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The role of life insurance in a financial plan

The role of life insurance in a financial plan Nov 1, 2024 10:00:00 AM Life insurance helps loved ones cover expenses and progress toward financial goals after you’re gone. When you’re making a financial plan, life insurance probably isn’t the first thing that comes to mind. But if you pass away, life insurance helps take care of your loved ones when you can’t. It helps your beneficiaries stay on track to pay off your mortgage, pursue secondary education, retire on time, and reach the other financial goals you’ve made together. It protects them from the sudden loss of income they could experience. Life insurance won’t help you reach your goals, but it ensures that your loved ones still can when you’re gone. In this guide, we’ll cover: Life insurance basics How to decide if you need life insurance How to apply for life insurance Life insurance basics Whatever policy you buy, life insurance has five main components: Policyholder: The person or entity who owns the life insurance policy. Usually, this is the person whose life is insured, but it’s also possible to take out a policy on someone else. The policyholder is responsible for paying the monthly or annual insurance premiums. Insured: Also known as the life assured, this is the person whose life the policy covers. The cost of life insurance heavily depends on who it covers. Beneficiary: The person, people or institution(s) that receive money if the insured dies. There can be more than one beneficiary named on the policy. Premium: This is what you pay monthly or annually to keep a policy active (or “in-force”). Stop paying premiums, and you could lose coverage. Death benefit: This is what the insurance company pays the beneficiaries if the insured person passes away. As soon as the policy is in force, the beneficiaries are usually eligible for the death benefit. In some circumstances, insurance companies aren’t obligated to pay the death benefit. This includes when: The insured outlives the policy term The policy lapses or gets canceled The death occurs within two years of the policy being in-force and the insurance company finds evidence of fraud on the application Term life insurance vs. permanent life insurance Term life policies last for a set period of time. When the term is up, the policy expires. This is usually the most affordable type of life insurance. And since it’s not permanent, you can let it expire once you reach your financial goals and have other means of providing for your loved ones. You’re not stuck paying for protection you no longer need. In fact, the premiums are so low that you can even abandon your policy later without losing much money. Permanent life insurance policies don’t have an expiration date. They last for as long as the policyholder pays the premiums. Since they’re permanent, these policies also have a cash-value component that can be borrowed against. These policies have higher premiums than term policies. Permanent life insurance policies include whole, variable, universal and variable universal life. So, should you sign up for life insurance? If you have financial dependents, and you don’t have enough money set aside to provide for them in the event of your passing, then life insurance should be considered. Here are some cases where buying life insurance might not be beneficial: You have neither a spouse nor dependents You don’t have any debt You can self-insure (you have enough saved to cover debts and expenses) Unless that describes you, getting life insurance should probably be on your To-Do list. How much coverage do you need, though? That depends. If you’re married, you might want to leave a financial cushion for your spouse. You also might want to make sure that they can continue to pay off the loans you co-signed. For example, your spouse could lose your house if they are unable to keep up with the mortgage payments. Consider choosing a policy that will cover any debts your spouse may owe and the loss of your income. A common rule of thumb for an amount is 10x the insured's income. If you have kids, consider getting a policy big enough to cover all childcare costs, including everything you pay now and what you may pay in the future, such as college tuition. You may wish to leave enough behind for your spouse to cover your kids’ education expenses. Your death benefit should usually cover the entire amount of all these expenses, minus any assets you already have that your family can use to make up some of the financial shortfall. This could be as little as $250,000 or as much as several million dollars. How to apply for life insurance Applying for life insurance usually takes four to eight weeks, but you can often complete the process in just seven steps: Compare quotes from multiple companies Choose a policy Fill out an application Take a medical exam Complete a phone interview Wait for approval Sign your policy And just like that, you have life insurance—and your dependents have a little more peace of mind. Life insurance is about preparing for the unexpected. As you set financial goals and plan for the future, it’s important to consider what your family’s finances would look like without you. This is your fail-safe. In the worst case scenario, life insurance could prevent financial loss from adding to your loved ones’ grief.

