There are three main things to bear in mind for your taxable account with regard to this transition: short- and long-term capital gains and capital losses.
If all your money is in a tax-deferred account (i.e. a 401k, IRA), you don't need to worry about these taxes. But if you have a taxable account you do.
Specifically, we’ve gotten a lot of questions on the tax implications of the transition to the new Betterment portfolio. Overall, barring special circumstances, the expected impact of the portfolio transition shouldn’t be substantial. As always, the precise tax consequences vary by customer because they depend on circumstances specific to each taxpayer. Consult your tax advisor if you have questions about your situation.
However, we’ve carefully thought through every aspect of this transition, and wanted to share some general thoughts with you.
If all your money is in a tax-deferred retirement account (like a 401k or traditional IRA), you don’t have to worry about these taxes right now. But if you’re saving money in a taxable account, where you end up with short- and long-term capital gains and/or capital losses, managing taxes can make a difference both this year and over the long haul.
The big three
When we transition you to a new portfolio, we’ll sell some of the ETFs you currently hold, and buy other ETFs. Buying securities generally has no immediate tax implications*, but selling them could. At a high level, selling securities has three tax outcomes:
a. Short-term capital gains: For investments held for a year or less, any gains are taxed at the same rate as the marginal rate on your ordinary income, i.e. salary, which is usually the highest rate that can apply to your income.
b. Long-term capital gains: For investments held more than a year, any gains are taxed at a rate that’s usually lower than the rate on short-term gains.
c. Losses: These could be short or long-term, and can be used to offset gains to minimize any tax owed for the year (and can be carried forward to future years as well).
Your tax transition
The transition to the new Betterment portfolio involves selling all customer holdings in TIP and SHY, our current bond funds. As discussed above, selling securities might be expected to trigger capital gains. However, both TIP and SHY have generally lost capital value over the past 24 months. This means that most customers may wind up with capital losses, not gains. Some good news: If you trigger capital gains at other times this year, either through withdrawals or activity outside of Betterment, this portfolio transition may actually reduce your 2013 tax liability.
While TIP and SHY are some of the least volatile assets in your portfolio, there’s always a chance that between now and the transition, the funds will rally enough to result in gains (short-term for recent deposits, long-term for older ones). We like to stress that this isn’t a reason to avoid investing now—paying $3 in tax on a gain of $10 (net gain $7) is better than having no gain at all.
It’s unlikely there will be substantial tax implications from capital gains between now and the transition, but if there were it’d be a good problem to have.
Keeping it simple
Needless to say, frequent trading can create adverse and avoidable tax consequences, which is why Betterment is set up to minimize those transactions at all times. Moreover, we believe the portfolio transition will be a great benefit to our customers and we’ve carefully orchestrated it to optimize tax implications as well as many other factors.
As always, we’ll be generating your tax statements for you early next year, which will capture all of your activity for the year in the aggregate, and we’ll automatically link up with services like TurboTax and H&R Block, to help make filing your returns as hassle-free as can be.
* One of the possible exceptions could apply if you have recently owned and sold any of the new bond ETFs outside of your Betterment account. Losses triggered by that earlier sale could be disallowed through the application of the wash sale rule. The application of this rule is complex, and proper analysis requires a holistic view of the taxpayer’s finances. Consult your tax advisor.
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