy rather quickly, however. Over the long term, stocks are expected to grow faster than bonds, causing the portfolio to drift from the desired asset allocation. Rebalancing may periodically realize some capital gains, so we cannot expect full tax deferral on these returns (although if cash flows exist, investing them intelligently can reduce the need to rebalance via selling). Furthermore, stocks do generate some return via dividends. The expected dividend yield varies with more granularity. Small cap stocks pay relatively little (these are growth companies that tend to reinvest any profits back into the business) whereas large cap stocks pay more (as these are mature companies that tend to distribute profits). Depending on the interest rate environment, stock dividends can exceed those paid by bonds. International stocks pay dividends too, and complicating things further, some of those dividends will not qualify as QDI, and will be taxed at the ordinary rate, like bond dividends (especially emerging markets stock dividends). Already, we can see the simple conventional wisdom straining to account for this real-world complexity. How large of a dividend must a stock fund pay before we take the resulting tax drag seriously? Is an emerging markets stock fund really more tax-efficient than a bond fund? If a bond fund is tax-exempt, doesn’t that asset class make the most sense in the taxable account? To have the full framework for addressing these questions, we next consider taxation of investment income in the qualified accounts, to the extent there is any. Returns in a Tax-Deferred Account (TDA) Compared to a taxable account, a TDA is governed by deceptively simple rules. However, earning the same return in a TDA involves trade-offs which are not intuitive. Applying a different time horizon to the same asset can swing our preference between a taxable account and a TDA. Understanding these dynamics is crucial to appreciating why an optimal asset location methodology cannot ignore liquidation tax, time horizon, and the actual composition of each asset’s expected return. In this section, we examine these trade-offs, which are some of the toughest to grasp. Although growth in a traditional IRA or traditional 401(k) is not taxed annually, it is subject to a liquidation tax. All the complexity of a taxable account described above is reduced to two rules. First, all tax is deferred until distributions are made from the account, which should begin only in retirement. Second, all distributions are taxed at the same rate, no matter the source of the return. The rate applied to all distributions is the higher ordinary rate, except that the additional 3.8% tax will not apply to those whose tax bracket in retirement would otherwise be high enough.5 First, we consider income that would be taxed annually at the ordinary rate (i.e. bond dividends and non-QDI stock dividends). The benefit of shifting these returns to a TDA is clear. In a TDA, these returns will eventually be taxed at the same rate, assuming the same tax bracket in retirement. But that tax will not be applied until the end, and compounding due to deferral can only have a positive impact on the after-tax return, as compared to the same income paid in a taxable account.6 The effect on returns that would otherwise be taxed at the preferential rate is more complex. For these returns, tax deferral comes at a price: when it does get taxed, it will be at the higher ordinary rate. There is potential for "negative tax arbitrage"—a conversion of lower-taxed income into higher-taxed income, which can lower the after-tax return. This runs counter to the goal of asset location, and needs to be considered very seriously. In particular, the risk is that LTCG (which we expect plenty of from stock funds) will be taxed like ordinary income. Under the basic assumption that in a taxable account, capital gains tax is already deferred until liquidation, favoring a TDA for an asset whose only source of return is LTCG is plainly harmful. There is no benefit from deferral, which you would have gotten anyway, and only harm from a higher tax rate. This logic supports the conventional wisdom that stocks belong in the taxable account. Not only do bonds benefit more from a TDA, the reasoning goes, but stocks are actually hurt by it! Again, reality is more complex. First, as already discussed, stocks do generate some return via dividends, and that portion of the return will benefit from tax deferral. This is obviously true for non-QDI dividends, already taxed as ordinary income, but QDI can benefit too. If the deferral period is long enough, the value of compounding will offset the hit from the higher rate at liquidation. Second, it is not accurate to assume that all capital gains tax will be deferred until liquidation in a taxable account. Rebalancing may realize some capital gains "prematurely" and this portion of the return could also benefit from tax deferral. Placing stocks in a TDA is a trade-off—one that must weigh the potential harm from negative rate arbitrage against the benefit of tax deferral. Valuing the latter means making assumptions about dividend yield and turnover. On top of that, the longer the investment period, the more tax deferral is worth. Kitces demonstrates that a dividend yield representing 25% of total return (at 100% QDI), and an annual turnover of 10%, could swing the calculus in favor of holding the stocks in a TDA, assuming a 30-year horizon.7 For foreign stocks with less than perfect QDI, we would expect the tipping point to come sooner. All of the above suggests that we should be wary of overloading a TDA with assets expected to generate substantial capital gains, if the time horizon is relatively short. However, the goal of this section is not to precisely define the circumstances under which stocks perform better in a TDA. Rather, it is to demonstrate that the problem defies a "rule of thumb" approach. Not all stocks are the same, and time horizon matters. The solution must optimize around these trade-offs. Returns in a Tax-Exempt Account (TEA) Investments in a Roth IRA or Roth 401(k) grow tax free, and are also not taxed upon liquidation. Since it eliminates all possible tax, a TEA presents a particularly valuable opportunity for maximizing after-tax return. The trade-off here is managing opportunity cost—every asset does better in a TEA, so how best to use its precious capacity? Clearly, a TEA is the most favorably taxed account. Conventional wisdom thus suggests that if a TEA is available, we use it to first place the least tax-efficient assets. But that approach is wrong. Everything Counts in Large Amounts—Why Expected Return Matters The powerful yet simple advantage of a TEA helps illustrate the limitation of focusing exclusively on tax efficiency when making location choices. Returns in a TEA escape all tax, whatever the rate or timing would have been, which means that an asset’s expected after-tax return equals its expected total return. A tax-inefficient asset is one that loses a relatively large portion of its annual return to taxes, whereas a tax-efficient one loses a relatively small portion. However, ranking assets in this way does not incorporate the absolute size of their returns. A small portion of a large return could benefit from sheltering more than a large portion of a small return. Even the least tax-efficient asset may not be the best candidate for permanent tax-avoidance, if its total return is expected to be relatively low. Savings from avoiding any annual tax do compound, but a small enough number will not amount to much. On the other hand, avoiding all tax on a large expected return may present a larger savings opportunity, even if that return is highly tax-efficient (taxed at liquidation, at the preferential rate). Putting this in concrete terms, when both a taxable account and a TEA are available, it may be worth putting a high-growth, low-dividend stock fund into the TEA, instead of a bond fund, even though the stock fund is vastly more tax-efficient. Not only that, but similar reasoning can apply to placement in a TDA as well, as long as the tax-efficient asset has a large enough expected return, and presents some opportunity for tax deferral (i.e., some portion of the return comes from dividends). In other words, an optimal asset location must consider both tax efficiency and expected return. Tax efficiency has something to say about the degree to which an asset will benefit from a qualified account, but the absolute amount of expected savings is what actually matters. Part III: Asset Location in Popular Culture To be sure, much like tax efficiency, "popular" is a relative concept. Still, much has been publicly written about asset location. The strategy is also (we assume) a topic of frequent rumor, conjecture, and innuendo. In this section, we look at existing approaches to asset location, and consider their advantages and limitations. But before diving into methodology, it is worth clearing