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Tax Optimization

Understanding Tax Loss Harvesting+

Articles by Betterment Editors

By the Editorial Staff
Betterment Resource Center  |  Published: September 1, 2018


TABLE OF CONTENTS

The Basics

Setting Up

Accounts

Portfolio

Wash Sales

Taxes


Betterment is not a tax advisor, and the information provided here should not be construed as tax advice. It should only be used for informational purposes. Please consult a qualified tax professional to determine the rules that apply to your individual tax situation.

What is Tax Loss Harvesting+ (TLH+)?

Tax loss harvesting is selling a security that has experienced a loss—and then buying a similar asset to replace it. The switch does two things: it allows the investor to realize, or “harvest”, a valuable loss while keeping the portfolio balanced at the desired allocation.

Capital losses can lower your tax bill by offsetting other gains or ordinary income up to certain levels.  But the only way to realize a loss is to sell the asset that has experienced a loss. 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.

Who is eligible to use TLH+?

Tax Loss Harvesting+ is available to all Betterment customers with at least one taxable account, regardless of balance, at no extra cost.

For more information on TLH+, please see our whitepaper.

Will I benefit from using TLH+?

Tax loss harvesting can be beneficial for many investors—provided that the IRS allows you to write off losses against capital gains and/or up to $3,000 of ordinary income. Any losses not used to offset gains and/or $3,000 of ordinary income can be carried forward indefinitely until used up. The earlier you start tax loss harvesting—and the higher your current tax bracket—the more beneficial it can be over time.

However, harvesting causes you to lower your basis, which can mean more taxes in the future—unless you don’t plan to liquidate your investments. That means deferring all gains can be an especially good strategy if you plan to donate to charity or leave your assets to your heirs, which results in a step-up in basis.

There are some specific instances when you should not use TLH+ or should proceed with caution. Tax deferral may be 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 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. See the IRS website for more details. Also, 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 short term capital gains.

Please consult your tax advisor if you have questions about how these guidelines may apply to your personal situation.

You can read more about best use cases in our white paper.

How can I get the most out of TLH+?

When you enable TLH+, you can maximize your benefit by contributing on a regular basis (by auto-depositing once or twice per month, for example) in order to create more opportunities for harvesting.

Additionally, move your investments with similar securities, including IRAs, to Betterment, so that we can provide the service holistically with no threat of a wash sale.

For example, if you have a taxable account or IRA that has any of the ETFs we use, e.g., VTI or VWO, move them to Betterment if you plan to enable TLH+. View the full list of tickers we use in our 12 asset class portfolio here.

Will TLH+ automatically be enabled in my account?

For new or existing customers, you will need to enable TLH+ from the Summary tab by clicking Get Started in the overview section. Once TLH+ is enabled, harvests will occur automatically according to our algorithm.

How do I turn TLH+ on or off?

To turn on Tax Loss Harvesting+, first log into Betterment. From “Home“, click “Set Up” in the Tax Loss Harvesting+ part of the Overview section. As part of the enablement process, you will answer a couple questions to ensure you are eligible. Once you have enabled TLH+, it can take up to one business day for your portfolio to transition and for harvest checks to begin.

To disable Tax Loss Harvesting+, click “Manage” in the “Tax Losses Harvested” box at the top of  “Home“. When you arrive at “Settings“, click “On” in the TLH+ column. Then click “Disable” to confirm.

How will I see it in my account?

When Tax Loss Harvesting+ is enabled, you will see the total amount of losses harvested on the Summary tab in the Overview section. You will also see transaction confirmations on the Activity tab when harvests occur, and will receive email notifications like you do for all transactions. Your portfolio Analysis page (example below) will show you both primary and parallel tickers—and the percentage of each you are holding.

Setting Up TLH+ Across Spouses

If you already have TLH+ turned on, you’ll need to turn it off and set it up again to include your spouse. First, make sure that you have selected “Home” from your menu and then click “Manage” in the “Tax Losses Harvested” box. When you get to “Settings”, click “On” in the TLH+ column. Then click “Disable” to confirm. Now, go back to “Home” and follow the steps below.

Click “Set Up” in the “Tax Losses Harvested” box. This will walk you through the setup including adding a spouse. You will need to verify your spouse’s email address and social security number to coordinate TLH+ across all of your accounts.

Can I do tax loss harvesting myself?

It would be virtually impossible for an individual to replicate the precision and harvesting frequency we deploy for customers at Betterment. Our algorithms work across multiple accounts and regularly scans for harvesting opportunities—along with sophisticated accounting—using complex logic to determine an optimal potential tax outcome for the customer.

