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Four ways we can help limit the tax impact of your investments
Four ways we 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. 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 This 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 ways Betterment helps you limit your tax impact 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 aims to help 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. Performance of S&P 500 with dividends reinvested Source: Bloomberg. Performance is provided for illustrative purposes to represent broad market returns for [asset classes] that may not be used in all Betterment portfolios. The [asset class] 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 funds used for each asset class in the Betterment portfolio will differ from the performance of the broad market index returns reflected here. Past performance is not indicative of future results. You cannot invest directly in the index. Content is meant for educational purposes and not intended to be taken as advice or a recommendation for any specific investment product or strategy. We “harvest” investment losses 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. So how do you 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. We use asset location to your advantage 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. 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 most cases, you can find ETFs with investment strategies that are similar or identical to a mutual fund, often with lower fees.
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The benefits of estimating your tax bracket when investing
The benefits of estimating your tax bracket when investing Knowing your tax bracket opens up a huge number of planning opportunities that have the potential to save you taxes and increase your investment returns. If you’re an investor, knowing your tax bracket opens up a number of planning opportunities that can potentially decrease your tax liability and increase your investment returns. Investing based on your tax bracket is something that good CPAs and financial advisors, including Betterment, do for customers. Because the IRS taxes different components of investment income (e.g., dividends, capital gains, retirement withdrawals) in different ways depending on your tax bracket, knowing your tax bracket is an important part of optimizing your investment strategy. In this article, we’ll show you how to estimate your tax bracket and begin making more strategic decisions about your investments with regards to your income taxes. First, what is a tax bracket? In the United States, federal income tax follows what policy experts call a "progressive" tax system. This means that people with higher incomes are generally subject to a higher tax rate than people with lower incomes. 2024 Tax Brackets Tax rate Taxable income for single filers Taxable income for married, filing jointly 10% $0 to $11,600 $0 to $23,200 12% $11,601 to $47,150 $23,201 to $94,300 22% $47,151 to $100,525 $94,301 to $201,050 24% $100,526 to $191,150 $201,051 to $383,900 32% $191,951 to $243,725 $383,901 to $487,450 35% $243,726 to $609,350 $487,451 to $731,200 37% $609,351 or more $731,201 or more Source: Internal Revenue Service Instead of thinking solely in terms of which single tax bracket you fall into, however, it's helpful to think of the multiple tax brackets each of your dollars of taxable income may fall into. That's because tax brackets apply to those specific portions of your income. For example, let's simplify things and say there's hypothetically only two tax brackets for single filers: A tax rate of 10% for taxable income up to $10,000 A tax rate of 20% for taxable income of $10,001 and up If you're a single filer and have taxable income of $15,000 this year, you fall into the second tax bracket. This is what's typically referred to as your "marginal" tax rate. Portions of your income, however, fall into both tax brackets, and those portions are taxed accordingly. The first $10,000 of your income is taxed at 10%, and the remaining $5,000 is taxed at 20%. How difficult is it to estimate my tax bracket? Luckily, estimating your tax bracket is much easier than actually calculating your exact taxes, because U.S. tax brackets are fairly wide, often spanning tens of thousands of dollars. That’s a big margin of error for making an estimate. The wide tax brackets allow you to estimate your tax bracket fairly accurately even at the start of the year, before you know how big your bonus will be, or how much you will donate to charity. Of course, the more detailed you are in calculating your tax bracket, the more accurate your estimate will be. And if you are near the cutoff between one bracket and the next, you will want to be as precise as possible. How Do I Estimate My Tax Bracket? Estimating your tax bracket requires two main pieces of information: Your estimated annual income Tax deductions you expect to file These are the same pieces of information you or your accountant deals with every year when you file your taxes. Normally, if your personal situation has not changed very much from last year, the easiest way to estimate your tax bracket is to look at your last year’s tax return. The 2017 Tax Cuts and Jobs Act changed a lot of the rules and brackets. The brackets may also be adjusted each year to account for inflation. Thus, it might make sense for most people to estimate their bracket by crunching new numbers. Estimating Your Tax Bracket with Last Year’s Tax Return If you expect your situation to be roughly similar to last year, then open up last year’s tax return. If you review Form 1040, you can see your taxable income on Page 1, Line 15, titled “Taxable Income.” As long as you don’t have any major changes in your income or personal situation this year, you can use that number as an estimate to find the appropriate tax bracket. Estimating Your Tax Bracket by Predicting Income, Deductions, and Exemptions Estimating your bracket requires a bit more work if your personal situation has changed from last year. For example, if you got married, changed jobs, had a child or bought a house, those, and many more factors, can all affect your tax bracket. It’s important to point out that your taxable income, the number you need to estimate your tax bracket, is not the same as your gross income. The IRS generally allows you to reduce your gross income through various deductions, before arriving at your taxable income. When Betterment calculates your estimated tax bracket, we use the two factors above to arrive at your estimated taxable income. You can use the same process. Add up your income from all expected sources for the year. This includes salaries, bonuses, interest, business income, pensions, dividends and more. If you’re married and filing jointly, don’t forget to include your spouse’s income sources. Subtract your deductions. Tax deductions reduce your taxable income. Common examples include mortgage interest, property taxes and charity, but you can find a full list on Schedule A – Itemized Deductions. If you don’t know your deductions, or don’t expect to have very many, simply subtract the Standard Deduction instead. By default, Betterment assumes you take the standard deduction. If you know your actual deductions will be significantly higher than the standard deduction, you should not use this assumption when estimating your bracket, and our default estimation will likely be inaccurate. The number you arrive at after reducing your gross income by deductions and exemptions is called your taxable income. This is an estimate of the number that would go on line 15 of your 1040, and the number that determines your tax bracket. Look up this number on the appropriate tax bracket table and see where you land. Again, this is only an estimate. There are countless other factors that can affect your marginal tax bracket such as exclusions, phaseouts and the alternative minimum tax. But for planning purposes, this estimation is more than sufficient for most investors. If you have reason to think you need a more detailed calculation to help formulate your financial plan for the year, you can consult with a tax professional. How Can I Use My Tax Bracket to Optimize My Investment Options? Now that you have an estimate of your tax bracket, you can use that information in many aspects of your financial plan. Here are a few ways that Betterment uses a tax bracket estimate to give you better, more personalized advice. Tax-Loss Harvesting: This is a powerful strategy that seeks to use the ups/downs of your investments to save you taxes. However, it typically doesn't make sense if you fall into a lower tax bracket due to the way capital gains are taxed differently. Tax Coordination: This strategy reshuffles which investments you hold in which accounts to try to boost your after-tax returns. For the same reasons listed above, if you fall on the lower end of the tax bracket spectrum, the benefits of this strategy are reduced significantly. Traditional vs. Roth Contributions: Choosing the proper retirement account to contribute to can also save you taxes both now and throughout your lifetime. Generally, if you expect to be in a higher tax bracket in the future, Roth accounts are best. If you expect to be in a lower tax bracket in the future, Traditional accounts are best. That’s why our automated retirement planning advice estimates your current tax bracket and where we expect you to be in the future, and uses that information to recommend which retirement accounts make the most sense for you. In addition to these strategies, Betterment’s team of financial experts can help you with even more complex strategies such as Roth conversions, estimating taxes from moving outside investments to Betterment and structuring tax-efficient withdrawals during retirement. Tax optimization is a critical part to your overall financial success, and knowing your tax bracket is a fundamental step toward optimizing your investment decisions. That’s why Betterment uses estimates of your bracket to recommend strategies tailored specifically to you. It’s just one way we partner with you to help maximize your money.