up a few popular misconceptions. "The Tax Is Coming From Inside the Account!": Debunking Some Urban Legends Urban Legend 1: Asset location is a one-time process. Just set it and forget it. While an initial location may add some value, doing it properly is a continuous process, and will require adjustments in response to changing conditions. Note that overlaying asset location is not a deviation from a passive investing philosophy, because optimizing for location does not mean changing the overall asset allocation (the same goes for tax loss harvesting). Rick Ferri, a financial analyst and respected investing expert, has this to say: The problem with asset location is that nothing is static. Tax rates change, tax brackets change, tax preferences change, and on and on. What was a logical tax location one year may turn out to be a lousy one a few years later, but you're stuck in the one you have.8 Other things that will change, all of which should factor into an optimal methodology: expected returns (both the risk-free rate, and the excess return), dividend yields, QDI percentages, and most importantly, relative account balances. Contributions, rollovers, and conversions can increase qualified assets relative to taxable assets, continuously providing more room for additional optimization. Ferri is also making the point that future location adjustments may be limited if the assets we want to relocate out of the taxable account have appreciated substantially (and adjusting our asset location would not be worth the tax cost of realizing those gains). This is a legitimate consideration, but should not prevent us from optimizing around what we know today. A rigorous strategy should weigh the costs and benefits of a potential future adjustment. In particular, during one’s working years, a steady stream of deposits (as well as dividends) will provide constant opportunities to move closer to whatever the optimal location is at that time. Urban Legend 2: Taking advantage of asset location means you should contribute more to a particular qualified account than you otherwise would. Definitely not! Asset location should play no role in deciding which accounts to fund. It optimizes around account balances as it finds them, and is not concerned with which accounts should be funded in the first place. Just because the presence of a TEA makes asset location more valuable, does not mean you should contribute to a TEA, as opposed to a TDA. That decision is primarily a bet on how your tax rate today will compare to your tax rate in retirement. To hedge, some may find it optimal to make contributions to both a TDA and TEA (this is called "tax diversification"). While these decisions are out of scope for this paper, Betterment’s retirement planning tools can help clients with these choices. Urban Legend 3: Asset location has very little value if one of your accounts is relatively small. It depends. Asset location will not do much for investors with a very small taxable balance and a relatively large balance in only one type of qualified account, because most of the overall assets are already sheltered. However, a large taxable balance and a small qualified account balance (especially a TEA balance) presents a better opportunity. Under these circumstances, there may be room for only the least tax-efficient, highest-return assets in the qualified account. Sheltering a small portion of the overall portfolio can deliver a disproportionate amount of value. Urban Legend 4: Asset location has no value if you are investing in both types of qualified accounts, but not in a taxable account. Not so. A TEA offers significant advantages over a TDA. Zero tax is better than a tax deferred until liquidation. While tax efficiency (i.e. annual tax drag) plays no role in these location decisions, expected returns and liquidation tax do. The assets we expect to grow the most should be placed in a TEA, and doing so will plainly increase the overall after-tax return. There is an additional benefit as well. Required minimum distributions (RMDs) apply to TDAs but not TEAs. Shifting expected growth into the TEA, at the expense of the TDA, will mean lower RMDs, giving the investor more flexibility to control taxable income down the road. In other words, a lower balance in the TDA can mean lower tax rates in retirement, if higher RMDs would have pushed the retiree into a higher bracket. This potential benefit is not captured in our results. Urban Legend 5: Enough with the fancy talk. Bonds always go in the IRA, and that’s all there is to it. Possibly, but not necessarily. This commonly asserted rule is a simplification, and will not be optimal under all circumstances. It is discussed at more length below. Existing Approaches to Asset Location: Advantages and Limitations Optimizing for After-Tax Return While Maintaining Separate Portfolios One approach to increasing after-tax return on retirement savings is to maintain a separate, standalone portfolio in each account with roughly the same level of risk-adjusted return, but tailoring each portfolio somewhat to take advantage of the tax profile of the account. Effectively, this means that each account separately maintains the desired exposure to stocks, while substituting certain asset classes for others. Generally speaking, managing a fully diversified portfolio in each account means that there is no way to avoid placing some assets with the highest expected return in the taxable account. Based on the discussion above, it should be obvious that a strategy which completely rules out the possibility of sheltering such assets cannot be optimal. The presence of a TEA, which is unambiguously best for the highest growth assets, only underscores this limitation. This approach does include a valuable tactic, which is to differentiate the high-quality bonds component of the allocation, depending on the account they are held in. The allocation to the component is the same in each account, but in a taxable account, it is represented by municipal bonds which are exempt from federal tax (MUB), and in a qualified account, by taxable investment grade bonds (AGG). This variation is effective because it takes advantage of the fact that these two asset classes have very similar characteristics (expected returns, covariance and risk exposures) allowing them to play roughly the same role from an asset allocation perspective. Municipal bonds, however, are highly tax-efficient, and are very compelling in a taxable account. Taxable investment grade bonds have significant tax drag, and work best in a qualified account. Betterment has applied this substitution since 2014. As we shall see, this MUB/AGG substitution is incorporated into TCP’s methodology. The Basic Priority List For those looking to unevenly distribute a single portfolio across multiple account types with no help from software, a rule-based approach has obvious appeal. The presence of multiple assets, and a highly personal ratio of account balances make for a complex problem. Most DIY investors and professional advisors are not mathematicians, so tackling the optimization with maximum precision is not viable. In other words, when implemented manually, this is a strategy crying for a heuristic—a simple set of rules that will produce an asset location which is hopefully "good enough." The easiest way to determine "what goes where" is to have confidence that at least with respect to certain assets, "this goes there first." Armed with such conviction, the casual locator can start "filling up" the qualified account, prioritizing those assets which are perceived to benefit most from sheltering. Moving down the list requires only basic arithmetic—subtract the dollar amount allocated to an asset from the available balance, look to the next asset, and repeat until the qualified account is full (and what’s left goes in the taxable). That list, more often than not, is a ranking of assets based solely on tax efficiency. At one extreme you may have say, high-yield bonds, which generate all of their returns as dividends, taxed annually at the ordinary rate (high tax drag). At the other extreme would be say, U.S. small cap stocks—mostly capital gains, and the few dividends they do generate are QDI, taxed at the preferential rate (very little tax drag). Everything else goes in between, with bonds and stocks clustering together on opposite ends. This basic prioritization is the source for the conventional wisdom that "bonds go in the IRA." As one would expect, the desire to reduce complexity, if taken too far, eventually leads to suboptimal results. One immediately obvious exception is that municipal bonds are maximally tax-efficient, and belong in a taxable account. Still, other bonds are, in fact, highly tax-inefficient. Yet, as many have pointed out, in the current low-yield environment, bonds just do not return that much, so the potential savings are low. Is there a hidden opportunity cost to blindly prioritizing bonds in the qualified