How is TLH+ better than services offered by competitors?

We do things differently. Often, brokerages that do automated tax loss harvesting will switch out of a replacement security after 30 days. If there is a market upswing during that time, customers will incur a short-term capital gain when the broker does the ‘switchback.’ We have eliminated this ‘switchback tax’ because we are able to manage two similar ETFs per asset class in a portfolio using our innovative Parallel Position Management system.

What else makes us different? We provide the real numbers—not marketing hype around tax loss harvesting. Other investment managers may tout a bigger number on their websites, but look closely and you’ll see that the number represents the mean annual offset, not real tax alpha given different liquidation scenarios. Measuring the value of harvesting this way is misleading, and not the way we present the benefit. However, when we used that method and compared apples-to-apples, we found that over the last 13 years, Betterment’s mean annual tax offset was 2x greater than what you can get with methods used by the competition.

How did we accomplish that? One reason is TLH+ avoids tax-indifferent switchbacks, and never caused negative tax offsets over that period, even though the portfolio was rebalanced.

Given that improvement, here’s how tax alpha looks for a sample investor. A person with annual income of $100,000 living in a high-income tax state such as California who initially invested $50,000 and invested $1,500 per month (increasing those deposits annually by 5% to account for salary growth and inflation), would have seen a real value +0.77% in additional returns between 2000-2013, even assuming that he liquidates 50% of the portfolio in 2014.

That’s extra returns for doing nothing other than turning on TLH+ — no extra risk, no additional costs. Just smart investing. The competition ignores liquidation, which would expose their algorithms as being far less effective. With TLH+…

You are never exposed to short-term capital gains in an attempt to harvest losses. Through our proprietary Parallel Position Management system, a dual-security asset class approach which enforces preference for one security, we never trigger capital gains in an attempt to harvest losses.

You have zero cash drag at all times. With fractional shares, and seamless handling of all inflows during wash sale windows, every dollar is always invested at the desired allocation risk level.

Your harvests also serve as an 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.

You never experience disallowed losses through overlap with your IRA. We use a tertiary ticker system, completely eliminating the possibility of harvested losses being permanently disallowed due to IRA activity. This makes our TLH+ ideal for those who invest in both taxable and tax-advantaged accounts.

TLH+ is available to all Betterment customers regardless of their balance, at no additional cost. Other services require a balance of $50,000 or more to access a tax loss harvesting service.

How does TLH+ work when I have multiple goals?

The way we’ve built goals to interact with tax lots, you get the best of both worlds. Goals give you an intuitive way to visualize your savings in different buckets, with different allocations and horizons. They also give you the ability to sell the most optimal lot available in your entire portfolio, whichever goal you’re selling from. So when we run harvesting we are looking for losses across all goals.

When you make withdrawals, we are looking for the most tax-efficient way to sell tax lots, from your entire portfolio (regardless of which goal you are withdrawing from). Think of it as a bunch of swapping that happens under the hood: for example, “Goal A” needs to sell some VTI for a withdrawal, but “Goal B” has a more tax-efficient lot of VTI to sell. TaxMin chooses to sell the “best” share of VTI from your entire portfolio. So when you need to withdraw from short-term goals, we’ll select the most tax-efficient lots, from the entire portfolio.

Can I turn TLH+ on for some goals but not others?

No. When you turn on TLH+, it works across all goals.

Does TLH+ work with my Betterment IRA?

Tax-advantaged retirement accounts, including Roth and Traditional IRAs, are already tax-free or tax-deferred, and it is not possible to harvest losses in these accounts to reduce taxes.

However, if you hold taxable and IRA accounts at Betterment, TLH+ does properly coordinate wash sale management across the accounts, ensuring that a harvested loss will never get permanently disallowed. This is a feature unique to TLH+.

How can I transition other investments to Betterment in order to use TLH+?

The easiest way to transition is often by selling the other investments and transferring the cash into a Betterment account via your linked bank account.  Once you make the deposit, the funds are seamlessly invested into our globally diversified portfolio of ETFs. Once you meet the requirement, you can enable TLH+ at any point.

Note: If you’re planning to sell investments held with other investment managers in order to move to Betterment, you may incur taxes. However, the cost of those taxes may well be more than made up for with the benefits investment switch. With our investment-switch calculator you can determine the time-value horizon for switching investments.

How do I safely use TLH+ if I have external accounts?

The key issue is to protect yourself from inadvertently triggering a wash sale while harvesting a loss in your Betterment account. This could happen when making certain purchases in an external account.