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Asset Location Methodology
Asset Location Methodology Intelligently applying asset location to a globally diversified portfolio is a complex, mathematically rigorous, and continuous undertaking. TABLE OF CONTENTS Summary Part I: Introduction to Asset Location Part II: After-Tax Return—Deep Dive Part III: Asset Location Myths Part IV: TCP Methodology Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework Part VI: Results Part VII: Special Considerations Addendum Summary 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 provides the ability to deliver additional after-tax return potential, 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. Part I: Introduction to Asset Location 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. 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. 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 could 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 potential 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. 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 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 help 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 can 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. TCP vs. TDF The primary appeal of a target-date fund (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. 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). Participants in a Betterment at Work plan can already enable Betterment’s Tax-Coordinated Portfolio feature (“TCP”) to manage a single portfolio across their 401(k), IRAs and taxable accounts they individually have with Betterment, designed to squeeze 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"—a 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 the after-tax return of a diversified portfolio. Part II: After-Tax Return—Deep Dive A good starting point for a discussion of investment taxation is the concept of "tax drag." 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. 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 potential 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 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 help minimize taxes. What is "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." Prioritizing assets on the basis of tax efficiency allows for asset location decisions to be made following a simple, rule-based approach. 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. 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). 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%. 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 seeks to avoid STCG when possible,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 table 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 more 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 potentially 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). Returns in a Tax-Deferred Account (TDA) Compared to a taxable account, a TDA is governed by straightforward 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.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.2 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.3 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. 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.4 For foreign stocks with less than perfect QDI, we would expect the tipping point to come sooner. 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. 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. 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). Part III: Asset Location Myths 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). 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. 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. 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: Bonds always go in the IRA. 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. 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 , and in a qualified account, by taxable investment grade bonds . 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 are highly tax-efficient due to their federal tax-exempt interest income, making them particularly compelling for 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. The Basic Priority List 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.5 That study inspired Michael Kitces, who leverages its insights into a more sophisticated approach to building a priority list.6 To visually capture the relationship between the two considerations, Kitces bends the one-dimensional list into a "smile." Asset Location Priority List 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. 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 Part IV: TCP Methodology 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.7 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.8 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.9 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. 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 potentially have twelve asset classes,15 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.10 In the taxable account, however, TCP will attempt to move as close as possible towards the optimal asset location without realizing capital gains. 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.11 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. Against this background, it is important to note 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, and the future may not cooperate, 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, the likelihood of this outcome grows. Part V: Monte Carlo—Betterment’s Testing Framework To test the output of the linear optimization method, we turned to a Monte Carlo testing framework,12 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. The simulations applied Betterment’s rebalancing methodology, which corrects drift from the target asset allocation in excess of 3% once the account balance meets or exceeds the required threshold, but stops short of realizing STCG, when possible. 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 assume 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.19 Avoiding the need to make specific assumptions here helps keep the analysis more universal. We used equal starting balances for the same reason.13 For every set of assumptions, we ran each market scenario while managing each account as a standalone (uncoordinated) Betterment portfolio as the benchmark.14 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.15 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. Part VI: Results More Bonds, More Alpha 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 a 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 TCP should be 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, 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 movements. Rationally, we should ignore this—after all, the overall allocation is the same—but that is easier said than done. How TCP Interacts with Tax Loss Harvesting+ TCP and TLH work in tandem, seeking to minimize tax impact. As described in more detail below, the precise interaction between the two strategies is highly dependent on personal circumstances. While it is possible that enabling a TCP may reduce harvest opportunities, both TLH and TCP derive their benefit without disturbing the desired asset allocation. Operational Interaction 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 attempting to protect any tax losses that are realized in the process. Conceptualizing Blended Performance 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. TLH is usually 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 aims to deliver tax alpha over the entire balance of all three accounts for the entire holding period. *** Betterment does not represent in any manner that TCP will result in any particular tax consequence or that specific benefits will be obtained for any individual investor. The TCP service is not intended as tax advice. Please consult your personal tax advisor with any questions as to whether TCP is a suitable strategy for you in light of your individual tax circumstances. Please see our Tax-Coordinated Portfolio Disclosures for more information. 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. 2But see "How IRA Withdrawals In The Crossover Zone Can Trigger The 3.8% Medicare Surtax," Michael Kitces, July 23, 2014. 3It 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. 4Pg. 5, The Kitces Report. January/February 2014. 5Daryanani, Gobind, and Chris Cordaro. 2005. "Asset Location: A Generic Framework for Maximizing After-Tax Wealth." Journal of Financial Planning (18) 1: 44–54. 6The Kitces Report, March/April 2014. 7While 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. 8In 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. 9TCP 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. 10Standard 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. 11Additionally, 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. 12Another 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". 13That 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. 14For 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. 15Full 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. 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.
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5 financial tips: What to do when rates fall
5 financial tips: What to do when rates fall Interest rates are falling but that doesn’t mean the sky is falling when it comes to your finances. Here are 5 tips to help you weather a falling-rate environment. Table of contents: Why does the Federal Reserve cut rates? What happens to cash, stocks, and bonds when rates drop? 5 financial tips to consider when the Fed cuts rates What should you do with your money when rates fall? It can be hard to know what to do with your money when the Federal Reserve (aka the Fed) cuts interest rates. But we’ve got you covered. In this article, we’ll explore why the Fed cuts rates, what happens when they do, and most importantly, what you can do to keep your finances on track. Why does the Federal Reserve cut rates? The Fed cuts interest rates for various reasons related to stimulating economic growth and addressing concerns about the economy's performance. As we look into the future, some of the specific reasons why the Fed might decide to cut interest rates include: Curb an economic slowdown: If the economy is showing signs of slowing down, such as a decline in GDP growth or an increase in the unemployment rate, the Fed may cut interest rates to encourage borrowing and spending to boost economic activity. Manage inflation: When inflation is stabilized or falling, the Fed might cut interest rates to stimulate demand and help achieve its target inflation rate. Lower interest rates make borrowing cheaper, which can lead to increased consumer spending and business investments. Stabilize financial markets: In times of market volatility, the Fed may cut interest rates to calm investors and restore confidence in the economy. Lower interest rates can reduce the risk of defaults on loans. Support job growth: The Fed aims to keep the labor market healthy by promoting job creation and wage growth. By cutting interest rates, the central bank makes it easier for businesses to hire workers and invest in their employees' future. What happens to cash, stocks, and bonds when rates drop? In a rate-cut environment, the performance of high-yield cash accounts, stocks, and bonds can be affected in various ways: Cash account returns: When interest rates fall, high-yield cash accounts may experience lower returns as the annual percentage yield on their investments decreases. However, cash accounts can still provide liquidity and safety during periods of market volatility. And high-yield cash accounts, like Betterment’s Cash Reserve, still offer a competitive variable yield for your excess cash. Stock prices: Rate cuts can potentially boost stock prices as lower interest rates can stimulate economic activity and encourage borrowing by companies. This can lead to a positive sentiment among investors and push stock prices higher. However, if the economy continues to weaken or is volatile, or if inflation rises, stocks may decline due to increased uncertainty. Bond prices: As interest rates decrease, current bond prices tend to rise because there is less demand for new bonds that now have lower yields. This inverse relationship between bond yields and prices means that existing bonds with higher yields become more attractive to investors seeking income. 5 financial tips to consider when the Fed cuts rates Depending on your financial situation, as interest rates fall, consider how you can apply these five tips to help keep your financial goals on track. Tip 1: Keep enough money in cash for short-term goals In a falling-rate environment, having a cash cushion can provide peace of mind and flexibility for unexpected expenses or opportunities. Make sure to allocate some funds for short-term goals, like upcoming bills or home improvements. Make sure you have an emergency fund: An emergency fund acts as a safety net during turbulent times. Aim to save 3–6 months' worth of living expenses in a high-yield savings account or money market fund. Keep enough cash for purchases you are planning to make in the next 12 months: Whether it's a new car, home renovation, or vacation, having cash on hand can help you take advantage of sales and discounts without worrying about interest rates. Tip 2: Consider moving excess cash to investments With interest rates falling, yield on cash accounts generally falls too, so consider investing your extra cash into assets with potentially higher returns. This could include stocks or bonds. Why bonds? When rates drop, bond prices tend to rise. They are also generally less risky than stocks, making them a solid addition to a diversified portfolio. Why stocks? Rate cuts can stimulate economic growth, potentially boosting stock prices. While investing in individual stocks carries risk, diversifying your portfolio across sectors and industries can help mitigate potential losses during market volatility. And if you have a long-term time horizon, staying invested can pay off over the years. While investing involves more risk than keeping your money in cash, stocks have had greater long-term gains historically than leaving your cash in savings. Bonus tip: Two ways to invest when rates fall. Lump sum investment: This simply means that you take all, or a large portion, of your cash and invest it in one sum. It’s easy, and it gets your cash invested in the market quickly. Dollar-cost averaging: You can automate your investments at Betterment using recurring transfers and deposits for dollar-cost averaging. It’s a great method to invest a little bit of each paycheck. Start investing at Betterment today. Tip 3: Diversify your investments Falling interest rates can have unforeseen effects on various asset classes. To hedge against these fluctuations, make sure to maintain a diversified investment strategy that includes a mix of stocks, bonds, and other assets. By investing in many types of assets, if one falls in value, your overall portfolio is less impacted. Diversification is your friend because we can’t predict the future. Tip 4: Understand how falling rates impact the housing market As interest rates decrease, mortgage rates for buyers may become more favorable. However, this could lead to increased demand and potentially higher home prices. If you're planning to buy or sell a property, be prepared for these shifts in the market, and work with a trusted real estate professional to understand what’s happening in your local housing market. Depending on housing prices and interest rates, you may want to weigh the benefits of buying, renting, or — if you already own a home — refinancing. Tip 5: Refinance high-interest debt Take advantage of lower rates by refinancing high-interest debt. This can include mortgages, auto loans, personal loans, and even credit card debt. For example, if you purchased your home when mortgage rates were at recent highs, refinancing to a lower rate could save you thousands of dollars in interest payments over the course of your loan. Another strategy to consider if you have multiple sources of debt is a loan consolidation. You may be able to secure better terms by consolidating your debts into one loan for easier management. What should you do with your money when rates fall? As we said in our five tips, we recommend considering moving excess cash to stocks and bonds to diversify your overall investing strategy. But what does that look like? It’s a balance of risk and reward to support your goals. Ask yourself: What are my financial goals? Are they short- or long-term? And how much risk am I willing to take? If you are willing to take on a bit more risk and have longer-term goals, then moving more money into stocks and bonds may be a wise approach to grow your money over time. Just make sure you have enough cash on hand for emergencies and short-term goals. At Betterment, we have accounts to support your goals. From growing your savings to building long-term wealth, you can be invested with your preferred balance of risk and return. Consider Cash Reserve: With our high-yield cash account, earn interest on your savings with no market risk and access your money whenever you need it. Goldman Sachs Tax-Smart Bonds: A 100% bond portfolio that gives higher-income individuals a personalized option to target additional after-tax yield. BlackRock Target Income: With this 100% bond portfolio, aim for higher yields while limiting stock market volatility with one of four levels of risk to choose from. Investing portfolios: Build wealth over time with one of our diversified portfolios of stocks and bonds. Ready to be invested? -
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How much cash is too much cash to be in savings?