accounts, no matter what? "Smile" Like You Mean It Numerous experts have published research on how to best navigate the complex trade-offs discussed so far. The conclusion is more often than not: "It just depends." However, manual asset locators need an approach that is more sophisticated than prioritization by tax efficiency, while still being rule-based and thus easy to implement. Gobind Daryanani and Chris Cordaro sought to balance considerations around tax efficiency and expected return, and illustrated that when both are very low, location decisions with respect to those assets have very limited impact.9 That study inspired Michael Kitces, who leverages its insights into a more sophisticated approach to building a priority list.10 To visually capture the relationship between the two considerations, Kitces bends the one-dimensional list into a "smile." Asset Location Priority List The rendering is both effective, and delightfully simple. Assets with a high expected return that are also very tax-efficient go in the taxable account. Assets with a high expected return that are also very tax-inefficient go in the qualified accounts, starting with the TEA. The "smile" guides us in filling the accounts from both ends simultaneously, and by the time we get to the middle, whatever decisions we make with respect to those assets just "don’t matter" much. It’s clear why this heuristic is better than a straight ranking—plotting the assets in two dimensions allows the location decisions to factor in the interaction between two independent variables, both of which are important. Prioritizing with a "smile" means that the valuable real estate in the qualified accounts will not be occupied by assets that may have high tax drag, but very little to actually drag. However, Kitces augments the graph in short order, recognizing that the basic "smile" does not capture a third key consideration—the impact of liquidation tax. Because capital gains will eventually be realized in a taxable account, but not in a TEA, even a highly tax-efficient asset might be better off in a TEA, if its expected return is high enough. The next iteration of the "smile" illustrates this preference. Asset Location Priority List With Limited High Return Inefficient Assets A two-dimensional representation of a relationship between three variables immediately raises questions. Just how high must its return be, for a tax-efficient asset to bump a tax-inefficient asset out of the TEA? How high must its tax drag be, for that tax-inefficient asset to retain its tax-exempt perch? Unlike at the bottom of the smile, these are decisions that "matter," but the rules are no longer clear. Two dimensions are not enough! To push the optimization further, we need to revisit the limitation of "tax efficiency" as a metric. It is a poor measure for what we are actually seeking to maximize, which is after-tax return. Tax efficiency, as it is used in asset location discussions, is only concerned with annual tax drag in the taxable account. However, "liquidation tax drag" also exists, and varies across all accounts (moderate in the taxable, highest in a TDA, and absent in a TEA). In other words, we must also attempt to quantify "liquidation tax efficiency," but doing so is complex, because it involves all three accounts, whereas the accepted definition of tax efficiency described the taxable account only. We would need to derive an annualized after-tax return for each asset, in each account. This metric is driven by the expected return, but also incorporates both annual and liquidation tax, and is sensitive to time horizon. Suddenly, we are quite far from rules of thumb, lists, and graphs. This is not to say that investors taking advantage of a sophisticated heuristic, whether through their own efforts, or with the help of a skilled advisor, will not select a beneficial asset location. Far from it. As Kitces summarizes, nailing the corners of his "smile" and not worrying about the middle will undoubtedly add value: "Just get those two right and you’ve done yourself a ton of good."11 We wholeheartedly agree. With automation, we should be able to do even better. Too many important factors cannot be accounted for with a prioritization approach. However many rules we devise, we'll land on "good enough" when the answer is not apparent. Only a mathematical optimization can squeeze maximum benefit from a given set of inputs. Part IV: TCP Methodology By now, it should be clear that there is no one-size-fits-all asset location for every set of inputs. Some circumstances apply to all investors, but shift through time—the expected return of each asset class (which combines separate assumptions for the risk-free rate and the excess return), as well as dividend yields, QDI percentages, and tax laws. Other circumstances are personal—which accounts the client has, the relative balance of each account, and the client’s time horizon. Solving for multiple variables while respecting defined constraints is a problem that can be effectively solved by linear optimization. This method is used to maximize some value, which is represented by a formula called an "objective function." What we seek to maximize is the after-tax value of the overall portfolio at the end of the time horizon. We get this number by adding together the expected after-tax value of every asset in the portfolio, but because each asset can be held in more than one account, each portion must be considered separately, by applying the tax rules of that account. We must therefore derive an account-specific expected after-tax return for each asset. Deriving Account-Specific After-Tax Return To define the expected after-tax return of an asset, we first need its total return (i.e., before any tax is applied). The total return is the sum of the risk-free rate (same for every asset) and the excess return (unique to every asset). Betterment derives excess returns using the Black-Litterman model as a starting point. This common industry method involves analyzing the global portfolio of investable assets and their proportions, and using them to generate forward-looking expected returns for each asset class. Next, we must reduce each total return into an after-tax return.12 The immediate problem is that for each asset class, the after-tax return can be different, depending on the account, and for how long it is held. In a TEA, the answer is simple—the after-tax return equals the total return—no calculation necessary. In a TDA, we project growth of the asset by compounding the total return annually. At liquidation, we apply the ordinary rate to all of the growth.13 We use what is left of the growth after taxes to derive an annualized return, which is our after-tax return. In a taxable account, we need to consider the dividend and capital gain component of the total return separately, with respect to both rate and timing. We project growth of the asset by taxing the dividend component annually at the ordinary rate (or the preferential rate, to the extent that it qualifies as QDI) and adding back the after-tax dividend (i.e., we reinvest it). Capital gains are deferred, and the LTCG is fully taxed at the preferential rate at the end of the period. We then derive the annualized return based on the after-tax value of the asset.14 Note that for both the TDA and taxable calculations, time horizon matters. More time means more value from deferral, so the same total return can result in a higher annualized after-tax return. Additionally, the risk-free rate component of the total return will also depend on the time horizon, which affects all three accounts. William Reichenstein and William Meyer express a key insight into what this really means: "The same asset, whether stock or bond, is effectively a different asset when held in a TDA or taxable account."15 Because we are accounting for the possibility of a TEA, as well, we actually have three distinct after-tax returns, and thus each asset effectively becomes three assets, for any given time horizon (which is specific to each Betterment customer). The Objective Function To see how this comes together, we first consider an extremely simplified example. Let’s assume we have a taxable account, both a traditional and Roth account, with $50,000 in each one, and a 30-year horizon. Our allocation calls for only two assets: 70% equities (stocks) and 30% fixed income (bonds). With a total portfolio value of $150,000, we need $105,000 of stocks and $45,000 of bonds. 