The IRS’s “wash sale rule” prevents you from realizing a loss from selling a security if a “substantially identical” security is purchased by the taxpayer 30 days after or before the sale. The rationale is that a taxpayer should not enjoy the benefit of deducting a loss if he or she did not truly dispose of the security, but in effect replaced it.

TLH+ will automatically manage your purchases when they are made inside your Betterment taxable account, as well as your Betterment IRA.

However, the rule applies when a “substantially identical” purchase is made in any account you own, including an IRA elsewhere, or even in your spouse’s account. (See more about the “What is the wash sale rule?”)

Purchases in non-Betterment accounts are not monitored, and could result in wash sales.

It is very important to note that just owning a “substantially identical” security is not the issue. The issue is typically buying more of it, but this could happen on auto-pilot, if for example, your dividends are automatically reinvested to buy more of what you have. You can also create an issue by selling the security in an external taxable account, but only if the sale is at a loss.

So how do you make sure that you do not inadvertently trade a “substantially identical” security in an external account? Of course, trading exactly the same ETF would qualify, but the definition could extend to an index fund that may have a different name, but is the same in substance. A conservative way to avoid a “substantially identical” purchase is to avoid purchasing an index fund that tracks the same index as the one that was sold.

Betterment cannot make this determination for you. However, you can follow these steps and examine your external investments for potential issues.

First, you should check if any ETF or mutual fund held in a non-Betterment account tracks the same index as any of the ETFs in our portfolio. You can check the indices followed by our ETFs here.

For example, VTI, one of the ETFs we purchase and harvest, tracks the CRSP US Total Market Index. So does the mutual fund VTSAX, also from Vanguard. Despite the fact that they are different types of investments, selling the ETF at a loss while purchasing the mutual fund inside the wash sale window could trigger a wash sale.

Another example is any fund that tracks the S&P 500. The large cap funds in Betterment’s portfolio track value-tilted indexes, so a fund that tracks the S&P 500 index with no tilt should not be problematic (e.g. VFINX, VFIAX, SPY, FUSEX , FUSVX and many more).

There are more fund providers than index creators, and in many cases, ETFs from different providers will track the same index. The information page for a given ETF should list the index that it tracks.

If none of your external investments track the same index, then you can utilize TLH+ without concern. One example that may look problematic at first glance is an actively managed fund which happens to use the same index as a benchmark. If it is trying to beat the index, rather than track it, such a fund shouldn’t be an issue.

If an index fund you hold definitely does track the same index, the best solution will depend is on the account type and trading activity in that account.

Non-traded assets: Wash sales occur only due to buy or sell trades, so if you are sure your account, whatever the type, will not trade (buy or sell) the security, it should be safe to turn on TLH+, even if you hold substantially identical assets there. Be aware that automated transactions, like automatic dividend reinvestment, can cause wash sales.

IRA: If the investments are in an IRA, you should roll over your IRA to Betterment. This ensures that no IRA washes will ever occur. You will not incur any taxes due to the rollover, and Betterment has one of the best rollover concierges in the industry.

Taxable account: If the assets are in a taxable account, and you cannot be sure that you will not be trading them, you should assess if moving the holdings over to Betterment would make you better off in the long run. The cost of capital gains taxes from liquidating may well be more than made up for with the benefits of a switch, including lower fees. With our investment-switch calculator you can check whether or not this makes sense for each of your investments.

Previous Employer 401k: If you have a 401k with a previous employer, you can roll over those assets to a Betterment IRA tax-free, and benefit from TLH+ with IRA wash sale protection.

Current Employer 401k: If your current employer’s 401k plan has investments tracking the same index, only purchases (not sales) of additional shares of those investments could result in wash sales in your Betterment account. One way to mitigate this is by investing exclusively in target date funds in your 401k. These are diversified and tend to be very low cost. While we cannot give tax advice, it is extremely unlikely that a target date fund would be deemed “substantially identical” to any ETF in the Betterment portfolio. This is because a target date fund consists of stocks and bonds, whereas Betterment uses stock ETFs and bond ETFs separately to build a portfolio. A good target date fund is basically an index fund with both stocks and bonds built in.

Can I turn on TLH+ if I am invested in a Target Date Fund?

While we cannot give tax advice, Target date funds are very likely not substantially identical for purposes of the IRS rule, even if they have some of the same indexes inside. This is because you don’t control the allocations or transactions within the fund.

You can liken this to holding AAPL stock in your brokerage account, which also exists in VTI – there are no conflicts there either.