Putting together an estate plan for your investments

Putting together an estate plan for your investments Nov 1, 2024 9:00:00 AM Help make sure the right people make decisions on your behalf and receive the inheritance you want. If you suddenly found yourself on life support or developed a serious mental illness, what would happen to you? If you died tomorrow, what would happen to your children, and your things? State laws can answer these questions, or you can decide for yourself with an estate plan. By preparing in advance, you can help ensure that the right people make decisions on your behalf and that your loved ones receive the inheritance you want them to. (And if there’s anyone who shouldn’t receive an inheritance, your estate plan can keep them from cutting in.) In this guide, we’ll cover: What your estate plan needs to do Who should be part of your estate plan What documents to include in your estate plan An estate plan can define what will happen with the people and things you’re responsible for if you die or become incapacitated. Who will make medical or financial decisions on your behalf? Who will be your child’s new guardian? How will your finances be divided? Who gets the house? Those aren’t decisions you want a stranger to make for you. But without an estate plan, that could be what happens. Unless you say otherwise, state laws will govern your estate. And those generic laws may not align with your values and goals. That’s why whatever your age and whatever your financial situation, an estate plan is crucial. Before you start creating an estate plan, it helps to consider your unique situation. What does your estate plan need to do? Your estate plan can answer questions about what happens with your assets and how your loved ones will be taken care of when you’re gone. So you need to consider how you’d answer those questions now, anticipating choices that could come up in the future. For example, if you’re expecting to receive an inheritance, be sure to think through how your estate plan would distribute it or who would manage it. And if there’s anyone you need or want to financially support, that should guide your estate plan as well. Who should be part of your estate plan? An estate plan doesn’t just decide who gets what. It can also determine who’s in charge of what. There are several key roles to consider in your estate plan. You may want to divide these roles between multiple people, or let one call the shots. For example, if all of your children have the authority to make medical decisions on your behalf, that may lead to more thoughtful decisions. But it’s a trade off. Each of the people you give power to has to sign off on decisions, which can slow things down and make it much more difficult to coordinate. Financial Power Of Attorney (POA) Giving someone financial power of attorney can make it easier for them to pay bills, file taxes, or cash checks on your behalf. You can decide how broad or limited their control is. Even with broad authority, a financial power of attorney can’t change your will. The idea is that if you’re physically or mentally unable to take care of your day-to-day finances, you’ve designated someone to take care of that for you. Make sure the person you designate has a copy of this paperwork or knows where to find it. You can also give a copy to your financial institutions. Advanced Healthcare Directive An advanced healthcare directive helps decide how to handle medical decisions when you can’t make them yourself. It can lay out specific care instructions like, “Do not resuscitate,” but it can also give someone medical power of attorney to make decisions on your behalf. When you can’t think through important decisions anymore, who do you want to make the call? Your spouse? Your children? A parent? A sibling? As with financial power of attorney, you can define the scope of this power. Joint Owner If you name someone the joint owner of your accounts, then when you die, they become the sole owner. This is a common way for married couples to handle their estates, and it usually keeps the state from getting involved in distributing your assets when you die. Just keep in mind: anyone you name as a joint owner gains equal control of your assets while you’re alive, too. Also, retirement accounts such as 401(k)s and IRAs can’t be put into joint ownership. Beneficiaries You may also want individual assets to go to specific people. In that case, you may want to name beneficiaries for your bank accounts, investment accounts, life insurance policy, real estate, and other major assets. Name beneficiaries in your will, and these assets will have to go through probate first, where a court process proves that your will is authentic. This typically increases the time before your beneficiaries receive the inheritance and reduces the amount that ultimately makes it to them. For your accounts, adding beneficiaries can be as simple as filling out a form through your bank or investment firm. In some states, you may be able to use a Transfer on Death (TOD) Deed to ensure that your real estate goes directly to the beneficiary. What documents should your estate plan include? While there are many legal documents that make up an estate plan, two of the more important ones are a will and a trust. Here’s