1. These are constants whose value we already know (as derived above). req,tax is the after-tax return of stocks in the taxable account, over 30 years req,trad is the after-tax return of stocks in the traditional account, over 30 years req,roth is the after-tax return of stocks in the Roth account, over 30 years rfi,tax is the after-tax return of bonds in the taxable account, over 30 years rfi,trad is the after-tax return of bonds in the traditional account, over 30 years rfi,roth is the after-tax return of bonds in the Roth account, over 30 years 2. These are the values we are trying to solve for (called "decision variables". xeq,tax is the amount of stocks we will place in the taxable account xeq,trad is the amount of stocks we will place in the traditional account xeq,roth is the amount of stocks we will place in the Roth account xfi,tax is the amount of bonds we will place in the taxable account xfi,trad is the amount of bonds we will place in the traditional account xfi,roth is the amount of bonds we will place in the Roth account 3. These are the constraints which must be respected. All positions for each asset must add up to what we have allocated to the asset overall. All positions in each account must add up to the available balance in each account. xeq,tax + xeq,trad + xeq,roth = 105,000 xfi,tax + xfi,trad + xfi,roth = 45,000 xeq,tax + xfi,tax = 50,000 xeq,trad + xfi,trad = 50,000 xeq,roth + xfi,roth = 50,000 4. This is the objective function, which uses the constants and decision variables to express the after-tax value of the entire portfolio, represented by the sum of six terms (the after-tax value of each asset in each of the three accounts). maxx req,taxxeq,tax + req,tradxeq,trad + req,rothxeq,roth + rfi,taxxfi,tax + rfi,tradxfi,trad + rfi,rothxfi,roth Linear optimization turns all of the above into a complex geometric representation, and mathematically closes in on the optimal solution. It assigns values for all decision variables in a way that maximizes the value of the objective function, while respecting the constraints. Accordingly, each decision variable is a precise instruction for how much of which asset to put in each account. If a variable comes out as zero, then that particular account will contain none of that particular asset. An actual Betterment portfolio can have up to twelve asset classes,16 depending on the allocation. That means TCP must effectively handle up to 36 "assets", each with its own after-tax return. However, the full complexity behind TCP goes well beyond increasing assets from two to twelve. Updated constants and constraints will trigger another part of the optimization, which determines what TCP is allowed to sell, in order to move an already coordinated portfolio toward the newly optimal asset location, while minimizing taxes. Reshuffling assets in a TDA or TEA is "free" in the sense that no capital gains will be realized.17 In the taxable account, however, TCP will attempt to move as close as possible towards the optimal asset location without realizing capital gains. The full optimization on an actual set of accounts must solve for hundreds of variables subject to hundreds of constraints, and reproducing the full objective function would take many pages. Good news! The computer will do it. Even better news: Because the calculation is automated, it can run every time any of our constants or constraints change, using every opportunity to either maintain, or move closer to the optimal asset location. Expected returns will periodically be updated, either because the risk-free rate has been adjusted, or because new excess returns have been derived via Black-Litterman. Future cash flows may be even more material. Additional funds in one or more of the accounts could significantly alter the constraints which define the size of each account, and the target dollar allocation to each asset class. Such events (including dividend payments, subject to a de minimis threshold) will trigger a recalculation, and potentially a reshuffling of the assets. Cash flows, in particular, can be a challenge for those managing their asset location manually. Inflows to just one account (or to multiple accounts in unequal proportions) create a tension between optimizing asset location and maintaining asset allocation, which is hard to resolve without mathematical precision. To maintain the overall asset allocation, each position in the portfolio must be increased pro-rata. However, some of the additional assets we need to buy "belong" in other accounts from an asset location perspective, even though new cash is not available in those accounts. If the taxable account can only be partially reshuffled due to built-in gains, we must choose either to move farther away from the target allocation, or the target location.18 With linear optimization, our preferences can be expressed through additional constraints, weaving these considerations into the overall problem. When solving for new cash flows, TCP penalizes allocation drift higher than it does location drift—another complexity not represented by the simplified objective function above. All the Math in the World Cannot Predict the Future We can reason our way into these choices, though some may be less intuitive than others. We can debate the many assumptions discussed above—changing any of them may impact these decisions. Linear optimization is only as good as its inputs, but extremely effective within that framework. Still, even linear optimization may not land on what will turn out to have been the optimal asset location, in retrospect. Events nobody can predict make this improbable, especially over a long horizon. But that is no reason not to select an optimized asset location based on what is known today, adjusting when new information becomes available. When asset location is automated, these adjustments are made centrally, and seamlessly propagated across all accounts. This makes the ongoing component of location management extremely efficient and consistent. However, it cannot be emphasized enough that expected returns (the key input into TCP, and portfolio management generally) are educated guesses at best. No matter how airtight the math, reasonable people will disagree on the "correct" way to derive them. The future may not cooperate, making a mockery of our best-laid plans, especially in the short-term. There is no guarantee that any particular asset location will add the most value, or even any value at all. But given decades, our certainty in the outcome grows. Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework To test the output of the linear optimization method, we turned to a rigorous Monte Carlo testing framework,19 built entirely in-house by Betterment’s experts. The forward-looking simulations model the behavior of the TCP strategy down to the individual lot level. We simulate the paths of these lots, accounting for dividend reinvestment, rebalancing, and taxation. As far as we are aware, this level of analysis for an asset location strategy has never been made public in the investment management industry. The forward market scenarios were derived from parametric sampling of a multivariate Gaussian distribution, where the mean was estimated using an equilibrium forecast method. Each set of assumptions was subject to at least 1,000 market scenarios. The covariance matrix was generated from historical returns. Forward dividends were simulated by sampling from a univariate Gaussian distribution, with the first and second moments derived from historical data, and with the same current dividend frequency. For QDI, we assumed the percentages reported by funds for 2015, over the whole period. The simulations applied Betterment’s rebalancing methodology, which corrects drift from the target asset allocation in excess of 3%, but stops short of ever realizing STCG. Betterment’s management fees were assessed in all accounts, and ongoing taxes were paid annually from the taxable account. All taxable sales first realized available losses before touching LTCG. The simulations assumed no additional cash flows other than dividends. This is not because we do not expect them to happen. Rather, it is because making assumptions around these very personal circumstances does nothing to isolate the benefit of TCP specifically. Asset location is driven by the relative sizes of the accounts, and cash flows will change these ratios, but the timing and amount is highly specific to the individual.20 Avoiding the need to make specific assumptions here helps keep the analysis more universal. We used equal starting balances for the same reason.21 R&D in the Cloud: Harder, Better, Faster, Stronger Betterment is hosted by Amazon Web Services (AWS), which allows us to dynamically increase or decrease the computing power available to our software in response to variable demand. The purpose of this infrastructure is to provide a consistently robust experience to customers in a scalable and efficient manner. However, an added benefit is that our R&D team has access to a platform that can temporarily support an extremely demanding computing load. Tracking positions at the tax lot level means accounting for basis on the fly, even for small trades, which Betterment executes using fractional shares. Each taxable sale is processed through our TaxMin lot selection algorithm, and all transactions (including purchases in qualified accounts) are run through our wash sale avoidance algorithms, which are described in our TLH+ white paper. All of this means that a 30-year simulation runs for multiple hours. AWS allows us to spin up thousands of servers simultaneously, each running a different market scenario in parallel. Each set of assumptions (combination of accounts, stock allocation) was tested under at least 1,000 market scenarios. The research presented here is the product of over 150,000 computer-hours, at times running on up to 3,000 AWS servers simultaneously. For every set of assumptions, we ran each market scenario while managing each account as a standalone (uncoordinated) Betterment portfolio as the benchmark.22 We then ran the same market scenarios with TCP enabled. In both cases, we calculated the after-tax value of the aggregate portfolio after full liquidation at the end of the period.23 Then, for each market scenario, we calculated the after-tax annualized internal rates of return (IRR) and subtracted the benchmark IRR from the TCP IRR. That delta represents the incremental tax alpha of TCP for that scenario. The median of those deltas across all market scenarios is the estimated tax alpha we present below for each set of assumptions. It is important to note that these results do not express the value of Betterment’s management vis-à-vis some particular non-Betterment investing strategy. Rather, they measure the incremental tax alpha of TCP, as compared to Betterment’s management of its uncoordinated portfolios in the same accounts. Still, these results are a reasonable measure of the effectiveness of Betterment’s implementation of asset location as applied to a passive investing strategy. Part VI: Who’s Up With TCP? Our Results If you have read this far, you are truly a tax management paladin, and our hats are off to you. We should hang out sometime. If you skipped ahead to get here, that’s okay too, as long as you promise to read the "Special Considerations" section, and the disclosures. All of the following projections assume a 30-year horizon, with an initial balance of $50,000 in each account. However, the specific tax rates matter when actually calculating tax alpha. We use the following assumptions, with deductibility of state taxes incorporated into the federal rate: "Moderate" tax rate: 28% federal tax bracket, the capital gains rates corresponding that bracket, and a state tax rate of 9.3% (the CA bracket corresponding to the 28% federal bracket). "High" tax rate: assumes 39.6%, the highest federal bracket, the capital gains rates corresponding to that bracket, and a state tax rate of 13.3% (the highest bracket in CA). Asset location for taxpayers in a 15% federal bracket or lower is driven by substantially different considerations, which are discussed below under "Special Considerations." The first set of results assumes a taxpayer subject to the Moderate tax rate both during the period, and in liquidation. 1. Three Accounts: TAX/TRAD/ROTH (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.82% 70% Stocks 0.48% 90% Stocks 0.27% 2. Two Accounts: TAX/TRAD (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.51% 70% Stocks 0.22% 90% Stocks 0.10% 3. Two Accounts: TAX/ROTH (Moderate tax) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.69% 70% Stocks 0.43% 90% Stocks 0.29% In the next set, we project tax alpha for a taxpayer subject to the highest rates. However, in this case, we want to use different rates for accumulation and liquidation, for a more realistic scenario. It is unlikely that a taxpayer in the 39.6% bracket during the working years will not be able to structure their taxable income in retirement to reduce the bracket substantially. We assume a Moderate rate in retirement, which applies on up to $230,000 of taxable income for a married couple filing jointly. 4. TAX/TRAD/ROTH (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.77% 70% Stocks 0.49% 90% Stocks 0.34% 5. Two Accounts: TAX/TRAD (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.54% 70% Stocks 0.27% 90% Stocks 0.20% 6. Two Accounts: TAX/ROTH (High tax, but Moderate tax for liquidation) Asset Allocation Additional Tax Alpha with TCP (Annualized) 50% Stocks 0.71% 70% Stocks 0.46% 90% Stocks 0.38% More Bonds, More Alpha The clearest pattern is that a higher allocation to bonds leads to a dramatically higher benefit across the board. This makes sense—the heavier your allocation to tax-inefficient assets, the more asset location can do for you. To be extremely clear: this is not a reason to select a lower allocation to stocks! Over the long-term, we expect a higher stock allocation to return more (because it’s riskier), both before, and after tax. These are measurements of the additional return due to TCP, which say nothing about the absolute return of the asset allocation itself. Conversely, a very high allocation to stocks shows a smaller (though still real) benefit. However, younger customers invested this aggressively should gradually reduce risk as they get closer to retirement (to something more like 50% stocks). Looking to the 70% stock allocation is therefore an imperfect but reasonable way to generalize the value of the strategy over a 30-year period. More Roth, More Alpha Another pattern is that the presence of a Roth makes the strategy more valuable. This also makes sense—a taxable account and a TEA are on opposite ends of the "favorably taxed" spectrum, and having both presents the biggest opportunity for TCP’s "account arbitrage." But again, this benefit should not be interpreted as a reason to contribute to a TEA over a TDA, or to shift the balance between the two via a Roth conversion. These decisions are driven by other considerations. TCP’s job is to optimize the relative balances as it finds them. Enabling TCP On Existing Taxable Accounts All of these results assume that TCP is enabled before the taxable account is funded, meaning that the initial location can be optimized without the need to sell potentially appreciated assets. A Betterment customer with an existing taxable account who enables TCP should not expect the full incremental benefit we project here, to the extent that assets with built-in capital gains need to be sold to achieve the optimal location. This is because TCP conservatively prioritizes avoiding a certain tax today, over potentially reducing tax in the future. However, the optimization is performed every time there is a deposit (or dividend) to any account. With future cash flows, the portfolio will move closer to whatever the optimal location is determined to be at the time of the deposit. Part VII: Special Considerations Low Bracket Taxpayers: Beware Taxation of investment income is substantially different for those who qualify for a marginal tax bracket of 15% or below. To illustrate, we have modified the chart from Part II to apply to such low bracket taxpayers. Dividends Capital Gains Ordinary Rate N/A Any security held for a year or less (STCG) Preferential Rate N/A N/A No Tax Qualified dividends from any security are not taxed Any security held for a year or more is not taxed (LTCG) TCP is not designed for these investors. Optimizing around this tax profile would reverse many assumptions behind TCP’s methodology. Municipal bonds no longer have an advantage over other bond funds. The arbitrage opportunity between the ordinary and preferential rate is gone. In fact, there’s barely tax of any kind. It is quite likely that such investors would not benefit much from TCP, and may even reduce their overall after-tax return. If the low tax bracket is temporary, TCP over the long-term may still make sense. Also note that some combinations of account balances can, in certain circumstances, still add tax alpha for investors in low tax brackets. One example is when an investor only has traditional and Roth IRA accounts, and no taxable accounts being tax coordinated. Low bracket investors should very carefully consider whether TCP is suitable for them. As a general rule, we do not recommend it. Potential Problems with Coordinating Accounts Meant for Different Time Horizons We began with the premise that asset location is sensible only with respect to accounts that are generally intended for the same purpose. This is crucial, because unevenly distributing assets will result in asset allocations in each account that are not tailored towards the overall goal (or any goal at all). This is fine, as long as we expect that all coordinated accounts will be available for withdrawals at roughly the same time (e.g. at retirement). Only the aggregate portfolio matters in getting there. However, uneven distributions are less diversified. Temporary drawdowns (e.g., the 2008 financial crisis) can mean that a single account may drop substantially more than the overall coordinated portfolio. If that account is intended for a short-term goal, it may not have a chance to recover by the time you need the money. Likewise, if you do not plan on depleting an account during your retirement, and instead plan on leaving it to be inherited for future generations, arguably this