How much cash is too much cash to be in savings? Cash is great. But can you have too much? And what should you do with it? Let’s find out. The main point: If you have too much cash in savings, you may be missing out on growth from stock or bond investments. Consider having cash in savings for short-term needs and putting the rest into investing accounts. Facts about cash in savings: Cash in savings is liquid, meaning it is easy to access when you need to withdraw it for spending. Cash in savings is also low risk, meaning your money should not decrease in value like stocks if you stay within FDIC insurance limits. But—cash in savings does not have the opportunity to grow compared to cash in stocks and bonds, especially when savings rates are not keeping up with inflation. Finding a balance: To strike the right balance between cash and investments, consider the following: Cash is a secure option for your emergency fund. Most experts recommend having three to six months of living expenses saved. Cash is the lowest-risk option but you can use a mix of bonds and stock too. Take a close look at your situation and save what feels right for you. After that, take a look at your extra cash. Cash and investments can also be right for your short-term goals. Having cash in savings can be wise for short-term goals (we consider anything under 12 months short-term). But depending on how you’re defining short-term and your risk tolerance, you may consider putting some cash for shorter-term goals in bonds and stocks. Investments can support your long-term goals. For most goals longer than 12 months, consider putting your cash into stock and bond investments. While investing involves more risk, stocks have had greater long-term gains historically than leaving your cash in savings. We have options for you: Open a Cash Reserve account if you’re looking for a secure way to save. It’s a high-yield cash account that helps grow your savings while offering FDIC insurance† up to $2 million ($4 million for joint accounts) through our program banks (up to $250,000 of coverage for each insurable capacity—e.g., individual or joint—at up to eight Program Banks). Open an investing account for your long-term goals. We’ll help assess your risk tolerance, provide investment recommendations, and make it easy to access expert-built portfolios to get you closer to your goals. -
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Make Your Money Hustle
Make Your Money Hustle Whether you’re saving or investing, it’s important to make sure you’re working with a company that puts your money to work. Whether you’re saving or investing, it’s important to make sure you’re working with a company that puts your money to work. Here’s how we do that at Betterment: SAVINGS High-yield cash accounts like Cash Reserve could be a smart hedge during volatile markets—especially for money you’re saving to be used soon. New customers can earn 13x more than the average savings account** with Betterment’s Cash Reserve account. Additionally, we offer up to $2M ($4M for joint accounts) in FDIC insurance through our program banks†, with unlimited withdrawals and no fees (up to $250,000 of coverage for each insurable capacity—e.g., individual or joint—at up to eight program banks). When you’re ready to start investing, you can set up recurring transfers from Cash Reserve directly into a portfolio, which helps you take advantage of dollar cost averaging. Qualifying deposit of $10 required, Terms and conditions apply. For Cash Reserve (“CR”), Betterment LLC only receives compensation from our program banks; Betterment LLC and Betterment Securities do not charge fees on your CR balance. INVESTING Low-cost, ETF-based portfolios make it easy to diversify your investments across thousands of stocks and bonds while keeping costs down. Our Investing and Capital Markets Teams monitor our portfolios, making adjustments when necessary to account for major market changes. We don’t just choose stocks. Our experts review and score assets, and run portfolio simulations against various scenarios to help measure expected long-term performance. As a fiduciary, it’s our job to act in your best interest. We’ll never recommend investments or give you guidance unless we believe it’ll help you reach your financial goals. Automated investing technology can perform multiple sophisticated, time-saving actions on your behalf, helping optimize your money. Automated rebalancing helps keep your portfolio at the preferred risk level as markets fluctuate and assets change in value. And we use deposits and automated dividend reinvestment to rebalance tax-efficiently. Recurring deposits and transfers help you save regularly without having to remember to do so. Just set the amount and frequency, and we handle the rest. Tax Coordination helps us optimize your after-tax returns by strategically holding investments in each account type.
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Five common Roth conversion mistakes
Five common Roth conversion mistakes Learn more about Roth conversion benefits—for high earners and retirees especially—and common conversion mistakes to avoid. Converting pre-tax funds from your traditional retirement accounts into a post-tax Roth IRA (i.e., a Roth conversion) can make sense in certain scenarios. But before you move any money, we recommend connecting with a trusted financial advisor and, in some cases, a tax advisor. They can help you sidestep five common Roth conversion mistakes: Converting outside of your intended tax year You must complete a Roth conversion by a year’s end (December 31) in order for it to count toward that specific tax year’s income. Keep in mind this is different from the IRA contribution deadline for a specific tax year, which (somewhat confusingly) bleeds into the following calendar year. As we’ve mentioned before, Roth conversions require careful planning on your part (and, ideally, your tax advisor) to determine how much you should convert, if at all, and when. Converting too much Speaking of, the question of how much to convert is a crucial one. Blindly converting too much could push you into a higher tax bracket. A common strategy used to avoid this is called “bracket filling.” You determine your income and how much room you have until you hit the next tax bracket, then convert just enough to “fill up” your current bracket. Of course, it can be difficult to determine your exact income. You might not know whether you’ll get a raise, for example, or how many dividends you’ll earn in investment accounts. Because of this, we highly recommend you work with a tax advisor to figure out exactly how much room you have and how much to convert. You no longer have the luxury of undoing a Roth conversion thanks to the 2017 Tax Cuts and Jobs Act. As a side note, you can squeeze more converted shares into your current bracket if the market is down since each share is worth less in that moment. To be clear, we don’t recommend making a Roth conversion solely because the market is down, but if you were already considering one, this sort of market volatility could make the conversion more efficient. Withdrawing converted funds too early When making a Roth conversion, you need to be mindful of the five-year holding period before withdrawing those converted funds, which is different from the 5 year holding period for qualified distributions. And as we mentioned earlier, you’ll typically pay taxes on the amount you convert at the time of conversion, and future withdrawals in retirement can be tax and 10% penalty free. After making a Roth conversion, however, you must wait five tax years for your withdrawal of your taxable conversion amount to avoid the 10% penalty. Withdrawals of amounts previously converted are always tax-free. Notably, this countdown clock is based on tax years, so any conversion made during a calendar year is deemed to have taken place January 1 of that year. So even if you make a conversion in December, the clock for the five year rule starts from earlier that year in January. One more thing to keep in mind is that each Roth conversion you make is subject to its own five year period related to the 10% early withdrawal penalty. Paying taxes from your IRA Paying any taxes due from a conversion out of the IRA itself will make that conversion less effective. As an example, if you convert $10,000 and are in the 22% tax bracket, you’ll owe $2,200 in taxes. One option is to pay the taxes out of the IRA itself. However, this means you’ll have only $7,800 left to potentially grow and compound over time. If you’re under the age of 59 ½, the amount withheld for taxes will also be subject to a 10% early withdrawal penalty. Instead, consider paying taxes owed using excess cash or a non-retirement account you have. This will help keep the most money possible inside the Roth IRA to grow tax-free over time. Keeping the same investments Conversions can be a great tool, but don’t stop there. Once you convert, you should also consider adjusting your portfolio to take advantage of the different tax treatment of traditional and Roth accounts. Each account type is taxed differently, which means their investments grow differently, too. You can take advantage of this by strategically coordinating which investments you hold in which accounts. This strategy is called asset location and can be quite complex. Luckily, we automated it with our Tax Coordination feature. -
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Four ways we can help limit the tax impact of your investments
Four ways we 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. 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 This 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 ways Betterment helps you limit your tax impact 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 aims to help 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. Performance of S&P 500 with dividends reinvested Source: Bloomberg. Performance is provided for illustrative purposes to represent broad market returns for [asset classes] that may not be used in all Betterment portfolios. The [asset class] 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 funds used for each asset class in the Betterment portfolio will differ from the performance of the broad market index returns reflected here. Past performance is not indicative of future results. You cannot invest directly in the index. Content is meant for educational purposes and not intended to be taken as advice or a recommendation for any specific investment product or strategy. We “harvest” investment losses 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. So how do you 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. We use asset location to your advantage 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. 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 most cases, you can find ETFs with investment strategies that are similar or identical to a mutual fund, often with lower fees. -
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Asset Location Methodology