what those entail. Last will and testament A will serves several purposes. It can clearly lay out your final wishes, state who will take care of your non-adult children, and say who receives your belongings. If you do a good job naming beneficiaries for your assets, this mostly affects personal belongings. A will should usually start with a declaration. This identifies who you are and says that the document is your will. You’ll generally have to sign it in front of witnesses (and possibly a notary). You’ll need to choose an executor who will ensure your wishes are carried out, including any final arrangements for your death and funeral services. Your will can define the scope and limitations of their power as well as any compensation you want them to receive. If you have non-adult children, your will should name their new guardians. Wills also define bequests: individual gifts you give someone. Think family heirlooms. Clothing. Vehicles. Money. You can change your will at any time. And as your valuables and relationships change, you’ll want to keep it up to date. Trust A trust is a legal entity that gives someone (usually you) the right to hold your assets for the benefit of someone else. It provides several advantages that help your financial plan live on when you’re gone. Some types of trusts can shield your assets from estate taxes. They can also protect your assets from creditors, litigation, and even public records. As part of your trust, these assets also avoid probate. By using a trust, you keep greater control over your assets, too. You can define who gets your assets and when, as well as what they can do with them. With Betterment, you can open an account in the name of a trust–revocable or irrevocable–that you have already established.

An investor’s guide to diversification

An investor’s guide to diversification Nov 1, 2024 8:00:00 AM Diversification is an investing strategy that helps reduce risk by allocating investments across various financial assets. Here’s everything you need to know. In 1 minute When you invest too heavily in a single asset, type of asset, or market, your portfolio is more exposed to the risks that come with it. That’s why investors diversify. Diversification means spreading your investments across multiple assets, asset classes, or markets. This aims to do two things: Limit your exposure to specific risks Make your performance more consistent As the market fluctuates, a diverse portfolio generally remains stable. Extreme losses from one asset have less impact—because that asset doesn’t represent your entire portfolio. Maintaining a diversified portfolio forces you to see each asset in relation to the others. Is this asset increasing your exposure to a particular risk? Are you leaning too heavily on one company, industry, asset class, or market? In 5 minutes In this guide, we’ll: Define diversification Explain the benefits of diversification Discuss the potential disadvantages of diversification What is diversification? Financial assets gain or lose value based on different factors. Stocks depend on companies’ performance. Bonds depend on the borrower’s (companies, governments, etc.) ability to pay back loans. Commodities depend on public goods. Real estate depends on property. Entire industries can rise or fall based on government activity. What’s good or bad for one asset may have no effect on another. If you only invest in stocks, your portfolio’s value completely depends on the performance of the companies you invest in. With bonds, changing interest rates or loan defaults could hurt you. And commodities are directly tied to supply and demand. Diversification works to spread your investments across a variety of assets and asset classes, so no single weakness becomes your fatal flaw. The more unrelated your assets, the more diverse your portfolio. So you might invest in some stocks. Some bonds. Some fund commodities. And then if one company has a bad quarterly report, gets negative press, or even goes bankrupt, it won’t tank your entire portfolio. You can make your portfolio more diverse by investing in different assets of the same type—like buying stocks from separate companies. Better yet: companies in separate industries. You can even invest internationally, since foreign markets can potentially be less affected by local downturns. What are the benefits of diversification? There are two main reasons to diversify your portfolio: It can help reduce risk It can provide more consistent performance Here’s how it works. Lower risk Each type of financial asset comes with its own risks. The more you invest in a particular asset, the more vulnerable you are to its risks. Put everything into bonds, for example? Better hope interest rates hold. Distributing your assets distributes your risk. With a diversified portfolio, there are more factors that can negatively affect your performance, but they affect a smaller percentage of your portfolio, so your overall risk is much lower. If 100% of your investments are in a single company and it goes under, your portfolio tanks. But if only 10% of your investments are in that company? The same problem just got a whole lot smaller. Consistent performance The more assets you invest in, the less impact each one has on your portfolio. If your assets