account has a longer time horizon than the others and should thus be invested more aggressively. In either case, We do not recommend managing accounts with materially different time horizons as a single portfolio. For a similar reason, you should avoid applying asset location to an account that you expect will be long-term, but one that you may look to for emergency withdrawals. For example, a Safety Net Goal should never be managed by TCP. Large Upcoming Transfers/Withdrawals If you know you will be making large transfers in or out of your tax-coordinated accounts, you may want to delay enabling our tax coordination tool until after those transfers have occurred. This is because large changes in the balances of the underlying accounts can necessitate rebalancing, and thus may cause taxes. With incoming deposits, we can intelligently rebalance your accounts by purchasing asset classes that are underweight. But when large withdrawals or transfers out are made, despite Betterment’s intelligent management of executing trades, some taxes can be unavoidable when rebalancing to your overall target allocation. The only exception to this rule is if the large deposit will be in your taxable account instead of your IRAs. In that case, you should enable tax-coordination before depositing money into the taxable account. This is so our system knows to tax-coordinate you immediately. The goal of tax coordination is to reduce the drag taxes have on your investments, not cause additional taxes. So if you know an upcoming withdrawal or outbound transfer could cause rebalancing, and thus taxes, it would be prudent to delay enabling tax coordination until you have completed those transfers. Mitigating Behavioral Challenges Through Design There is a broader issue that stems from locating assets with different volatility profiles at the account level, but it is behavioral. Uncoordinated portfolios with the same allocation move together. Asset location, on the other hand, will cause one account to dip more than another, testing an investor’s stomach for volatility. Those who enable TCP across their accounts should be prepared for such differentiated movement. Rationally, we should ignore this—after all, the overall allocation is the same—but that is easier said than done. Rick Ferri has an interesting example of how this played out during the last big downturn: "[T]here is a hidden risk with having different allocations in taxable versus non-taxable, and we saw this risk turn into reality during 2008 and early 2009. A few clients terminated their higher risk taxable portfolio because that specific portfolio was losing more money than the more conservative non-taxable portfolio. In other words, they separated their portfolios in their mind and compared returns rather than looking at the big picture."24 This is an important consideration, and should not be ignored. A good advisor should seek to maximize a client’s returns net of tax, fees, and behavior. So while this effect is real, we believe that intelligent product design can mitigate it somewhat for the modern investor. Clients using a digital investment service can access their balance and returns in real-time, and in our experience, rely far less on traditional statements, which are account-specific. Generally, this is behaviorally undesirable: an unavoidable cost of online investing. In this case, however, it presents an opportunity. App design has more latitude in presenting information than a statement does. A well-designed interface can surface aggregate performance only, nudging the client towards the "big picture," and deprioritizing counterproductive information.25 So while a client can still access each account’s balance and infer account-level performance, behaviorally sensitive UX can make an impact on what clients focus on. How TCP Interacts with Tax Loss Harvesting+ Asset location is highly compatible with tax loss harvesting. While the latter derives value from the taxable account only, both work in tandem to improve after-tax return. The reason they work well together is that both derive their benefit without disturbing the desired asset allocation. Operational Compatibility Betterment’s implementations of both strategies are especially compatible, because of certain design decisions made when building TLH+, Betterment’s automated tax loss harvesting service. For that strategy, effective wash sale management was paramount. Special attention was paid to avoiding a type of wash sale that permanently disallows a realized loss. This can happen when a security is sold at a loss in a taxable account, and a substantially identical security is purchased in a qualified account within the wash sale window. TLH+ was designed around a "tertiary ticker" system, which ensures that no purchase in an IRA or 401(k) managed by Betterment will interfere with a harvested loss in a Betterment taxable account. A sale in a taxable account, and a subsequent repurchase of the same asset class in a qualified account would be incidental for accounts managed as separate portfolios. Under TCP, however, we expect this to occasionally happen by design. When "relocating" assets, either during initial setup, or as part of ongoing optimization, TCP will sell an asset class in one account, and immediately repurchase it in another. The tertiary ticker system allows this reshuffling to happen seamlessly, while protecting any tax losses that are realized in the process. Conceptualizing Blended Performance Estimating the benefit of TCP and TLH on a standalone basis already requires making many generalized assumptions. However, modeling their combined benefit is even more difficult to generalize. Simulations of both strategies must be at the tax lot level, and combined performance is highly path dependent. They are expected to add more value together than either one would on its own, but simply adding up the two standalone estimates is clearly inaccurate, and a better answer is elusive. TCP will affect the composition of the taxable account in ways that are hard to predict, because its decisions will be driven by changes in relative balances among the accounts. Meanwhile, the weight of specific asset classes in the taxable account is a material predictor of the potential value of TLH (more volatile assets should offer more harvesting opportunities). The precise interaction between the two strategies is far more dependent on personal circumstances, such as today’s account balance ratios and future cash flow patterns, than on generally applicable inputs like asset class return profiles and tax rules. These dynamics are best understood as a hierarchy. Asset allocation comes first, and determines what mix of asset classes we should stick to overall. Asset location comes second, and continuously generates tax alpha across all coordinated accounts, within the constraints of the overall portfolio. Tax loss harvesting comes third, and looks for opportunities to generate tax alpha from the taxable account only, within the constraints of the asset mix dictated by asset location for that account. Decision logic at each tier is encapsulated, following the architectural principle of "information hiding." To illustrate in concrete terms: TCP knows only that the overall allocation must be 70% stocks, but should not be concerned with what drove that determination. Similarly, TLH does not need to know why the taxable account must hold (for example) municipal bonds and domestic equities only. Both seek to optimize after-tax return within their domain, playing the hand they are dealt. To sum up, it is worth highlighting why asset location sets the parameters for tax loss harvesting, and not the other way around. TLH is most effective in the first several years after an initial deposit to a taxable account. Over decades, however, we expect it to generate value only from subsequent deposits and dividend reinvestments. Eventually, even a substantial dip is unlikely to bring the market price below the purchase price of the older tax lots. Meanwhile, TCP continues to deliver tax alpha over the entire balance of all three accounts for the entire holding period. Conclusion An investment strategy intended to maximize the after-tax value of a portfolio should focus on increasing annualized after-tax return. Traditional approaches to asset location are concerned with prioritizing assets in certain accounts based on their relative "tax efficiency", with the objective of sheltering income from annual tax. This narrow focus ignores numerous factors which affect annualized after-tax return, but are hard to account for without a mathematically rigorous approach. To reach its potential, an optimal asset location methodology must incorporate these realities, which include liquidation tax, time horizon, expected total return, and the actual composition of each expected return. Automation provides us with an opportunity to tackle these complexities. Betterment’s TCP considers both generally applicable