Asset Location Methodology Intelligently applying asset location to a globally diversified portfolio is a complex, mathematically rigorous, and continuous undertaking. TABLE OF CONTENTS Summary Part I: Introduction to Asset Location Part II: After-Tax Return—Deep Dive Part III: Asset Location Myths Part IV: TCP Methodology Part V: Monte Carlo on the Amazon—Betterment’s Testing Framework Part VI: Results Part VII: Special Considerations Addendum Summary 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 provides the ability to deliver additional after-tax return potential, 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. Part I: Introduction to Asset Location 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. 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. 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 could 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 potential 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. 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 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 help 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 can 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. TCP vs. TDF The primary appeal of a target-date fund (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. 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). Participants in a Betterment at Work plan can already enable Betterment’s Tax-Coordinated Portfolio feature (“TCP”) to manage a single portfolio across their 401(k), IRAs and taxable accounts they individually have with Betterment, designed to squeeze 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"—a 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 the after-tax return of a diversified portfolio. Part II: After-Tax Return—Deep Dive A good starting point for a discussion of investment taxation is the concept of "tax drag." 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. 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 potential 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 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 help minimize taxes. What is "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." Prioritizing assets on the basis of tax efficiency allows for asset location decisions to be made following a simple, rule-based approach. 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. 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). 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%. 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 seeks to avoid STCG when possible,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 table 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 more 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 potentially 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). Returns in a Tax-Deferred Account (TDA) Compared to a taxable account, a TDA is governed by straightforward 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.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.2 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.3 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. 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.4 For foreign stocks with less than perfect QDI, we would expect the tipping point to come sooner. 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. 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. 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). Part III: Asset Location Myths 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). 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. 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. 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: Bonds always go in the IRA. 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. 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 , and in a qualified account, by taxable investment grade bonds . 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 are highly tax-efficient due to their federal tax-exempt interest income, making them particularly compelling for 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. The Basic Priority List 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.5 That study inspired Michael Kitces, who leverages its insights into a more sophisticated approach to building a priority list.6 To visually capture the relationship between the two considerations, Kitces bends the one-dimensional list into a "smile." Asset Location Priority List 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. 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 Part IV: TCP Methodology 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.7 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.8 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.9 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. 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 potentially have twelve asset classes,15 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.10 In the taxable account, however, TCP will attempt to move as close as possible towards the optimal asset location without realizing capital gains. 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.11 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. Against this background, it is important to note 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, and the future may not cooperate, 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, the likelihood of this outcome grows. Part V: Monte Carlo—Betterment’s Testing Framework To test the output of the linear optimization method, we turned to a Monte Carlo testing framework,12 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. The simulations applied Betterment’s rebalancing methodology, which corrects drift from the target asset allocation in excess of 3% once the account balance meets or exceeds the required threshold, but stops short of realizing STCG, when possible. 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 assume 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.19 Avoiding the need to make specific assumptions here helps keep the analysis more universal. We used equal starting balances for the same reason.13 For every set of assumptions, we ran each market scenario while managing each account as a standalone (uncoordinated) Betterment portfolio as the benchmark.14 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.15 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. Part VI: Results More Bonds, More Alpha 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 a 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 TCP should be 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, 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 movements. Rationally, we should ignore this—after all, the overall allocation is the same—but that is easier said than done. How TCP Interacts with Tax Loss Harvesting+ TCP and TLH work in tandem, seeking to minimize tax impact. As described in more detail below, the precise interaction between the two strategies is highly dependent on personal circumstances. While it is possible that enabling a TCP may reduce harvest opportunities, both TLH and TCP derive their benefit without disturbing the desired asset allocation. Operational Interaction 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 attempting to protect any tax losses that are realized in the process. Conceptualizing Blended Performance 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. TLH is usually 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 aims to deliver tax alpha over the entire balance of all three accounts for the entire holding period. *** Betterment does not represent in any manner that TCP will result in any particular tax consequence or that specific benefits will be obtained for any individual investor. The TCP service is not intended as tax advice. Please consult your personal tax advisor with any questions as to whether TCP is a suitable strategy for you in light of your individual tax circumstances. Please see our Tax-Coordinated Portfolio Disclosures for more information. 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. 2But see "How IRA Withdrawals In The Crossover Zone Can Trigger The 3.8% Medicare Surtax," Michael Kitces, July 23, 2014. 3It 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. 4Pg. 5, The Kitces Report. January/February 2014. 5Daryanani, Gobind, and Chris Cordaro. 2005. "Asset Location: A Generic Framework for Maximizing After-Tax Wealth." Journal of Financial Planning (18) 1: 44–54. 6The Kitces Report, March/April 2014. 7While 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. 8In 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. 9TCP 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. 10Standard 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. 11Additionally, 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. 12Another 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". 13That 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. 14For 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. 15Full 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. 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.
Planning
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The benefits of estimating your tax bracket when investing
The benefits of estimating your tax bracket when investing Knowing your tax bracket opens up a huge number of planning opportunities that have the potential to save you taxes and increase your investment returns. If you’re an investor, knowing your tax bracket opens up a number of planning opportunities that can potentially decrease your tax liability and increase your investment returns. Investing based on your tax bracket is something that good CPAs and financial advisors, including Betterment, do for customers. Because the IRS taxes different components of investment income (e.g., dividends, capital gains, retirement withdrawals) in different ways depending on your tax bracket, knowing your tax bracket is an important part of optimizing your investment strategy. In this article, we’ll show you how to estimate your tax bracket and begin making more strategic decisions about your investments with regards to your income taxes. First, what is a tax bracket? In the United States, federal income tax follows what policy experts call a "progressive" tax system. This means that people with higher incomes are generally subject to a higher tax rate than people with lower incomes. 2024 Tax Brackets Tax rate Taxable income for single filers Taxable income for married, filing jointly 10% $0 to $11,600 $0 to $23,200 12% $11,601 to $47,150 $23,201 to $94,300 22% $47,151 to $100,525 $94,301 to $201,050 24% $100,526 to $191,150 $201,051 to $383,900 32% $191,951 to $243,725 $383,901 to $487,450 35% $243,726 to $609,350 $487,451 to $731,200 37% $609,351 or more $731,201 or more Source: Internal Revenue Service Instead of thinking solely in terms of which single tax bracket you fall into, however, it's helpful to think of the multiple tax brackets each of your dollars of taxable income may fall into. That's because tax brackets apply to those specific portions of your income. For example, let's simplify things and say there's hypothetically only two tax brackets for single filers: A tax rate of 10% for taxable income up to $10,000 A tax rate of 20% for taxable income of $10,001 and up If you're a single filer and have taxable income of $15,000 this year, you fall into the second tax bracket. This is what's typically referred to as your "marginal" tax rate. Portions of your income, however, fall into both tax brackets, and those portions are taxed accordingly. The first $10,000 of your income is taxed at 10%, and the remaining $5,000 is taxed at 20%. How difficult is it to estimate my tax bracket? Luckily, estimating your tax bracket is much easier than actually calculating your exact taxes, because U.S. tax brackets are fairly wide, often spanning tens of thousands of dollars. That’s a big margin of error for making an estimate. The wide tax brackets allow you to estimate your tax bracket fairly accurately even at the start of the year, before you know how big your bonus will be, or how much you will donate to charity. Of course, the more detailed you are in calculating your tax bracket, the more accurate your estimate will be. And if you are near the cutoff between one bracket and the next, you will want to be as precise as possible. How Do I Estimate My Tax Bracket? Estimating your tax bracket requires two main pieces of information: Your estimated annual income Tax deductions you expect to file These are the same pieces of information you or your accountant deals with every year when you file your taxes. Normally, if your personal situation has not changed very much from last year, the easiest way to estimate your tax bracket is to look at your last year’s tax return. The 2017 Tax Cuts and Jobs Act changed a lot of the rules and brackets. The brackets may also be adjusted each year to account for inflation. Thus, it might make sense for most people to estimate their bracket by crunching new numbers. Estimating Your Tax Bracket with Last Year’s Tax Return If you expect your situation to be roughly similar to last year, then open up last year’s tax return. If you review Form 1040, you can see your taxable income on Page 1, Line 15, titled “Taxable Income.” As long as you don’t have any major changes in your income or personal situation this year, you can use that number as an estimate to find the appropriate tax bracket. Estimating Your Tax Bracket by Predicting Income, Deductions, and Exemptions Estimating your bracket requires a bit more work if your personal situation has changed from last year. For example, if you got married, changed jobs, had a child or bought a house, those, and many more factors, can all affect your tax bracket. It’s important to point out that your taxable income, the number you need to estimate your tax bracket, is not the same as your gross income. The IRS generally allows you to reduce your gross income through various deductions, before arriving at your taxable income. When Betterment calculates your