are unrelated, their gains and losses depend on different factors, so their performance is unrelated, too. When one loses value, that loss is mitigated by the other assets. And since they’re unrelated, some of your other assets may even increase in value at the same time. Watch the value of a single stock or commodity over time, and you’ll see its value fluctuate significantly. But watch two unrelated stocks or commodities—or one of each—and their collective value fluctuates less. They can offset each other. Diversification can make your portfolio performance less volatile. The gains and losses are smaller, and more predictable. Potential disadvantages of diversification While the benefits are clear, diversification can have a couple drawbacks: It creates a ceiling on potential short-term gains Diverse portfolios may require more maintenance Limits short-term gains Diversification usually means saying goodbye to extremes. Reducing your risk also reduces your potential for extreme short-term gains. Investing heavily in a single asset can mean you’ll see bigger gains over a short period. For some, this is the thrill of investing. With the right research, the right stock, and the right timing, you can strike it rich. But that’s not how it usually goes. Diversification is about playing the long game. You’re trading the all-or-nothing outcomes you can get with a single asset for steady, moderate returns. May require more maintenance As you buy and sell financial assets, diversification requires you (or a broker) to consider how each change affects your portfolio’s diversity. If you sell all of one asset and re-invest in another you already have, you increase the overall risk of your portfolio. Maintaining a diversified portfolio adds another layer to the decision-making process. You have to think about each piece in relation to the whole. A robo advisor or broker can do this for you, but if you’re managing your own portfolio, diversification may take a little more work.

Three keys to managing joint finances with your partner

Three keys to managing joint finances with your partner Nov 1, 2024 8:00:00 AM Talking about money with your partner can be a difficult conversation. The key is to have open communication, sooner rather than later. Money has wrecked its fair share of relationships. Maybe you’ve even seen one of yours go up in flames because of it. But it doesn’t have to. And while every partnership is different, we’ve seen an emphasis on three areas help our clients avoid the worst of money fights: Communication Prioritization Logistics Whether you’re married or not, and whether you join your accounts or keep them separate, they can help soften one of love’s thorniest topics. Open (and keep open) those lines of communication When you choose to share your life with someone special, you bring all sorts of baggage with you. Among the bags you might want to start unpacking first is your relationship with money. It could be complicated, and there’s probably all sorts of emotions wrapped up in it—especially with debt—but transparency can help avoid unpleasant surprises down the road. So to start with, try sizing up the financial state of your union by crunching a few numbers for each of you: Net worth (assets − liabilities) This can be the most emotionally-charged of numbers, and it’s no surprise why. It’s right there in the name: net worth. We tend to bundle up our concept of our own self-worth with our finances, and when those finances don’t look pretty, feelings of shame or embarrassment may follow. So it’s important to support each other during this exercise. Help your partner feel safe enough to share these sensitive details in the first place. When you’re both ready, add up all your assets (cash, investments, home equity, etc.), then subtract your total liabilities—namely debt (credit cards, student loans, mortgage, etc.)—to get a good sense of your separate and combined balance sheets. If you’re a Betterment customer, connecting your external financial accounts to Betterment can be a handy shortcut for this number-crunching. Cash flow (income − expenses) Now comes the time to size up how much money is coming in and going out each month, with the difference being what you currently have available to save for all your goals (more on those later). For simplicity’s sake, it can be easier to start with your take-home pay, which may already factor in payroll taxes and expenses such as health care insurance. If you already contribute to a 401(k), which automatically comes out of your paycheck, be sure to count this toward your tallied savings when the time comes! Toss in a survey of your respective credit scores, which could affect future goals such as home ownership, and you’ve started to lay the foundation for a healthier money partnership. And by no means is this a one-time exercise. For some couples, it helps to schedule a monthly financial check-in. Why monthly? Some people don’t like talking about finances at all. A monthly check-in gives you a safe space to start the conversation. Others think and talk about money all the time, which can be draining on a partner. Unless it’s urgent, you can make a note and wait to bring it up until the next check-in. A recurring monthly check-in solves both these problems and