Why are there different funds for bonds in my taxable and IRA accounts?

In all non-IRA accounts, bonds will be represented by MUB (and the alternate TFI). These are municipal bonds, which are exempt from federal and most state taxes. This improves tax-efficiency for investors and adds as much as 1% in expected after-tax returns compared to the asset class they replace.

We’ll continue to use core bonds in your IRA accounts, (AGG and BND), where they can grow tax-free.

Where can I see what funds I am invested in if I am using TLH+?

When you log into your Betterment account, go to the Portfolio page. There you can see each asset class, and the tickers used in each, and the exact shares you hold of each.

You can also view the full set of of primary and alternate tickers, and compare their costs.

What is a wash sale and how does it affect me?

The wash sale rule disallows the realization of a loss from selling a security if a “substantially identical” security is purchased 30 days before or after the sale. The rationale is that a taxpayer should not enjoy the benefit of deducting a loss if he or she 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 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.

This includes your spouse’s holdings (IRA, 401k and taxable investments)—even one dividend reinvestment elsewhere can throw off Betterment’s careful harvests and reduce your net tax benefit. (The IRS does not consider a shift of ownership from one spouse to another as a true disposal, for purposes of the wash sale rule.)

You especially want to avoid a wash sale involving an IRA account. In general, a “washed” loss is postponed until the replacement is sold, but if the replacement is purchased in an IRA account, the loss is permanently disallowed.

Using our Parallel Position Management system, we weigh wash sale implications of every deposit and withdrawal and dividend reinvestment, and systematically choose the better outcome. The system protects against IRA wash sales in a completely unique and airtight way—nobody else does this. Additionally, it protects not just harvested losses, but also losses realized through customer withdrawals. When appropriate, TLH+ even optimizes deposits prior to a harvest, potentially allocating to alternate assets in anticipation of harvesting.

Betterment is the only investing service to provide tax loss harvesting in coordination with an IRA account to maximize the benefit.

What is cash drag?

When a part of your total balance is not invested in securities but in a cash or cash-equivalent security it has no market exposure and is referred to as cash drag. Cash drag hurts portfolio returns over the long term because you are not invested in the market, and could weaken the potential benefits of tax loss harvesting.

Betterment customers never experience cash drag as our trading platform uses fractional shares, and our TLH+ algorithm utilizes secondary and tertiary securities to avoid holding cash.

What is a switchback?

A switchback occurs when you purchase a correlated replacement security in order to harvest a loss, but switch back to the original security after 30 days, regardless of whether it has lost or gained valued. It’s a common approach for both advisors and DIY investors, and used by other automated investing services. It can potentially trigger short-term capital gains, and undo the benefits of harvesting.

Betterment’s Tax Loss Harvesting+ utilizes a Parallel Position Management system to avoid switching back to the original security unless it is tax efficient to do so. Learn more about the Parallel Position Management in our white paper.

What is tax alpha?

Tax alpha is the net benefit from tax savings an investor can expect to see in his or her investor returns and is measured by percentage points. This amount can vary greatly from individual to individual, as it is dependent on tax bracket.

How will TLH+ affect my tax returns?

You will receive a 1099-B corresponding to any tax loss harvests that occur in your account during the year (as harvests involve a sale in order to realize a loss). This is in addition to non-TLH related investment sales generally (e.g. money withdrawals, allocation changes, or portfolio rebalances).

What are the other ways Betterment makes my investments more tax efficient?

Tax Loss Harvesting+ is only one piece of the suite of tax optimization services we offer to all customers. More tax benefits we include:

Tax Impact Preview allows customers to see the estimated tax consequences of a withdrawal, allocation change, or goal-to-goal transfer before they complete the transaction. This allows customers to make tax-informed decisions when managing their investments.

TaxMin lot selling Every customer benefits from our TaxMin cost basis accounting method, where we sell lots with losses before gains, and lots with long-term gains before short-term gains. It is a more efficient way to handle accounting that can save thousands in taxes.

Smart rebalancing We use all cash flows and dividends as an opportunity to rebalance your portfolio. This reduces the need for hard rebalancing, which lowers your capital gains tax over time. Our sophisticated infrastructure will never rebalance your short-term capital gains.

Tax-efficient securities Our portfolio comprises tax-efficient exchange traded funds (ETFs), which can provide an estimated 0.7% in tax savings per year.

Asset location In your non-IRA accounts, one asset class includes municipal bonds where you will be exempt from federal and most state taxes. We’ll put core bonds in your IRA accounts, where they can grow tax-free.

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