estimated tax bracket, we use the two factors above to arrive at your estimated taxable income. You can use the same process. Add up your income from all expected sources for the year. This includes salaries, bonuses, interest, business income, pensions, dividends and more. If you’re married and filing jointly, don’t forget to include your spouse’s income sources. Subtract your deductions. Tax deductions reduce your taxable income. Common examples include mortgage interest, property taxes and charity, but you can find a full list on Schedule A – Itemized Deductions. If you don’t know your deductions, or don’t expect to have very many, simply subtract the Standard Deduction instead. By default, Betterment assumes you take the standard deduction. If you know your actual deductions will be significantly higher than the standard deduction, you should not use this assumption when estimating your bracket, and our default estimation will likely be inaccurate. The number you arrive at after reducing your gross income by deductions and exemptions is called your taxable income. This is an estimate of the number that would go on line 15 of your 1040, and the number that determines your tax bracket. Look up this number on the appropriate tax bracket table and see where you land. Again, this is only an estimate. There are countless other factors that can affect your marginal tax bracket such as exclusions, phaseouts and the alternative minimum tax. But for planning purposes, this estimation is more than sufficient for most investors. If you have reason to think you need a more detailed calculation to help formulate your financial plan for the year, you can consult with a tax professional. How Can I Use My Tax Bracket to Optimize My Investment Options? Now that you have an estimate of your tax bracket, you can use that information in many aspects of your financial plan. Here are a few ways that Betterment uses a tax bracket estimate to give you better, more personalized advice. Tax-Loss Harvesting: This is a powerful strategy that seeks to use the ups/downs of your investments to save you taxes. However, it typically doesn't make sense if you fall into a lower tax bracket due to the way capital gains are taxed differently. Tax Coordination: This strategy reshuffles which investments you hold in which accounts to try to boost your after-tax returns. For the same reasons listed above, if you fall on the lower end of the tax bracket spectrum, the benefits of this strategy are reduced significantly. Traditional vs. Roth Contributions: Choosing the proper retirement account to contribute to can also save you taxes both now and throughout your lifetime. Generally, if you expect to be in a higher tax bracket in the future, Roth accounts are best. If you expect to be in a lower tax bracket in the future, Traditional accounts are best. That’s why our automated retirement planning advice estimates your current tax bracket and where we expect you to be in the future, and uses that information to recommend which retirement accounts make the most sense for you. In addition to these strategies, Betterment’s team of financial experts can help you with even more complex strategies such as Roth conversions, estimating taxes from moving outside investments to Betterment and structuring tax-efficient withdrawals during retirement. Tax optimization is a critical part to your overall financial success, and knowing your tax bracket is a fundamental step toward optimizing your investment decisions. That’s why Betterment uses estimates of your bracket to recommend strategies tailored specifically to you. It’s just one way we partner with you to help maximize your money. -
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How to plan for retirement
How to plan for retirement It depends on the lifestyle you want, the investment accounts available, and the income you expect to receive. Most people want to retire some day. But retirement planning looks a little different for everyone. There’s more than one way to get there. And some people want to live more extravagantly—or frugally—than others. Your retirement plan should be based on the life you want to live and the financial options you have available. And the sooner you sort out the details, the better. Even if retirement seems far away, working out the details now will set you up to retire when and how you want to. In this guide, we’ll cover: How much you should save for retirement Choosing retirement accounts Supplemental income to consider Self-employed retirement options How much should you save for retirement? How much you need to save ultimately depends on what you want retirement to look like. Some people see themselves traveling the world when they retire. Or living closer to their families. Maybe there’s a hobby you’ve wished you could spend more time and money on. Perhaps for you, retirement looks like the life you have now—just without the job. For many people, that’s a good place to start. Take the amount you spend right now and ask yourself: do you want to spend more or less than that each year of retirement? How long do you want your money to last? Answering these questions will give you a target amount you’ll need to reach and help you think about managing your income in retirement. Don’t forget to think about where you’ll want to live, too. Cost of living varies widely, and it has a big effect on how long your money will last. Move somewhere with a lower cost of living, and you need less to retire. Want to live it up in New York City, Seattle, or San Francisco? Plan to save significantly more. And finally: when do you want to retire? This will give you a target date to save it by (in investing, that’s called a time horizon). It’ll also inform how much you need to retire. Retiring early reduces your time horizon, and increases the number of expected years you need to save for. Choosing retirement accounts Once you know how much you need to save, it’s time to think about where that money will go. Earning interest and taking advantage of tax benefits can help you reach your goal faster, and that’s why choosing the right investment accounts is a key part of retirement planning. While there are many kinds of investment accounts in general, people usually use five main types to save for retirement: Traditional 401(k) Roth 401(k) Traditional IRA (Individual Retirement Account) Roth IRA (Individual Retirement Account) Health Savings Account (HSA) Traditional 401(k) A Traditional 401(k) is an employer-sponsored retirement plan. These have two valuable advantages: Your employer may match a percentage of your contributions Your contributions are tax deductible You can only invest in a 401(k) if your employer offers one. If they do, and they match a percentage of your contributions, this is almost always an account you’ll want to take advantage of. The contribution match is free money. You don’t want to leave that on the table. And since your contributions are tax deductible, you’ll pay less income tax while you’re saving for retirement. Roth 401(k) A Roth 401(k) works just like a Traditional one, but with one key difference: the tax advantages come later. You make contributions, your employer (sometimes) matches a percentage of them, and you pay taxes like normal. But when you withdraw your funds during retirement, you don’t pay taxes. This means any interest you earned on your account is tax-free. With both Roth and Traditional 401(k)s, you can contribute a maximum of $23,000 in 2024, or $30,500 if you’re age 50 or over. Traditional IRA (Individual Retirement Account) As with a 401(k), an IRA gives you tax advantages. Depending on your income, contributions may lower your pre-tax income, so you pay less income tax leading up to retirement. The biggest difference? Your employer doesn’t match your contributions. The annual contribution limits are also significantly lower: just $7,000 for 2024, or $8,000 if you’re age 50 or over. Roth IRA (Individual Retirement Account) A Roth IRA works similarly, but as with a Roth 401(k), the tax benefits come when you retire. Your contributions still count toward your taxable income right now, but when you withdraw in retirement, all your interest is tax-free. So, should you use a Roth or Traditional account? One option is to use both Traditional and Roth accounts for tax diversification during retirement. Another strategy is to compare your current tax bracket to your expected tax bracket during retirement, and try to optimize around that. Also keep in mind that your income may fluctuate throughout your career. So you may choose to do Roth now, but after a significant promotion you might switch to Traditional. Health Savings Account (HSA) An HSA is another solid choice. Contributions to an HSA are tax deductible, and if you use the funds on medical expenses, your distributions are tax-free. After age 65, you can withdraw your funds just like a traditional 401(k) or IRA, even for non-medical expenses. You can only contribute to a Health Savings Accounts if you’re enrolled in a high-deductible health plan (HDHP). In 2024, you can contribute up to $4,150 to an HSA if your HDHP covers only you, and up to $8,300 if your HDHP covers your family. What other income can you expect? Put enough into a retirement account, and your distributions will likely cover your expenses during retirement. But if you can count on other sources of income, you may not need to save as much. For many people, a common source of income during retirement is social security. As long as you or your spouse have made enough social security contributions throughout your career, you should receive social security benefits. Retire a little early, and you’ll still get some benefits (but it may be less). This can amount to thousands of dollars per month. You can estimate the benefits you’ll receive using the Social Security Administration’s Retirement Estimator. Retirement accounts for the self-employed Self-employed people have a few additional options to consider. One Participant 401(k) Plan or Solo 401(k) A Solo 401(k) is similar to a regular 401(k). However, with a Solo 401(k), you’re both the employer and the employee. You can combine the employee contribution limit and the employer contribution limit. As long as you don’t have any employees and you’re your own company, this is a pretty solid option. However, a Solo 401(k) typically requires more advance planning and ongoing paperwork than other account types. If your circumstances change, you may be able to roll over your Solo 401(k) plan or consolidate your IRAs into a more appropriate retirement savings account. Simplified Employee Pension (SEP IRA) With a SEP IRA, the business sets up an IRA for each employee. Only the employer can contribute, and the contribution rate must be the same for each qualifying employee. Savings Incentive Match Plan for Employees (SIMPLE IRA) A SIMPLE IRA is ideal for small business owners who have 100 employees or less. Both the employer and the employee can contribute. You can also contribute to a Traditional IRA or Roth IRA—although how much you can contribute depends on how much you’ve put into other retirement accounts. -
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What is a tax advisor? Attributes to look for
