When engaging in a transaction on a Betterment account—whether it involves a withdrawal, transfer, or portfolio rebalancing—Betterment’s advanced technology plays a crucial role. It determines which securities to sell and identifies the specific tax lots to liquidate. This tax-smart technology is essential for minimizing the tax implications of investments.
The selection process for tax lots considers both the cost basis and the duration each lot has been held.
This sophisticated approach aims to address tax inefficiencies while enhancing overall investment performance.
Table of Contents:
The importance of tax lot selection
When withdrawing a specific dollar amount from an investment account, the brokerage converts that amount into shares and proceeds to sell the respective number of shares. If a complete liquidation of the portfolio is not necessary, the choice of which shares to sell is critical. Different brokers have default methods for making this selection, which can significantly affect tax obligations upon sale.
Betterment’s default approach focuses on minimizing tax burdens during share sales. This is particularly relevant due to legislative changes regarding how investment cost basis is reported to the IRS—changes prompted by the 2008 financial crisis. The cost basis reflects the initial amount paid for a security and is a fundamental aspect of a tax lot, created each time a security is purchased.
Understanding cost basis and its implications
For example, if an investor purchases $450 worth of Vanguard Total Stock Market ETF (VTI) at a trading price of $100, this transaction creates a tax lot of 4.5 shares, with a cost basis of $450. The IRS uses this cost basis to calculate realized gains upon selling a security, while the purchase date helps classify the gains as either short-term or long-term.
It is essential for investors to recognize that various methods exist for reporting cost basis. Understanding which method their broker employs can directly influence their taxes. Brokers document the cost basis on Form 1099-B, which Betterment provides electronically each tax season.
FIFO versus TaxMin: A comparison
When holding the same security purchased at different prices over time and opting to sell only a portion of holdings, the tax outcome depends on which specific shares are sold. The default method most brokers employ is FIFO, or “first in, first out,” where the oldest shares are sold first. This approach simplifies the process for brokers, allowing efficient transaction management at year-end for IRS reporting.
While FIFO can yield slightly better results compared to random selections—especially in avoiding short-term gains by selling older shares first—it may not consider whether selling a specific lot will result in a gain or a loss. Often, FIFO may inadvertently favor realizing gains over losses, as older shares are more likely to have appreciated in value.
Fortunately, the IRS permits brokers to implement alternative default methods for selecting shares. Betterment has refined its algorithms to move beyond FIFO to a system known as TaxMin. This method aims to improve tax treatment for securities sales by considering various criteria for selecting specific tax lots.
How TaxMin works in practice
When a sale is initiated within a taxable account, Betterment’s algorithm first identifies which security to sell, aiming to align the portfolio with target allocations. Subsequently, it determines which specific tax lots of that security to sell. For instance, if the algorithm decides that VTI should be sold, and you possess 10 shares acquired at different times with varying cost bases, it evaluates which shares to sell to minimize tax liability.
The selection process for tax lots considers both the cost basis and the duration each lot has been held. This sophisticated approach aims to address tax inefficiencies while enhancing overall investment performance.0
Strategic selling for optimal tax outcomes
The selection process for tax lots considers both the cost basis and the duration each lot has been held. This sophisticated approach aims to address tax inefficiencies while enhancing overall investment performance.1
The selection process for tax lots considers both the cost basis and the duration each lot has been held. This sophisticated approach aims to address tax inefficiencies while enhancing overall investment performance.2
The selection process for tax lots considers both the cost basis and the duration each lot has been held. This sophisticated approach aims to address tax inefficiencies while enhancing overall investment performance.3