provides a forum to talk about upcoming big expenses and important money tasks, among other things. To make things fun, you can build your check-ins around something you already enjoy, like a weekend morning coffee date. Prioritize as partners With key details like your net worth and cash flow in place, next comes the process of visualizing what you—as individuals and as a couple—want your money to do for you and your family. Couples don’t always see eye-to-eye on this, so now's the time to hash out any differences of opinion. If you have financial liabilities, know that it’s possible to manage debt and save at the same time; it all comes down to prioritizing. In general, we recommend putting your dollars to work in this order: Assuming your employer offers a 401(k) and matching contribution, contribute just enough to your 401(k) to get the full match so you’re not leaving any money on the table. Address short-term, high-priority goals such as: High-interest debt Emergency fund (3-6 months’ worth of living expenses) Save more for retirement in tax-advantaged investment accounts such as a 401(k) and IRA. How much more? Sign up for Betterment and we can help you figure that out. Save for other big money goals such as home ownership, education, vacations, etc. The devil is in the details with #4, of course. And you may not be able to save as much as you need to for every single goal at this time. Just know that if you start at the top and set specific goals—”I’ll contribute X amount of dollars each month to pay off my high-interest debt in X number of years,” for example—you’ll eventually free up cash flow to put toward priorities that fall further down on your list. Tend to the logistical paperwork With your planning well underway, next comes execution. How exactly will you set up your financial accounts? If you’re married, will you file taxes jointly or separately? And how will you update (or set up for the first time) your estate plan? These are three big questions best to start considering now. Set up your accounts for success There’s the process of jointly managing finances with your significant other, then there's the actual act of opening joint accounts. These are accounts you both share legal ownership of. Whether or not you decide to keep all or some of your accounts separate is a highly-personal decision. One way to address it is the “yours, mine, ours” approach, also known as the “three-pot” approach. To keep some financial autonomy, you and your partner might each maintain credit cards and checking accounts in your own names to cover personal expenses or debt repayments. The bulk of your monthly income, however, would go into a joint account to cover your monthly bills and shared expenses. Head on over to our Help Center for more information on how to manage money with a partner at Betterment. If you’re married, weigh the pros and cons of filing taxes jointly In most cases, the financial benefits of you and your spouse filing one joint tax return will outweigh each of you filing separately, but it‘s important to know and understand your options. When you choose to file separately, you limit or altogether forgo several tax breaks and deductions including but not limited to: Child and Dependent Care Tax Credit Earned Income Tax Credit The American Opportunity Credit and Lifetime Learning Credit for higher education expenses The student loan interest deduction Traditional IRA deductions Roth IRA contributions That being said, you might consider filing separately if you find yourself in one of these scenarios: You and your spouse both have taxable income and at least one of you (ideally the person with the lower income) has significant itemized deductions that are limited by adjusted gross income (AGI). You participate in income-driven repayment plans for student loans. Filing separately may mean lower monthly loan payments in this scenario. You want to separate your tax liability from your spouse’s. If you know or suspect that your spouse is omitting income or overstating deductions and/or credits, you may want to file separately. You and/or your spouse live in a community property state. Special rules apply in these states for allocating income and deductions between each spouse’s tax return. We’re not a tax advisor, and since everyone’s situation is different, none of this should be considered tax advice for you specifically. If you have questions about your specific circumstances, you should seek the advice of a trusted tax professional. Update (or establish) your estate plan An estate plan can define what will happen with the people and things you’re responsible for if you die or become incapacitated. Who will make medical or financial decisions on your behalf? Who will be your child’s new guardian? How will your finances be divided? Who gets the house? If you haven’t yet created one, now may be the time. And if you have, it’s important to keep it up-to-date based on your latest life circumstance. Don’t forget to update your beneficiaries on any accounts that may pass outside the estate. That’s because beneficiary designation forms—not your will—determine who inherits your retirement savings and life insurance benefits. You can review, add, and update beneficiary listings on your Betterment accounts online.

