Maximizing Returns: A Guide to Betterment's Tax-Efficient Lot Selection Process

When engaging in transactions within a Betterment account, such as making withdrawals or rebalancing a portfolio, the platform utilizes advanced algorithms. These algorithms determine which securities to sell and the specific tax lots involved. This innovative tax-smart technology efficiently manages tax implications, thereby minimizing the overall tax burden on investments.

The concept of selecting tax lots efficiently plays a crucial role in this process. It involves analyzing the cost basis and the duration for which each security has been held. When a withdrawal occurs, the broker converts that figure into shares and decides which shares to liquidate. Each broker has a default method for making this decision, which can significantly influence the taxation of the sale.

Table of Contents:

Understanding cost basis and tax lots

Every time a security is purchased, a new tax lot is created, containing essential details such as the purchase price and date. The cost basis is the amount paid for that security, critical for determining taxable gains or losses upon sale. For example, purchasing $450 worth of Vanguard Total Stock Market ETF (VTI) at $100 each results in a tax lot of 4.5 shares with a cost basis of $450.

The way this cost basis is reported to the IRS has evolved, particularly following the financial crisis of 2008. Understanding how brokers report cost basis is essential, as this can directly impact tax responsibilities. Betterment provides this information electronically through Form 1099-B during tax season, ensuring customers have easy access to their tax-related data.

The implications of FIFO

When selling securities, most brokers default to the FIFO (first in, first out) method, meaning the oldest shares are sold first. While this method simplifies transaction management for brokers, it may not always be the most tax-efficient option. Although FIFO can help avoid short-term capital gains taxes, it does not account for whether selling a specific lot results in a gain or loss.

FIFO often favors gains over losses, as older shares are more likely to have appreciated in value compared to more recent purchases affected by market fluctuations. This approach may lead to a higher tax burden than necessary.

Betterment’s innovative TaxMin approach

To enhance tax efficiency in transactions, Betterment has developed the TaxMin method. This method selects specific shares based on predetermined rules rather than relying solely on FIFO. The updated algorithm prioritizes tax efficiency by minimizing the tax impact of sales for most investors.

When initiating a transaction, Betterment’s algorithm first determines the appropriate security to sell, ensuring the portfolio aligns with its target allocation. Once a security is identified, the algorithm evaluates which tax lots should be sold. For instance, if a client holds multiple shares of VTI purchased at different times, the system assesses which shares can be sold to minimize tax liabilities.

How TaxMin optimizes tax outcomes

The TaxMin algorithm is structured to realize taxable losses before gains, taking into account the cost basis of each lot. It aims to sell shares that have depreciated first, maximizing potential losses that can offset gains. If losses are not available, the system evaluates which securities can be sold with the lowest capital gains.

If a security has both short-term and long-term capital gains, Betterment’s system typically prioritizes realizing long-term gains first, followed by short-term gains. This strategic approach aims to minimize the overall tax implications of investment transactions.