How Tax Impact Preview Works to Help Avoid Surprises

Betterment continues to make investing more transparent and tax-efficient, and empowers you to make smarter financial decisions.

208 2  Avoid Surprises with Tax Impact Preview

Two words that don’t belong together: taxes and surprise. But all too often, a transaction made in your investment account has unexpected, costly consequences many months later.

Selling securities has tax implications. Typically, these announce themselves the following year, when you get your tax statement.  Today, we are changing that, with Tax Impact Preview.

Betterment’s Tax Impact Preview feature provides a real-time tax estimate for a withdrawal or allocation change—before you confirm the transaction. Tax Impact Preview shows you exactly the information you should be focusing on to make an informed decision—potentially lowering your tax bill.

Tax-Aware Investors Can Consider:

  1. Do the benefits outweigh the costs?
  2. Should I wait to avoid short-term capital gains?
  3. Is there another source of funds I could use that might have a lower or no tax impact?

“Customers can become overly focused on short-term returns and change allocations or make withdrawals in reaction to fluctuations in the market,” says Alex Benke, CFP®, product manager for this new feature, “Tax Impact Preview will help these customers stay focused on the big picture and avoid unpleasant surprises on their tax bill.”

Tax Impact Preview: An Industry First

Betterment is the only investment platform to offer this kind of real-time tax information—and it joins a suite of tools which already helps investors minimize their taxes, including Tax CoordinationTax Loss Harvesting+, TaxMin, and more. Tax Impact Preview is available to all Betterment customers at no additional cost.

Learn more about the suite of tax-efficiency features available for your portfolio.

How It Works

When you initiate a sale of securities (a withdrawal or allocation change), our algorithms first determine which ETFs to sell (rebalancing you in the process, by first selling the overweight components of your portfolio). Within each ETF, our lot selection algorithm, which we call TaxMin, will select the most tax-efficient lots, selling losses first, and short-term gains last.

Transaction Timeline Table

With Tax Impact Preview, you will now see an “Estimate tax impact” button when you initiate an allocation change or withdrawal, which will give you detailed estimates of expected gains and/or losses, breaking them down by short and long-term.

Using this timely information, you can better decide if the tax result makes sense for you.  If your transaction results in a net gain, we estimate the maximum tax you might owe.

Why Estimated?

The precise tax owed depends on many circumstances specific to you: not just your tax bracket, but also the presence of past and future capital gains or losses for the year across all of your investment accounts. We use the highest applicable rates, to give you an upper-bound estimate.

You might ask—why are the gains and losses about to be realized not exact, even if the resulting tax is only an estimate? The gains and losses depend on the exact price that the various ETFs will sell at. If the estimate is done after market close, the prices are sure to move a bit by the time the market opens. Even during the day, a few minutes will pass between the preview and the trades, and prices will shift some, so the estimates will no longer be 100% accurate.

Finally, while we are able to factor in wash sale implications from prior purchases in your Betterment account, the estimates could change substantially due to future purchases, and we do not factor in activity in non-Betterment accounts.

That is why every number we show you, while useful, is an estimate. Tax Impact Preview is not tax advice, and you should consult a tax professional on how these estimates apply to your individual situation.

Why You Should Avoid Short-Term Capital Gains

Smart investors take every opportunity to defer a gain from short-term to long-term—it can make a substantive difference in the return from that investment. To demonstrate, let’s assume a long-term rate of 20% and a short-term rate of 40%. A $10,000 investment with a 10% return—or $1,000—will result in a $400 tax if you sell 360 days after you invested. But if you wait 370 days to sell, the tax will be only $200.

That’s the difference between a 6% and 8% after-tax return. Until now, making the smart choice meant doing your own calculations for every trade you were about to make. This is the kind of stuff most people hate doing, and automation excels at, so we built it into our product.

A Sample Scenario

Betterment customer Jenny, 34, has been watching the recent market news and feels nervous about her "Build Wealth" goal, which has a balance of $95,290. She is currently at 90% stocks—the optimal allocation for an investor with more than a 20 year horizon.

Jenny decides to temporarily move her allocation to 10% stocks to minimize her exposure to the roller coaster on Wall Street.

What Jenny may not realize is that changing allocation will cost her very real money—in the form of a tax bill. And even if she suspects it, she cannot appreciate the extent of the cost. The taxes are abstract, but the anxiety from the rocky market is real.

Tax Allocation Evaluation

Before finalizing the allocation change, Jenny clicks “Estimate tax impact” and sees that she is about to realize $4,641 in capital gains, with $4,290 of that short-term, which could incur up to $2,304 in taxes if she goes through with the trades.

Putting a real dollar cost on knee-jerk reactions to market volatility is exactly what we as investors need at the critical moment when we are about to deviate from our long-term plan.

Market timing is not a good idea, and most of us know this. However, emotions can get the better of even the most sophisticated investors, and we can all use some help in making the right decisions.

Smarter Design for Better Decisions, Lower Taxes

We believe that unhelpful emotion can be mitigated by good product design, which emphasizes the right information at just the right time.

For instance, we never show you the individual daily performance of the ETFs in your portfolio—you are more likely to see losses that way, even if your overall portfolio is up. Seeing losses causes stress, which leads to emotional behavior, which can hurt your long-term returns. And yet, every other investment platform shows you individual asset performance front and center.

On the other hand, showing you the estimated tax impact of a transaction before you commit to it encourages better decisions, and yet nobody except Betterment shows you this information.

This distinction is at the core of our mission. Building the perfect investment service is not just about a pretty web interface, or a slick mobile app (though these are nice too!). It means rethinking every convention from the ground up.

We are very excited about Tax Impact Preview, because it’s already helping our customers make better choices, and lessen their tax burden.