ETF Selection For Portfolio Construction: A Methodology

ETF Selection For Portfolio Construction: A Methodology Oct 31, 2024 9:00:00 AM When constructing a portfolio, Betterment focuses on exchange traded funds (“ETFs”) securities with generally low-costs and high liquidity. TABLE OF CONTENTS Why ETFs Total Annual Cost of Ownership Mitigating Market Impact Conclusion 1. Why ETFs? When constructing a portfolio, Betterment focuses on exchange traded funds (“ETFs”) securities with generally low-costs and high liquidity. An ETF is a security that generally tracks a broad-market stock or bond index or a basket of assets just like an index mutual fund, but trades just like a stock on a listed exchange. By design, index ETFs closely track their benchmarks—such as the S&P 500 or the Dow Jones Industrial Average—and are bought and sold like stocks throughout the day. ETFs have certain structural advantages when compared to mutual funds. These include: A. Clear Goals and Mandates Betterment generally selects ETFs that have mandates to passively track broad-market benchmark indexes. A passive mandate explicitly restricts the fund administrator to the singular goal of replicating a benchmark rather than making active investment decisions constituting market timing, building concentration in either a single name, group of names, or themes in an effort to beat the fund’s underlying benchmark. Adherence to this mandate ensures the same level of investment diversification as the benchmark indexes, makes performance more predictable, and reduces idiosyncratic risk associated with active manager decisions. B. Intraday Availability ETFs are transactable during all open market hours just like any other stock. As such, they are heavily traded by the full spectrum of equity market participants including market makers, short-term traders, buy-and-hold investors, and fund administrators themselves creating and redeeming units as needed (or increasing or decreasing the supply of ETFs based on market demand). This diverse trading activity leads to most ETFs carrying low liquidity premiums (or lower costs to transact due to competition from readily available market participants pushing prices downward) and equity-like transaction times irrespective of the underlying holdings of each fund. This generally makes ETFs fairly liquid, which makes them cheaper and easier to trade on-demand for activities like creating a new portfolio or rebalancing an existing one. C. Low Fee Structures Because most benchmarks update constituents (i.e., the specific stocks and related weights that make up a broad-market index) fairly infrequently, passive index-tracking ETFs also register lower annual turnover (or the rate a fund tends to transact its holdings) and thus fewer associated costs are passed through to investors. In addition, ETFs are generally managed by their administrators as a single share class that holds all assets as a single entity. This structure naturally lends itself as a defense against administrators practicing fee discrimination across the spectrum of available investors. With only one share class, ETFs are investor-type agnostic. The result is that ETF administrators provide the same exposures and low fees to the entire spectrum of potential buyers. D. Tax Efficiency In the case when a fund (irrespective of its specific structure) sells holdings that have experienced capital appreciation, the capital gains generated from those sales must, by law, be accrued and distributed to shareholders by year-end in the form of distributions. These distributions increase tax liabilities for all of the fund’s shareholders. With respect to these distributions, ETFs offer a significant tax advantage for shareholders over mutual funds. Because mutual funds are not exchange traded, the only available counterparty available for a buyer or seller is the fund administrator. When a shareholder in a mutual fund wishes to liquidate their holdings in the fund, the fund’s administrator must sell securities in order to generate the cash required to satisfy the redemption request. These redemption-driven sales generate capital gains that lead to distributions for not just the redeeming investor, but all shareholders in the fund. Mutual funds thus effectively socialize the fund’s tax liability to all shareholders, leading to passive, long-term investors having to help pay a tax bill for all intermediate (and potentially short-term) shareholder transactions. Because ETFs are exchange traded, the entire market serves as potential counterparties to a buyer or seller. When a shareholder in an ETF wishes to liquidate their holdings in the fund, they simply sell their shares to another investor just like that of a single company’s equity shares. The resulting transaction would only generate a capital gain or loss for the seller and not all investors in the fund. In addition, ETFs enjoy a slight advantage when it comes to taxation on dividends paid out to investors. After the passing of the Jobs and Growth Tax Relief Reconciliation Act of 2003, certain qualified dividend payments from corporations to