Investors often focus on visible aspects of their portfolios, such as asset allocation and returns. However, the invisible elements, like taxes you avoid through background technology, are equally crucial. At Betterment, we consider every day Tax Day implementing year-round tax optimization strategies that may go unnoticed but make a substantial difference in your long-term returns.
Taxes can gradually erode your investment gains over time. A competent financial advisor should prioritize tax minimization. These invisible wins are challenging to spot in the moment, so let’s bring them to light. Here are four advanced methods we employ to buy, sell, and hold shares with the goal of reducing your tax liability.
Strategic asset placement for tax efficiency
From a tax perspective, you have three primary account types for retirement savings:
- Tax-deferred accounts (e.g., traditional IRAs, 401(k)s), where taxes are paid later
- Tax-exempt accounts (e.g., Roth IRAs, Roth 401(k)s), where taxes are paid now
- Taxable accounts, where taxes are paid both now and later
Due to their distinct tax treatments, certain investments are better suited for specific accounts. For instance, bond interest is typically taxed at a higher rate than stock gains, making taxable accounts less ideal for bonds. This strategic placement of assets based on tax treatments is known as asset location.
Our automated, mathematically precise approach to asset location is called Tax Coordination. When enabled, Tax Coordination ensures that more of your portfolio’s growth is shielded in a Roth account, allowing you to withdraw funds without paying taxes. To learn more about Tax Coordination and its suitability for your needs, review its disclosure.
Intelligent portfolio rebalancing
When your portfolio’s asset class weights drift from their targets, our technology automatically rebalances them. However, there are multiple ways to achieve this. The straightforward method of selling overweight assets and buying underweight ones (known as sell/buy rebalancing) can trigger capital gains and increase your tax burden.
Instead, we leverage available cash flows entering or exiting your portfolio. For example, when you make a withdrawal, we first rebalance the target allocation for cash, then strategically liquidate overweight assets while aiming to minimize your tax impact. This approach allows us to maintain portfolio balance while keeping tax consequences in check.
Selective share selling and donating
There are times when selling an asset is unavoidable, such as when cash flows are insufficient to maintain portfolio balance or when withdrawing funds for a significant purchase. The key question then becomes: which specific assets should be sold?
The IRS and many brokers follow the first in, first out (FIFO) rule, selling your oldest assets first. While this method can help avoid short-term capital gains, it often overlooks opportunities to sell assets at a loss and harvest those losses for potential tax benefits.
Our algorithms take a more refined approach to share selection, known as TaxMin technology. TaxMin is designed to avoid frequent small rebalance transactions and seek tax-efficient outcomes, such as reducing wash sales and minimizing short-term capital gains.
In the case of donating shares, we apply the inverse logic, termed TaxMax. When donating, it is beneficial to choose shares with the most gains, as any replacement shares will have a reset tax basis.
Capitalizing on market downturns
Investments, like life, have their ups and downs. During market downturns, an asset’s price may fall below its purchase price. Our tax-loss harvesting strategy takes advantage of these moments by selling taxable assets that have decreased in value.
We then use available funds to purchase similar investments to replace the sold assets, making adjustments to rebalance your portfolio. The harvested losses can be used to defer taxes you owe now into the future. While this strategy may not suit everyone, it can help some investors gain tax advantages on a portion of their taxable investments. Our fully automated approach makes this tax hack accessible to a broader range of investors.
By implementing these sophisticated strategies, we help you navigate tax laws wisely and boost your long-term returns. The next time you review your returns, consider how much of that growth will remain after taxes. As a Betterment customer, you can be confident that we are diligently working to minimize tax drags, allowing you to focus on living your life while we handle the tax toiling.