What is a tax advisor? Attributes to look for Since Betterment isn't a tax advisor, we often suggest that customers see a tax advisor regarding certain issues or decisions. Who exactly is a tax advisor and how should you think about picking one? Tax season is now upon us. Now that you’ve probably received all of your tax forms, you may be facing a choice for how to proceed with filing: do it yourself with tax software or hire a professional tax advisor? Although it certainly will be more expensive than using tax software, hiring a tax advisor makes sense for certain individuals, depending on their financial circumstances. Here are two important factors to consider when deciding if a tax advisor is right for you: Time: Even with tax software guiding you, filing your taxes yourself can be time consuming. You’ll need to make sure that you’ve entered or imported the data from your tax forms correctly, which often takes at least several hours, and your time is worth something. Complexity: The more complicated your financial situation, the more a tax advisor may be able to help you. Have partnership income, or income from an S corporation? Been subject to alternative minimum tax in past years? Received or exercised stock options this year? Tax software can handle these issues, but it will take time, and the risk of mistakes (and even an audit) increases. If you decide that your situation warrants professional assistance, some further questions are worth exploring: what exactly is a tax advisor and how should you think about picking one? Who counts as a tax advisor? Anyone with an IRS Prepare Tax Identification number (a “PTIN” for short) can be paid to file tax returns on behalf of others. But merely having a PTIN doesn’t tell you much about the tax preparer; tax preparers have different experience, skills, and expertise. What you really want is a tax advisor, a professional with a certification and experience level that qualifies her not only to prepare your return, but to use her knowledge of the tax code to provide advice on your financial situation. There are three different professional certifications to consider, each of which qualifies a tax advisor to practice with unlimited representation rights before the IRS. This means that in addition to preparing returns, they also are licensed to represent their clients on audits, payments and collection issues, and appeals. Certified Public Accountants (CPAs) CPAs have completed coursework in accounting, passed the Uniform CPA Examination, and are licensed by state boards of accountancy (which require that they meet experience and good character standards). Some, but not all, CPAs specialize in tax preparation and planning. You can find complaints about CPAs either by searching records with state boards of accountancy and at Better Business Bureaus. Enrolled Agents Enrolled agents are licensed by the Internal Revenue Service after they have passed a three-part examination and a background check. The IRS maintains complaints about enrolled agents on the website of its office for enrollment, and you can also find complaints on the National Association of Enrolled Agents website. Licensed Tax Attorneys Licensed attorneys have graduated from law school, passed a state bar exam, and are admitted to the bar in at least one state. Some, but not all, attorneys specialize in tax preparation and planning. Many tax attorneys have completed an additional year of law school study in a master’s program in tax (called a Tax LL.M. degree). Disciplinary actions against attorneys can be found by searching the state bar associations with which the attorney is registered. How to Select a Tax Advisor or Tax Consultant No tax advisor with one of the certifications described above is necessarily better than any of the others in all situations. Rather, what matters most is: How the advisor approaches the tax preparation process, including the specific experience the tax advisor has with issues relevant to your particular financial situation. Whether you feel comfortable with the tax advisor. How the advisor structures their fees. You may be able to screen potential advisors along several of these dimensions based on information you can find about them online; for others, an initial meeting will be critical to determine if the advisor is right for you. 1. Assess your confidence in the quality of a tax advisor's recommendations, as well as their experience. Here are a few specific factors to consider carefully when assessing the potential quality of a tax advisor's work. First, you should try to identify a tax advisor who will act ethically and with integrity. Before scheduling a meeting with a potential tax advisor, check to see if the advisor has been subject to any complaints, disciplinary actions, or other ethical infractions. When meeting with the advisor, be on the lookout for outlandish promises: if an advisor guarantees you a certain refund without having first looked at your returns, you should be wary (any promise that sounds too good to be true probably is). If the advisor suggests taking a position on a tax return that strikes you as overly aggressive (because it is not grounded in your actual financial situation) or if you simply do not understand something the advisor is saying, make sure to ask, and keep asking until you are satisfied with the answer. Having a tax advisor prepare your returns does not take away your responsibility for the accuracy of your tax return. Of course, an advisor who knowingly takes an improper position on a tax return will face consequences, but it is your return, and you can too. A good tax advisor also should provide more value than simply filling out your returns. She should help you to structure your finances in an optimal way from a tax perspective. Not every tax advisor has expertise with every nuance of the tax code, and so you’ll want to make sure that the advisor you select has significant experience with the particular issues for which you’re seeking expert advice. Of course, there are certain common issues that every good advisor should know: for example, how to maximize the value and efficacy of your charitable contributions, how to weigh the tax tradeoffs between renting and owning a home, or how to save money for or gift money to family members. For other less common situations, however, you’ll want an advisor with specific experience. If you own a business or are self-employed, if you work for a startup and own a significant number of stock options, or if some portion of your income is reported on a K-1 (because you are a partner in a business or own shares in an S corporation), you likely will be best served by finding an advisor who has worked with a significant number of clients with these tax issues. Finally, maintaining the security of your personal information is more important than ever these days, and the inputs for your taxes is some of the most sensitive information you have. There will always be some risk of data breaches, but a good tax advisor will take steps to safeguard your information. Make sure that you ask about how the tax advisor stores your personal information and what methods she uses to communicate with you regarding sensitive topics. You also should ask about whether the advisor has ever been subject to a data breach and what steps the advisor is taking to protect against future ones. 2. Assess your comfort level with the working relationship. You want to make sure you have a good rapport with your tax advisor, and that you feel like you understand each other. At your first meeting, make sure to bring three years’ worth of old tax returns for your advisor to review. Ask if you missed any deductions, and if your old returns raise any audit flags. Consider the advisor’s responses. Does the advisor seem willing to spend time with you to ask thorough questions to fully understand your situation? Or does she rush through in a way that makes you feel like she might be missing certain issues or nuances? Does the advisor explain herself in a way that is understandable to you, even though you don’t have a tax background? Or does the advisor leave you confused? A tax advisor may work by herself or be a member of a larger organization or practice. Each approach has its benefits and drawbacks. You can be sure that a solo practitioner will be the one who actually prepares your returns, but it may be harder to reach the advisor during the height of tax season, and the advisor may find it difficult to get a second opinion on tricky issues or issues outside her core areas of expertise. On the other hand, although the collective expertise of a larger practice may exceed that of even a very talented advisor practicing on her own, it may be more difficult to ensure that your return is prepared personally by your advisor. Finally, think about whether you want to work with a tax advisor who is already part of your social network, or who has been referred by a trusted family member or friend. On the one hand, having the seal of approval of someone you know and trust may help to assure you that the advisor is right for you. On the other hand, consider whether it will be harder to part ways with the advisor down the road if she fails to meet your standards. 3. Evaluate the cost of the tax advice. The final issue you’ll want to think about is cost. Tax preparation services are a low margin business (particularly with the competition that tax preparers face from low cost software), but you can expect to pay more for tax planning services or advice. The best cost structure is one where the tax advisor charges for her time or for the specific forms that the advisor completes and files. By paying for the advice itself and not a particular outcome, this cost arrangement properly aligns the incentives between your tax advisor and you. Be wary of compensation structures that create the potential for conflicts of interest between you and and your tax advisor. For example, some tax advisors may try to earn additional revenue from you by selling other services or financial products along with tax preparation. Ultimately, when it comes to cost, your goal should not be solely to minimize your combined out of pocket cost to the IRS and your advisor for this year’s tax return. Rather, you should take a longer term view, recognizing that good, personalized tax advice can help you to structure your financial life in a tax-efficient way that can pay dividends for years to come.
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How Betterment Manages Risks in Your Portfolio
Betterment’s tools can keep you on track with the best chance of reaching your goals.
How Betterment Manages Risks in Your Portfolio true Betterment’s tools can keep you on track with the best chance of reaching your goals. Investing always involves some level of risk. But you should always have control over how much risk you take on. When your goals are decades away, it's easier to invest in riskier assets. The closer you get to reaching your goals, the more you may want to play it safe. Betterment’s tools can help manage risk and keep you on track toward your goals. In this guide, we’ll: Explain how Betterment provides allocation advice Talk about determining your personal risk level Walk through some of Betterment’s automated tools that help you manage risk Take a look at low-risk portfolios The key to managing your risk: asset allocation Risk is inherent to investing, and to some degree risk is good. High risk, high reward, right? What’s important is how you manage your risk. You want your investments to grow as the market fluctuates. One major way investors manage risk is through diversification. You’ve likely heard the old cliche, “Don’t put all your eggs in one basket.” This is the same reasoning investors use. We diversify our investments, putting our eggs in various baskets, so to speak. This way if one investment fails, we don’t lose everything. But how do you choose which baskets to put your eggs in? And how many eggs do you put in those baskets? Investors have a name for this process: asset allocation. Asset allocation involves splitting up your investment dollars across several types of financial assets (like stocks and bonds). Together these investments form your portfolio. A good portfolio will have your investment dollars in the right baskets: protecting you from extreme loss when the markets perform poorly, yet leaving you open to windfalls when the market does well. If that sounds complicated, there’s good news: Betterment will automatically recommend how to allocate your investments based on your individual goals. How Betterment provides allocation advice At Betterment, our recommendations start with your financial goals. Each of your financial goals—whether it’s a vacation or retirement—gets its own allocation of stocks and bonds. Next we look at your investment horizon, a fancy term for “when you need the money and how you’ll withdraw it.” It’s like a timeline. How long will you invest for? Will you take it out all at once, or a little bit at a time? For a down payment goal, you might withdraw the entire investment after 10 years once you’ve hit your savings mark. But when you retire, you’ll probably withdraw from your retirement account gradually over the course of years. What if you don’t have a defined goal? If you’re investing without a timeline or target amount, we’ll use your age to set your investment horizon with a default target date of your 65th birthday. We’ll assume you’ll withdraw from it like a retirement account, but maintain a slightly riskier portfolio even when you hit the target date, since you haven’t decided when you'll liquidate those investments. But you’re not a “default” person. So why would you want a default investment plan? That’s why you should have a goal. When we know your goal and time horizon, we can determine the best risk level by assessing possible outcomes across a range of bad to average markets. Our projection model includes many possible futures, weighted by how likely