investors are only subject to the lower long-term capital gains tax rather than standard income tax (which is still in force for ordinary, non-qualified dividends). Qualified dividends have to be paid by a domestic corporation (or foreign corporation listed on a domestic stock exchange) and must be held by both the investor and the fund for 61 of the 120 days surrounding the dividend payout date. As a result of active mutual funds’ higher turnover, a higher percentage of dividends paid out to their investors violate the holding period requirement and increase investor tax profiles. E. Investment Flexibility The maturation and growth of the global ETF market over the past few decades has led to the development of an immense spectrum of products covering different asset classes, markets, styles, and geographies. The result is a robust market of potential portfolio components which are versatile, extremely liquid, and easily substitutable. Despite all the advantages of ETFs, it is still important to note that not all ETFs are exactly alike or equally beneficial to an investor. Betterment’s investment selection process seeks to select ETFs that provide exposure to the desired asset classes with the least amount of difference between underlying asset class behavior and portfolio performance. In other words, we attempt to minimize the “frictions” (the collection of systematic and idiosyncratic factors that lead to performance deviations) between ETFs and their benchmarks. Betterment’s measure of these frictions is summarized as the “total annual cost of ownership”, or TACO: a composition of all relevant frictions used to rank and select ETF candidates for the Betterment portfolio. 2. Total Annual Cost of Ownership (TACO) The total annual cost of ownership (TACO) is Betterment’s fund scoring method, used to rate funds for inclusion in the Betterment portfolio. TACO takes into account an ETF’s transactional and liquidity costs as well as costs associated with holding funds. In addition to TACO, Betterment also considers certain other qualitative factors of ETFs, including but not limited to, whether the ETF fulfills a desired portfolio mandate and/or exposure. TACO is determined by two components, a fund’s cost-to-trade and cost-to-hold. The first, cost-to-trade, represents the cost associated with trading in and out of funds during the course of regular investing activities, such as rebalancing, cash inflows or withdrawals, and tax loss harvesting. Cost-to-trade is generally influenced by two factors: Volume: A measure of how many shares change hands each day. Bid-ask spread: The difference between the price at which you can buy a security and the price at which you can sell the same security at any given time. The second component, cost-to-hold, represents the annual costs associated with owning the fund and is generally influenced by these two factors: Expense ratios: Fund expenses imposed by an ETF administrator. Tracking difference: The deviation in performance from the fund’s benchmark index. Let’s review the specific inputs to each component in more detail: Cost-to-Trade: Volume and Bid-Ask Spread Volume: Volume is a historical measure of how many shares may change hands each day. This helps assess how easy it might be to find a buyer or seller in the future. This is important because it tends to indicate the availability of counterparties to buy (e.g., when Betterment is selling ETFs) and sell (e.g., when Betterment is buying ETFs). The more shares of an ETF Betterment needs to buy on behalf of our client, the more volume is needed to complete the trades without impacting market prices. As such, we measure average market volume for each ETF as a percentage of Betterment’s normal trading activity. Funds with low average daily trading volume compared to Betterment’s trading volume will have a higher cost, because Betterment’s higher trading volume is more likely to influence market prices. Bid-Ask Spread: Generally market transactions are associated with two prices: the price at which people are willing to sell a security, and the price others are willing to pay to buy it. The difference between these two numbers is known as the bid-ask spread, and can be expressed in currency or percentage terms. For example, a trader may be happy to sell a share at $100.02, but only wishes to buy it at $99.98. The bid-ask currency spread here is $.04, which coincidentally also represents a bid-ask percentage of 0.04%. In this example, if you were to buy a share, and immediately sell it, you’d end up with 0.04% less due to the spread. This is how traders and market makers make money—by providing liquid access to markets for small margins. Generally, heavily traded securities with more competitive counterparties willing to transact will carry lower bid-ask spreads. Unlike the expense ratio, the degree to which you care about bid-ask spread likely depends on how actively you trade. Buy-and-hold investors typically care about it less compared to active traders, because they will accrue significantly fewer transactions over their intended investment horizons. Minimizing