inputs and customer-specific circumstances when optimizing an asset location for each set of accounts. TCP’s reliance on linear optimization makes it a "living implementation" of asset location. As material assumptions change, TCP can be easily adjusted across the entire customer base, without the need to rewrite its fundamental rules. Accordingly, the service can optimize after-tax returns for Betterment’s customers based on today’s expectations, without sacrificing operational flexibility, which will be utilized in the years to come. Addendum As of May 2020, for customers who indicate that they’re planning on using a Health Savings Account (HSA) for long-term savings, we allow the inclusion of their HSA in their Tax-Coordinated Portfolio. If an HSA is included in a Tax-Coordinated Portfolio, we treat it essentially the same as an additional Roth account. This is because funds within an HSA grow income tax-free, and withdrawals can be made income tax-free for medical purposes. With this assumption, we also implicitly assume that the HSA will be fully used to cover long-term medical care spending. The tax alpha numbers presented above have not been updated to reflect the inclusion of HSAs, but remain our best-effort point-in-time estimate of the value of TCP at the launch of the feature. As the inclusion of HSAs allows even further tax-advantaged contributions, we contend that the inclusion of HSAs is most likely to additionally benefit customers who enable TCP. 1"Boost Your After-Tax Investment Returns." Susan B. Garland. Kiplinger.com, April 2014. 3Pg. 13, The Kitces Report. March/April 2014. 4This does not include withdrawals or customer-directed allocation changes. If these are substantial enough, realizing STCG may be unavoidable. In such cases, Betterment customers are notified before they confirm their instruction, via Tax Impact Preview. 5But see "How IRA Withdrawals In The Crossover Zone Can Trigger The 3.8% Medicare Surtax," Michael Kitces, July 23, 2014. 6It is worth emphasizing that asset location optimizes around account balances as it finds them, and has nothing to say about which account to fund in the first place. Asset location considers which account is best for holding a specified dollar amount of a particular asset. However, contributions to a TDA are tax-deductible, whereas getting a dollar into a taxable account requires more than a dollar of income. 7Pg. 5, The Kitces Report. January/February 2014. 8 "Problems with Reichenstein's "Asset Location Decision Revisted." Bogleheads.org. Nov. 10, 2013. 9Daryanani, Gobind, and Chris Cordaro. 2005. "Asset Location: A Generic Framework for Maximizing After-Tax Wealth." Journal of Financial Planning (18) 1: 44–54. 10The Kitces Report, March/April 2014. 11 "Minimizing the Tax Drag on Your Investments," By Carla Fried. The New York Times, Feb. 7, 2014. 12While the significance of ordinary versus preferential tax treatment of income has been made clear, the impact of an individual’s specific tax bracket has not yet been addressed. Does it matter which ordinary rate, and which preferential rate is applicable, when locating assets? After all, calculating the after-tax return of each asset means applying a specific rate. It is certainly true that different rates should result in different after-tax returns. However, we found that while the specific rate used to derive the after-tax return can and does affect the level of resulting returns for different asset classes, it makes a negligible difference on resulting location decisions. The one exception is when considering using very low rates as inputs (the implication of which is discussed under "Special Considerations"). This should feel intuitive: Because the optimization is driven primarily by the relative size of the after-tax returns of different asset classes, moving between brackets moves all rates in the same direction, generally maintaining these relationships monotonically. The specific rates do matter a lot when it comes to estimating the benefit of the asset location chosen, so rate assumptions are laid out in the "Results" section. In other words, if one taxpayer is in a moderate tax bracket, and another in a high bracket, their optimal asset location will be very similar and often identical, but the high bracket investor may benefit more from the same location. 13In reality, the ordinary rate is applied to the entire value of the TDA, both the principal (i.e., the deductible contributions) and the growth. However, this will happen to the principal whether we use asset location or not. Therefore, we are measuring here only that which we can optimize. 14TCP today does not account for the potential benefit of a foreign tax credit (FTC). The FTC is intended to mitigate the potential for double taxation with respect to income that has already been taxed in a foreign country. The scope of the benefit is hard to quantify and its applicability depends on personal circumstances. All else being equal, we would expect that incorporating the FTC may somewhat increase the after-tax return of certain asset classes in a taxable account—in particular developed and emerging markets stocks. If maximizing your available FTC is important to your tax planning, you should carefully consider whether TCP is the optimal strategy for you. 15Note that Reichenstein and Meyer develop this concept to optimize asset allocation—an approach known as "after-tax asset allocation." They stress that pre-tax contributions to TDAs are "partnerships", and the government is effectively a minority partner, with an interest in part of the return and principal. This view has implications for what the asset allocation should be, when factoring in liquidation tax. After-tax asset location prioritizes allocation over after-tax return, and is not without its detractors. TCP today does not optimize for after-tax allocation. 16One component of the portfolio gets special treatment, as previewed in an earlier section. The overall asset allocation treats high-quality bonds as one asset class. However, when solving for this asset class, the optimizer uses MUB’s return for the after-tax return in the taxable account, and AGG’s return for the after-tax return in the qualified accounts. The resulting decision variables tell us the dollar value of high-quality bonds that goes in each account, but the actual purchases follow the same split—MUB in the taxable, AGG in the qualified. The sum of the MUB position and AGG positions will equal the overall allocation to high-quality bonds. 17Standard market bid-ask spread costs will still apply. These are relatively low, as Betterment considers liquidity as a factor in its investment selection process. Betterment customers do not pay for trades. 18Additionally, in the interest of making interaction with the tool maximally responsive, certain computationally demanding aspects of the methodology were simplified for purposes of the tool only. This could result in a deviation from the target asset location imposed by the TCP service in an actual Betterment account. 19Another way to test performance is with a backtest on actual market data. One advantage of this approach is that it tests the strategy on what actually happened. Conversely, a forward projection allows us to test thousands of scenarios instead of one, and the future is unlikely to look like the past. Another limitation of a backtest in this context—sufficiently granular data for the entire Betterment portfolio is only available for the last 15 years. Because asset location is fundamentally a long-term strategy, we felt it was important to test it over 30 years, which was only possible with Monte Carlo. Additionally, Monte Carlo actually allows us to test tweaks to the algorithm with some confidence, whereas adjusting the algorithm based on how it would have performed in the past is effectively a type of "data snooping". 20In simulations, as in the actual product, Betterment uses cash flows to purchase underweight assets first, helping reduce portfolio drift and reducing the likelihood that a taxable sale will be required to rebalance. This will increase the after-tax return both for TCP, and for uncoordinated accounts baseline. However, note that when accounts are coordinated, there is a higher likelihood that taxable sales can be avoided. Because we are now managing a single portfolio, TCP will make whatever use it can of the qualified accounts to reduce overall drift, and to the extent that the overweight asset is available in a qualified account, it will sell that position. For all transactions, the algorithms have a preference for correcting allocation drift first, but will attempt to optimize for location as part of the same transaction, if possible. 21That said, the strategy is expected to change the relative balances dramatically over the course of the period, due to unequal allocations. We expect a Roth balance in particular to eventually outpace the others, since the optimization will favor assets with the highest expected return for the TEA. This is exactly what we want to happen. 