we believe each to be. By some standards, we err on the side of caution with a fairly conservative allocation model. Our mission is to help you get to your goal through steady saving and appropriate allocation, rather than taking on unnecessary risk. How much risk should you take on? Your investment horizon is one of the most important factors in determining your risk level. The more time you have to reach your investing goals, the more risk you can afford to safely take. So generally speaking, the closer you are to reaching your goal, the less risk your portfolio should be exposed to. This is why we use the Betterment auto-adjust—a glide path (aka formula) used for asset allocation that becomes more conservative as your target date approaches. We adjust the recommended allocation and portfolio weights of the glide path based on your specific goal and time horizon. Want to take a more aggressive approach? More conservative? That’s totally ok. You’re in control. You always have the final say on your allocation, and we can show you the likely outcomes. Our quantitative approach helps us establish a set of recommended risk ranges based on your goals. If you choose to deviate from our risk guidance, we’ll provide you with feedback on the potential implications. Take more risk than we recommend, and we’ll tell you we believe your approach is “too aggressive” given your goal and time horizon. Even if you care about the downsides less than the average outcome, we’ll still caution you against taking on more risk, because it can be very difficult to recover from losses in a portfolio flagged as “too aggressive.” On the other hand, if you choose a lower risk level than our “conservative” band, we'll label your choice “very conservative.” A downside to taking a lower risk level is you may need to save more. You should choose a level of risk that’s aligned with your ability to stay the course. An allocation is only optimal if you’re able to commit to it in both good markets and bad ones. To ensure you’re comfortable with the short-term risk in your portfolio, we present both extremely good and extremely poor return scenarios for your selection over a one-year period. How Betterment automatically optimizes your risk An advantage of investing with Betterment is that our technology works behind the scenes to automatically manage your risk in a variety of ways, including auto-adjusted allocation and rebalancing. Auto-adjusted allocation For most goals, the ideal allocation will change as you near your goal. We use automation to make those adjustments as efficient and tax-friendly as possible. Deposits, withdrawals, and dividends can help us guide your portfolio toward the target allocation, without having to sell any assets. If we do need to sell any of your investments, our tax-smart technology minimizes the potential tax impact. First we look for shares that have losses. These can offset other taxes. Then we sell shares with the smallest embedded gains (and smallest potential taxes). Betterment’s auto-adjusted allocation not only saves you time, but it also gives you a smooth, tax-efficient path from higher risk to lower risk. Rebalancing Over time, individual assets in a diversified portfolio move up and down in value, drifting away from the target weights that help achieve proper diversification. The difference between your target allocation and the actual weights in your current ETF portfolio is called portfolio drift. We define portfolio drift as the total absolute deviation of each super asset class from its target, divided by two. These super asset classes are US Bonds, International Bonds, Emerging Markets Bonds, US Stocks, International Stocks, and Emerging Markets Stocks. A high drift may expose you to more (or less) risk than you intended when you set the target allocation. Betterment automatically monitors your account for rebalancing opportunities to reduce drift, although rebalancing will likely not occur at a lower account balance. There are several different methods depending on the circumstances: Cash flow rebalancing generally occurs when cash flows going into or out of the portfolio are already happening. We use inflows (like deposits and dividend reinvestments) to buy asset classes that are under-weight. This reduces the need to sell, which in turn reduces capital gains taxes. And we use outflows (like withdrawals) by seeking to first sell asset classes that are overweight. Sell/buy rebalancing reshuffles assets that are already in the portfolio. When cash flows can’t keep your ETF portfolio’s drift within 3% percentage points (or 5% percentage points for portfolios that contain mutual funds and 7% for portfolios with crypto ETFs), we try to sell just enough of overweight super asset classes to buy into underweight super asset classes and reduce the drift to zero. These super asset classes are US Bonds, International Bonds, Emerging Markets Bonds, US Stocks, International Stocks, and Emerging Markets Stocks. A couple exceptions exist, and those are when we attempt to avoid realizing short term capital gains within taxable accounts or wash sales. Allocation change rebalancing occurs when you change your target allocation. This sells securities and could possibly realize capital gains, but we still utilize our tax minimization algorithm to help reduce the tax impact. We’ll let you know the potential tax impact before you confirm your allocation change. Once you confirm it, we’ll rebalance to your new target with minimized drift. If you are an Advised client, rebalancing in your account may function differently depending on the portfolio type your Advisor has selected for you. We recommend reaching out to your Advisor for further details. How Betterment reduces risk in portfolios Investments like short-term US treasuries can help reduce risk in portfolios. At a certain point, however, including assets such as these in a portfolio no longer improves returns for the amount of risk taken. For Betterment, this point is our 60% stock portfolio. Portfolios with a stock allocation of 60% or more don’t incorporate these exposures. We include our U.S. Ultra-Short Income ETF and our U.S. Short-Term Treasury Bond ETF in the portfolio at stock allocations below 60% for both the IRA and taxable versions of the Betterment Core portfolio strategy. If your portfolio includes no stocks (meaning you allocated 100% bonds), we can take the hint. You likely don’t want to worry about market volatility. So in that case, we recommend that you invest everything in these ETFs. At 100% bonds and 0% stocks, a Betterment Core portfolio consists of 60% U.S. short-term treasury bonds, 20% U.S. short-term high quality bonds, and 20% inflation protected bonds. Increase the stock allocation in your portfolio, and we’ll decrease the allocation to these exposures. Reach the 60% stock allocation threshold, and we’ll remove these funds from the recommended portfolio. At that allocation, they decrease expected returns given the desired risk of the overall portfolio. Short-term U.S. treasuries generally have lower volatility (any price swings are quite mild) and smaller drawdowns (shorter, less significant periods of loss). The same can be said for short-term high quality bonds, but they are slightly more volatile. It’s also worth noting that these asset classes don’t always go down at exactly the same time. By combining these asset classes, we’re able to produce a portfolio with a higher potential yield while maintaining relatively lower volatility. As with other assets, the returns for assets such as high quality bonds include both the possibility of price returns and income yield. Generally, price returns are expected to be minimal, with the primary form of returns coming from the income yield. The yields you receive from the ETFs in Betterment’s 100% bond portfolio are the actual yields of the underlying assets after fees. Since we’re investing directly in funds that are paying prevailing market rates, you can feel confident that the yield you receive is fair and in line with prevailing rates. -
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How To Plan Your Taxes When Investing
Tax planning should happen year round. Here are some smart moves to consider that can help you save ...
How To Plan Your Taxes When Investing true Tax planning should happen year round. Here are some smart moves to consider that can help you save money now—and for years to come. Editor’s note: We’re about to dish on taxes and investing in length, but please keep in mind Betterment isn’t a tax advisor, nor should any information here be considered tax advice. Please consult a tax professional for advice on your specific situation. In 1 minute No one wants to pay more taxes than they have to. But as an investor, it’s not always clear how your choices change what you may ultimately owe to the IRS. Consider these strategies that can help reduce your taxes, giving you more to spend or invest as you see fit. Max out retirement accounts: The more you invest in your IRA and/or 401(k), the more tax benefits you receive. So contribute as much as you’re able to. Consider tax loss harvesting: When your investments lose value, you have the opportunity to reduce your tax bill. Selling depreciated assets lets you deduct the loss to offset other investment gains or decrease your taxable income. You can do this for up to $3,000 worth of losses every year, and additional losses can count toward future years. Rebalance your portfolio with cash flows: To avoid realizing gains before you may need to, try to rebalance your portfolio without selling any existing investments. Instead, use cash flows, including new deposits and dividends, to adjust your portfolio’s allocation. Consider a Roth conversion: You can convert all or some of traditional IRA into a Roth IRA at any income level and at any time. You’ll pay taxes upfront, but when you retire, your withdrawals are tax free. It’s worth noting that doing so is a permanent change, and it isn’t right for everyone. We recommend consulting a qualified tax advisor before making the decision. Invest your tax refund: Tax refunds can feel like pleasant surprises, but in reality they represent a missed opportunity. In practice, they mean you’ve been overpaying Uncle Sam throughout the year, and only now are you getting your money back. If you can, make up for this lost time by investing your refund right away. Donate to charity: Giving to causes you care about provides tax benefits. Donate in the form of appreciated investments instead of cash, and your tax-deductible donation can also help you avoid paying taxes on capital gains. In 5 minutes Taxes are complicated. It’s no wonder so many people dread tax season. But if you only think about them at the start of the year or when you look at your paycheck, you could be missing out. As an investor, you can save a lot more in taxes by being strategic with your investments throughout the year. In this guide, we’ll: Explain how you can save on taxes with strategic investing Examine specific tips for tax optimization Consider streamlining the process via automation Max out retirement accounts every year Retirement accounts such as IRAs and 401(k)s come with tax benefits. The more you contribute to them, the more of those benefits you enjoy. Depending on your financial situation, it may be worth maxing them out every year. The tax advantages of 401(k)s and IRAs come in two flavors: Roth and traditional. Contributions to Roth accounts are made with post-tax dollars, meaning Uncle Sam has already taken a cut. Contributions to traditional accounts, on the other hand, are usually made with pre-tax dollars. These two options effectively determine whether you pay taxes on this money now or later. So, which is better, Roth or Traditional? The answer depends on how much money you expect to live on during retirement. If you think you’ll be in a higher tax bracket when you retire (because you’ll be withdrawing more than you currently make each month), then paying taxes now with a Roth account can keep more in your pocket. But if you expect to be in the same or lower tax bracket when you retire, then pushing your tax bill down the road via a Traditional retirement account may be the better route. Use tax loss harvesting throughout the year Some of your assets will decrease in value. That’s part of investing. But tax loss harvesting is designed to allow you to use losses in your taxable (i.e. brokerage) investing accounts to your advantage. You gain a tax deduction by selling assets at a loss. That deduction can offset other investment gains or decrease your taxable income by up to $3,000 every year. And any losses you don’t use rollover to future years. Traditionally, you’d harvest these losses at the end of the year as you finalize your deductions. But then you could miss out on other losses throughout the year. Continuously monitoring your portfolio lets you harvest losses as they happen. This could be complicated to do on your own, but automated tools make it easy. At Betterment, we offer Tax Loss Harvesting+ at no extra cost. Once you determine if Tax Loss Harvesting+ is right for you (Betterment will ask you a few questions to help you determine this), all you have to do is enable it, and this feature looks for opportunities regularly, seeking to help increase your after-tax returns.