these costs is beneficial to building an efficient portfolio which is why Betterment attempts to select ETFs with narrower bid-ask spreads. Cost-to-Hold: Expense Ratio and Tracking Difference Expense Ratio: An expense ratio is the set percentage of the price of a single share paid by shareholders to the fund administrators every year. ETFs often collect these fees from the dividends passed through from the underlying assets to holders of the security, which result in lower total returns to shareholders. Tracking Difference: Tracking difference is the underperformance or outperformance of a fund relative to the benchmark index it seeks to track. Funds may deviate from their benchmark indexes for a number of reasons, including any trades with respect to the fund’s holdings, deviations in weights between fund holdings and the benchmark index, and rebates from securities lending. It’s important to note that, over any given period, tracking difference isn’t necessarily negative; in some periods, it could lead to outperformance. However, tracking difference can introduce systematic deviation in the long-term returns of the overall portfolio when compared purely with a comparable basket of benchmark indexes other than ETFs. Finding TACO We calculate TACO as the sum of the above components: TACO = "Cost-to-Trade" + "Cost-to-Hold" As mentioned above, cost-to-trade estimates the costs associated with buying and selling funds in the open market. This amount is weighted to appropriately represent the aggregate investing activities of the average Betterment client in terms of cash flows, rebalances, and tax loss harvests. The cost-to-hold represents our expectations of the annual costs an investor will incur from owning a fund. Expense ratio makes up the majority of this cost, as it is the most explicit and often the largest cost associated with holding a fund. We also account for tracking difference between the fund and its benchmark index. In many cases, cost-to-hold, which includes an ETF’s expense ratio, will be the dominant factor in the total cost calculations. Of course, one can’t hold a security without first purchasing it, so we must also account for transaction costs, which we accomplish with our cost-to-trade component. 3. Minimizing Market Impact Market impact, or the change in price caused by an investor buying or selling a fund, is incorporated into Betterment’s total cost number through the cost-to-trade component. This is specifically through the interaction of bid-ask spreads and volume. However, we take additional considerations to control for market impact when evaluating our universe of investable funds. A key factor in Betterment’s decision-making is whether the ETF has relatively high levels of existing assets under management and average daily traded volumes. This helps to ensure that Betterment’s trading activity and holdings will not dominate the security’s natural market efficiency, which could either drive the price of the ETF up or down when trading. We define market impact for any given investment vehicle as the Betterment platform’s relative size (RSRS) in two key areas. Our share of the fund’s assets under managements is calculated quite simply as RS of AUM = ('AUM of Betterment' / 'AUM of ETF') while our share of the fund’s daily traded volume is calculated as RS Vol = ('Vol of Betterment' / 'Vol of ETF') ETFs without an appropriate level of assets or daily trade volume might lead to a situation where Betterment’s activity on behalf of clients moves the existing market for the security. In an attempt to avoid potentially negative effects upon our investors, we generally do not consider ETFs with smaller asset bases and limited trading activity unless some other extenuating factor is present. Conclusion As with any investment, ETFs are subject to market risk, including the possible loss of principal. The value of any portfolio will fluctuate with the value of the underlying securities. ETFs may trade for less than their net asset value (NAV). There is always a risk that an ETF will not meet its stated objective on any given trading day. Betterment reviews its asset selection analysis on a periodic basis to assess: the validity of existing selections, potential changes by fund administrators (raising or lowering expense ratios), and changes in specific ETF market factors (including tighter bid-ask spreads, lower tracking differences, growing asset bases, or reduced selection-driven market impact). Betterment also considers the tax implications of portfolio selection changes and estimates the net benefit of transitioning between investment vehicles for our clients. We use the ETFs that result from this process in our allocation advice that is based on your investment horizon, balance, and goal. For the details on our allocation advice, please see Betterment’s Goal Allocation Recommendation Methodology.

How To Plan Your Taxes When Investing

How To Plan Your Taxes When Investing Oct 31, 2024 7:00:00 AM 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.

Betterment Editors

Betterment Editors

Articles by Betterment Editors