22For the uncoordinated taxable portfolio, we assume an allocation to municipal bonds (MUB) for the high-quality bonds component, but use investment grade taxable bonds (AGG) in the uncoordinated portfolio for the qualified accounts. While TCP makes use of this substitution, Betterment has offered it since 2014, and we want to isolate the additional tax alpha of TCP specifically, without conflating the benefits. 23Full liquidation of a taxable or TDA portfolio that has been growing for 30 years will realize income that is guaranteed to push the taxpayer into a higher tax bracket. We assume this does not happen, because in reality, a taxpayer in retirement will make withdrawals gradually. The strategies around timing and sequencing decumulation from multiple account types in a tax-efficient manner are out of scope for this paper. 24https://www.bogleheads.org/forum/viewtopic.php?t=98662 25Since inception, Betterment has never displayed daily performance of individual ETFs in a portfolio, and has generally de-emphasized daily performance of a portfolio, since focusing on short-term volatility is not productive, and instead increases the probability of suboptimal investor behavior. Instead, the interface was designed to emphasize information that an investor can and should act on—such as an indication of whether the portfolio is on track to reaching its specified goal, and if not, what can be done to put it back on track. Authors Boris Khentov, J.D., is VP of Operations and Legal Counsel at Betterment. He has a B.A. in Computer Science from Harvard University and a J.D. from Northwestern University School of Law. Prior to Betterment, Boris was a software engineer at Antenna Software, and practiced tax and capital markets law at Cleary Gottlieb Steen & Hamilton LLP. Boris helped oversee the development of Tax-Coordinated Portfolio, and wrote so very many words. No capital gains were realized in the writing of this paper. Rukun Vaidya is a Product Manager at Betterment. He has a degree in Operations Research from Cornell University. Prior to Betterment, Ruk spent five years performing risk research at Highbridge Capital, where he focused on statistical arbitrage, quantitative macro, and quantitative commodities. As the lead Product Manager for Tax-Coordinated Portfolio, Ruk conceived its methodology and led the implementation team. Ruk had a joke in here, but it did not make it through compliance. Lisa Huang, Ph.D., is Head of Quantitative Analysis & Research at Betterment. She holds a degree in mathematics and biochemistry from UCLA, and a Ph.D. in theoretical physics from Harvard University. Prior to Betterment, Lisa was a quantitative strategist at Goldman Sachs, leading research collaborations and building models for fixed income strategies. She is the brains behind the "Cloud Ferrari" that is Betterment’s Monte Carlo performance testing framework. Lisa is always right, especially when the problem is so hard that everyone else barely has a clue. Additional References Berkin. A. "A Scenario Based Approach to After-Tax Asset Allocation." 2013. Journal of Financial Planning. Jaconetti, Colleen M., CPA, CFP®. Asset Location for Taxable Investors, 2007. https://personal.vanguard.com/pdf/s556.pdf. Poterba, James, John Shoven, and Clemens Sialm. "Asset Location for Retirement Savers." November 2000. https://faculty.mccombs.utexas.edu/Clemens.Sialm/PSSChap10.pdf. Reed, Chris. "Rethinking Asset Location - Between Tax-Deferred, Tax-Exempt and Taxable Accounts." Accessed 2015. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2317970. Reichenstein, William, and William Meyer. "The Asset Location Decision Revisited." 2013. Journal of Financial Planning 26 (11): 48–55. Reichenstein, William. 2007. "Calculating After-Tax Asset Allocation is Key to Determining Risk, Returns, and Asset Location." Journal of Financial Planning (20) 7: 44–53. Disclosures The value provided by Tax-Coordinated Portfolio (TCP) will vary depending on each investor’s personal circumstances. Investors who have a short time horizon may get little to no value from the asset location strategy employed by TCP. Under certain circumstances, investors could conceivably even decrease their after-tax returns by enabling TCP. As a general matter, asset location strategies like the one implemented by TCP distribute assets unevenly across multiple accounts based on the varying return profiles of each asset (separately considering the potential for capital appreciation and dividend yield). These figures are "expected returns"—projections for what future returns might be. While these figures are empirically derived (using the Black-Litterman method as a starting point) they are still speculative, and actual returns will differ year-to-year, often substantially. Therefore, while the reasonable expectation may be that asset A will pay more dividends than asset B (and/or appreciate more than asset B), the opposite could happen in any given year, or across a number of years, such that asset location decisions based on differing expectations do not maximize after-tax returns. The longer the investing period, the more likely it is that the relative performance of the various assets in the portfolio will converge on what is expected. Shorter periods, however, are more likely to produce unexpected results. Asset location seeks to place assets with higher expected returns into tax-advantaged accounts. Therefore, toward the end of the accumulation phase, an investor should expect his or her tax-advantaged accounts to have a higher balance than they otherwise would have had (and the taxable retirement account to have a lower balance than it would have had, had an asset location strategy not been deployed). While under most circumstances, more growth in a tax-advantaged account (in exchange for less growth in a taxable account) is desirable, there are potential trade-offs which should be considered. For instance, tax-advantaged accounts incur penalties for early withdrawal, so to the extent that access to funds prior to retirement becomes necessary, liquidity may come at a higher cost for a portion of funds that might otherwise be accessible penalty-free (had that appreciation taken place in the taxable account instead). If the tax-advantaged assets are primarily or exclusively tax-deferred, rather than tax-exempt (e.g., a traditional IRA vs. a Roth IRA), then additional considerations should be weighed. Because all distributions from a tax-deferred account are taxed at ordinary rates, including amounts that would be taxed as long-term capital gains when realized in a taxable account, shifting such appreciation could amount to a conversion of lower taxed income into higher taxed income. Over a long enough period, the tax deferral (i.e., the ability to continually reinvest the tax savings and compound that growth, before eventually paying the tax) is expected to be valuable enough to justify such a conversion. This is especially likely when the taxpayer expects to be in a lower income tax bracket in retirement than during the accumulation phase (often, though not always the case). However, when asset location is practiced over a short period (years, not decades) and the taxpayer maintains a high income tax bracket at the time of distribution, conversion of some capital gains into ordinary income may dominate the after-tax return, thereby rendering the asset location strategy counterproductive. As a separate matter, a higher tax-deferred balance could mean higher required minimum distributions (RMDs) in retirement, which could be an important consideration for those seeking to minimize their RMDs. No performance estimates are based on actual client trading history, and actual Betterment clients may experience different results. Factors which will determine the actual benefit of TCP include, but are not limited to, market performance, the relative size of each account included in TCP, the equity exposure of the portfolio, the frequency and size of deposits into the various accounts, the tax rates applicable to the investor in a given tax year and in future years, and the time elapsed before liquidation of any of the accounts becomes necessary. Nothing herein should be interpreted as tax advice, and Betterment does not represent in any manner that the tax consequences described herein will be obtained, or that any Betterment product will result in any particular tax consequence. Please consult your personal tax advisor as to whether TCP is a suitable strategy for you, given your particular circumstances. The tax consequences of asset location are complex and uncertain. You and your tax advisor are responsible for how transactions conducted in your account are reported to the IRS on your personal tax return. Betterment assumes no responsibility for the tax consequences to any client of any transaction.
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