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Tax impact using our cost basis accounting method

Selecting tax lots efficiently can address and reduce the tax impact of your investments.

Tax impact using our cost basis accounting method true Selecting tax lots efficiently can address and reduce the tax impact of your investments. Every time you have a transaction in a Betterment account that involves a sale—such as a withdrawal, transfer, or rebalance—Betterment’s technology determines (1) which security or securities to sell, and (2) within each security, which specific tax lots to sell. With tax-smart technology, selecting tax lots efficiently can address and reduce the tax impact of your investments. Selecting tax lots efficiently can address and reduce the tax impact of your investments. When choosing which tax lots of a security to sell, our 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 are 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. Basis reporting 101 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 “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 a security, 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. 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. 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. While Betterment was initially built to use FIFO as the default method, we’ve 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, Betterment’s algorithm first determines what security or securities to sell in order to reduce drift in the portfolio, bringing the portfolio closer to its target allocation as a part of the transaction. Once the algorithm has identified which security to sell, it needs to make a choice as to which specific tax lots of that holding will be sold. For example, if the algorithm identifies a client’s portfolio should sell VTI, and the portfolio holds 10 shares of VTI purchased at different times with different cost basis, it next needs to determine which of the 10 shares of VTI to sell that will minimize taxes on the transaction. This second choice, which specifies tax lots to sell, follows a set of rules which we call TaxMin. This method is more granular in its approach and will aim to improve the tax impact for most transactions, as compared to FIFO. How does the TaxMin method work? 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) generally results in a lower tax liability in the long run. Accordingly, 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. Generally, the algorithm is designed to we sell shares in a way that is intended to prioritize realizing available losses (which can mean that we can prioritize selling tax lots with a long-term loss or a short-term loss, depending on which loss type would result in minimizing taxes for the particular transaction), and when losses are not available, evaluating which securities can be sold with the lowest capital gains (similarly, which can prioritize tax lots with only short-term capital gains over those with long-term capital gains). If the identified security to sell has both short-term capital gains and long-term capital gains, Betterment’s system will generally prioritize realizing the long-term capital gains first, and if needed, followed by short-term capital gains. generating short-term capital losses, then long-term capital losses, followed by long-term capital gains and then lastly, short-term capital gains. In short, the algorithm targets selling tax looks through each category before moving to the next, but within each category, lots with the highest cost basis in order to minimize taxes on the overall transaction are targeted first. In the case of a gain, the higher the cost 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 cost basis, the bigger the loss (which can be beneficial, since losses can be used to offset gains). 1 TaxMin is designed to generally minimize taxes because it prioritizes selling tax lots at a loss before it sells tax lots at a gain. However, for certain groups – investors in relatively low income tax brackets, especially those who expect to be subject to higher tax rates in the future, and those who can recognize capital gains at a 0% tax rate – it may be more beneficial to prioritize selling assets at a gain in the short run. Investors with different individual tax circumstances should consider whether other offerings might provide more tax efficiency in these scenarios. Also, clients should be aware that when a client 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. 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.) 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.

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