* Keep in mind, however, that everyone’s tax situation is different—and Tax Loss Harvesting+ may not be suitable for yours. In general, we don’t recommend it if: Your future tax bracket will be higher than your current tax bracket. You can currently realize capital gains at a 0% tax rate. You’re 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. Rebalance your portfolio with cash flows As the market ebbs and flows, your portfolio can drift from its target allocation. One way to rebalance your portfolio is by selling assets, but that can cost you in taxes. A more efficient method for rebalancing is to use cash flows like new deposits and dividends you’ve earned. This can help keep your allocation on target while keeping taxes to a minimum. Betterment can automate this process, automatically monitoring your portfolio for rebalancing opportunities, and efficiently rebalancing your portfolio throughout the year once your account has reached the balance threshold. Consider getting out of high-cost investments Sometimes switching to a lower-cost investment firm means having to sell investments, which can trigger taxes. But over time, high-fee investments could cost you more than you’d pay in taxes to move to a lower cost money manager. For example, if selling a fund will cost you $1,000 in taxes, but you will save $500 per year in fees, you can break even in just two years. If you plan to be invested for longer than that, switching can be a savvy investment move. Consider a Roth conversion The IRS limits who can contribute to a Roth IRA based on income. But there’s no income limit for converting your traditional IRA into a Roth IRA. It’s not for everyone, and it does come with some potential pitfalls, but you have good reasons to consider it. A Roth conversion could: Lower the taxable portion of the conversion due to after-tax contributions made previously Lower your tax rates Put you in a lower tax bracket than normal due to retirement or low-income year Provide tax-free income in retirement or for a beneficiary Provide an opportunity to use an AMT (alternative minimum tax) credit carryover Provide an opportunity to use an NOL (net operating loss) carryover If you decide to convert your IRA, don’t wait until December—you’d miss out on 11 months of potential tax-free growth. Generally, the earlier you do your conversion the better. That said, Roth conversions are permanent, so be certain about your decision before making the change. It’s worth speaking with a qualified tax advisor to determine whether a Roth conversion is right for you. Invest your tax refund It might feel nice to receive a tax refund, but it usually means you’ve been overpaying your taxes throughout the year. That’s money you could have been investing! If you get a refund, consider investing it to make up for lost time. Depending on the size of your refund, you may want to resubmit your Form W-4 to your employer to adjust the amount of taxes withheld from each future paycheck. The IRS offers a Tax Withholding Estimator to help you get your refund closer to $0. Then you could increase your 401(k) contribution by that same amount. You won’t notice a difference in your paycheck, but it can really add up in your retirement account. Donate to charity It’s often said that it’s better to give than to receive. This is doubly true when charitable giving provides tax benefits in addition to the feeling of doing good. You can optimize your taxes while supporting your community or giving to causes you care about. To donate efficiently, consider giving away appreciated investments instead of cash. Then you avoid paying taxes on capital gains, and the gift is still tax deductible. You’ll have to itemize your deductions above the standard deduction, so you may want to consider “bunching” two to five years’ worth of charitable contributions. Betterment’s Charitable Giving can help streamline the donation process by automatically identifying the most appreciated long-term investments and partnering directly with highly-rated charities across a range of causes. -
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How Betterment’s tech helps you manage your money
Our human experts harness the power of technology to help you reach your financial goals. Here’s ...
How Betterment’s tech helps you manage your money true Our human experts harness the power of technology to help you reach your financial goals. Here’s how. When you’re trying to make the most of your money and plan for the future, there are some things humans simply can’t do as well as algorithms. The big idea: Here at Betterment, we’re all about automated investing—using technology with human experts at the helm—to manage your money smarter and help you meet your financial goals. How does it work? Robo-advisors use algorithms and automation to optimize your investments faster than a human can. They do the heavy lifting behind the scenes, managing all the data analysis and adapting investment expertise to fit your circumstances. All you need to do is fill in the gaps with details about your financial goals. The result: you spend less time managing your finances and more time enjoying your life, while Betterment focuses on your specific reasons for saving, adjusting your risk based on your timeline and target amount. Plus, robo-advisors cost less to operate. While the specific fees vary from one robo-advisor to the next, they all tend to be a fraction of what it costs to work with a traditional investment manager, which translates to savings for you. Learn more about how much it costs to save, spend and invest with Betterment. A winning combination of human expertise and technology: Automation is what Betterment is known for. But our team of financial experts is our secret sauce. They research, prototype, and implement all the advice and activity that you see in your account. Our algorithms and tools are built on the expertise of traders, quantitative researchers, tax experts, CFP® professionals, behavioral scientists, and more. Four big benefits (just for starters): No more idle cash: We automatically reinvest dividends, even purchasing fractions of shares on your behalf, so you don’t miss out on potential market returns. A focus on the future: Nobody knows the future. And that makes financial planning tough. Your situation can change at any time but our tools and advice can help you see how various changes could affect your goals. We show you a range of potential outcomes so you can make more informed decisions. Anticipating taxes: We may not be able to predict future tax rates, but we can be pretty sure that certain incomes and account types will be subject to some taxes. This becomes especially relevant in retirement planning, where taxes affect which account types are most valuable to you. Factoring in inflation: We don’t know how inflation will change, but we can reference known historical ranges, as well as targets set by fiscal policy. The most important thing is to factor in some inflation because we know it won’t be zero. We currently assume a 2% inflation rate in our retirement planning advice and in our safe withdrawal advice, which is what the Fed currently targets. Additional advice is always available: At Betterment, we automate what we can and complement our automated advice with access to our financial planning experts through our Premium plan, which offers unlimited calls and emails with our team of CFP® professionals. You can also schedule a call with an advisor to assist with a rollover or help with your initial account setup. Whether you need a one-time consultation or ongoing support, you can always discuss your unique financial situations with one of our licensed financial professionals Managing your money with Betterment: Our mission is to empower you to make the most of your money, so you can live better. Sometimes the best way to do that is with human creativity and critical thought. Sometimes it’s with machine automation and precision. Usually, it takes a healthy dose of both. -
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Three steps to size up your emergency fund
Strive for at least three months of expenses while taking these factors into consideration.
Three steps to size up your emergency fund true Strive for at least three months of expenses while taking these factors into consideration. Imagine losing your job, totaling your car, or landing in the hospital. How quickly would your mind turn from the shock of the event itself to worrying about paying your bills? If you’re anything like the majority of Americans recently surveyed by Bankrate, finances would add insult to injury pretty fast: 57% | Percentage of U.S. adults currently unable to afford a $1,000 emergency expense In these scenarios, an emergency fund can not only help you avoid taking on high-interest debt or backtracking on other money goals, it can give you one less thing to worry about in trying times. So how much should you have saved, and where should you put it? Follow these three steps. 1. Tally up your monthly living expenses — or use our shortcut. Coming up with this number isn’t always easy. You may have dozens of regular expenses falling into one of a few big buckets: Food Housing Transportation Medical When you create an Emergency Fund goal at Betterment, we automatically estimate your monthly expenses based on two factors from your financial profile: Your self-reported household annual income Your zip code’s estimated cost of living You’re more than welcome to use your own dollar figure, but don’t let math get in the way of getting started. 2. Decide how many months make sense for you We recommend having at least three months’ worth of expenses in your emergency fund. A few scenarios that might warrant saving more include: You support others with your income Your job security is iffy You don’t have steady income You have a serious medical condition But it really comes down to how much will help you sleep soundly at night. According to Bankrate’s survey, nearly ⅔ of people say that total is six months or more. Whatever amount you land on, we’ll suggest a monthly recurring deposit to help you get there. We’ll also project a four-year balance based on your initial and scheduled deposits and your expected return and volatility. Why four years? We believe that’s a realistic timeframe to save at least three months of living expenses through recurring deposits. If you can get there quicker and move on to other money goals, even better! 3. Pick a place to keep your emergency fund We recommend keeping your emergency fund in one of two places: cash—more specifically a low-risk, high-yield cash account—or a bond-heavy investing account. A low-risk, high-yield cash account like our Cash Reserve may not always keep pace with inflation, but it comes with no investment risk. An investing account is better suited to keep up with inflation but is relatively riskier. Because of this volatility, we currently suggest adding a 30% buffer to your emergency fund’s target amount if you stick with the default stock/bond allocation. There also may be tax implications should you withdraw funds. Your decision will again come down to your comfort level with risk. If the thought of seeing your emergency fund’s value dip, even for a second, gives you heartburn, you might consider sticking with a cash account. Or you can always hedge and split your emergency fund between the two. There’s no wrong answer here! Remember to go with the (cash) flow There’s no final answer here either. Emergency funds naturally ebb and flow over the years. Your monthly expenses could go up or down. You might have to withdraw (and later replace) funds. Or you simply might realize you need a little more saved to feel secure. Revisit your numbers on occasion—say, once a year or anytime you get a raise or big new expense like a house or baby—and rest easy knowing you’re tackling one of the most important financial goals out there.
