Betterment’s tax loss harvesting methodology

TABLE OF CONTENTS

1. Navigating the “Wash Sale” rule
2. The Betterment resolution
3. Tax loss harvesting mannequin calibration
4. Finest practices for TLH
5. How we calculate the worth of tax loss harvesting
6. Your personalised Estimated Tax Financial savings instrument
7. Conclusion

There are numerous methods to get your investments to work more durable for you— diversification, draw back danger administration, and an acceptable mixture of asset lessons tailor-made to your beneficial allocation. Betterment does this mechanically through its ETF portfolios.

However there’s one other means that will help you get extra out of your portfolio—utilizing funding losses to enhance your after-tax returns with a technique known as tax loss harvesting. On this article, we introduce Betterment’s tax loss harvesting (TLH): a classy, totally automated instrument that Betterment prospects can select to allow.

Betterment’s tax loss harvesting service scans portfolios often for alternatives (short-term dips that consequence from market volatility) for alternatives to understand losses which may be beneficial come tax time. Whereas the idea of tax loss harvesting shouldn’t be new for rich traders, tax loss harvesting makes use of quite a few improvements that typical implementations could lack. It takes a holistic strategy to tax-efficiency, in search of to optimize user-initiated transactions along with including worth via automated exercise, similar to rebalances.

What’s tax loss harvesting?

Capital losses can decrease your tax invoice by offsetting features, however the one option to understand a loss is to promote the depreciated asset. Nonetheless, in a well-allocated portfolio, every asset performs a vital function in offering a bit of complete market publicity. For that cause, an investor shouldn’t need to quit potential anticipated returns related to every asset simply to understand a loss.

At its most simple degree, tax loss harvesting is promoting a safety that has skilled a loss—after which shopping for a correlated asset (i.e. one that gives comparable publicity) to interchange it. The technique has two advantages: it permits the investor to “harvest” a beneficial loss, and it retains the portfolio balanced on the desired allocation.

How can it decrease your tax invoice?

Capital losses can be utilized to offset capital features you’ve realized in different transactions over the course of a yr—features on which you’d in any other case owe tax. Then, if there are losses left over (or if there have been no features to offset), you may offset as much as $3,000 of unusual revenue for the yr. If any losses nonetheless stay, they are often carried ahead indefinitely.

Tax loss harvesting is primarily a tax deferral technique, and its profit relies upon fully on particular person circumstances. Over the long term, it could possibly add worth via some mixture of those distinct advantages that it seeks to supply:

• Tax deferral: Losses harvested can be utilized to offset unavoidable features within the portfolio, or capital features elsewhere (e.g., from promoting actual property), deferring the tax owed. Financial savings which can be invested could develop, assuming a conservative development price of 5% over a 10-year interval, a greenback of tax deferred could be value $1.63. Even after belatedly parting with the greenback, and paying tax on the $0.63 of development, you’re forward.
• Pushing capital features right into a decrease tax price: Should you’ve realized short-term capital features (STCG) this yr, they’ll typically be taxed at your highest price. Nonetheless, in case you’ve harvested losses to offset them, the corresponding achieve you owe sooner or later may very well be long-term capital achieve (LTCG). You’ve successfully turned a achieve that might have been taxed as much as 50% at present right into a achieve that will probably be taxed extra evenly sooner or later (as much as 30%).
• Changing unusual revenue into long-term capital features: A variation on the above: offsetting as much as $3,000 out of your unusual revenue shields that quantity out of your prime marginal price, however the offsetting future achieve will doubtless be taxed on the LTCG price.
• Everlasting tax avoidance in sure circumstances: tax loss harvesting offers advantages now in trade for growing built-in features, topic to tax later. Nonetheless, below sure circumstances (charitable donation, bequest to heirs), these features could keep away from taxation fully.

At a excessive degree, the so-called “Wash Sale” rule disallows a loss from promoting a safety if a “considerably an identical” safety is bought 30 days after or earlier than the sale. The rationale is {that a} taxpayer shouldn’t take pleasure in the advantage of deducting a loss if they didn’t really eliminate the safety.

The wash sale rule applies not simply to conditions when a “considerably an identical” buy is made in the identical account, but additionally when the acquisition is made within the particular person’s IRA/401(ok) account, and even in a partner’s account. This broad software of the wash sale rule seeks to make sure that traders can not make the most of nominally completely different accounts to keep up their possession, and nonetheless profit from the loss.

A wash sale involving an IRA/401(ok) account is especially unfavorable. Usually, a “washed” loss is postponed till the substitute is bought, but when the substitute is bought in an IRA/401(ok) account, the loss is completely disallowed.

If not managed appropriately, wash gross sales can undermine tax loss harvesting. Dealing with proceeds from the harvest shouldn’t be the only concern—any deposits made within the following 30 days (whether or not into the identical account, or into the person’s IRA/401(ok)) additionally have to be allotted with care.

Minimizing the wash

The best option to keep away from triggering a wash sale is to keep away from buying any safety in any respect for the 30 days following the harvest, conserving the proceeds (and any inflows throughout that interval) in money. This strategy, nevertheless, would systematically maintain a portion of the portfolio out of the market. Over the long run, this “money drag” might damage the portfolio’s efficiency.

Extra superior methods repurchase an asset with comparable publicity to the harvested safety that isn’t “considerably an identical” for functions of the wash sale rule. Within the case of a person inventory, it’s clear that repurchasing inventory of that very same firm would violate the rule. Much less clear is the remedy of two index funds from completely different issuers (e.g., Vanguard and Schwab) that monitor the identical index. Whereas the IRS has not issued any steerage to recommend that such two funds are “considerably an identical,” a extra conservative strategy when coping with an index fund portfolio could be to repurchase a fund whose efficiency correlates carefully with that of the harvested fund, however tracks a unique index.

Tax loss harvesting is usually designed round this index-based logic and usually seeks to scale back wash gross sales, though it can not keep away from potential wash gross sales arising from transactions in tickers that monitor the identical index the place one of many tickers shouldn’t be presently a major, secondary, or tertiary ticker (as these phrases are outlined on this white paper). This example might come up, for instance, when different tickers are transferred to Betterment or the place they had been beforehand a major, secondary, or tertiary ticker. Moreover, for some portfolios constructed by third events (e.g., Vanguard, Blackrock, or Goldman Sachs), sure secondary and tertiary tickers monitor the identical index. Sure asset lessons in portfolios constructed by third events (e.g., Vanguard, Blackrock, or Goldman Sachs) should not have tertiary tickers, such that completely disallowed losses might happen if there have been overlapping holdings in taxable and tax-advantaged accounts. Betterment’s TLH function might also allow wash gross sales the place the anticipated tax advantage of the general harvest transaction sufficiently outweighs the impression of anticipated washed losses .

Deciding on a viable substitute safety is only one piece of the accounting and optimization puzzle. Manually implementing a tax loss harvesting technique is possible with a handful of securities, little to no money flows, and rare harvests. Property could nevertheless dip in worth however doubtlessly get better by the top of the yr, subsequently annual methods or rare harvests could depart many losses on the desk. The wash sale administration and tax lot accounting essential to help extra frequent harvesting shortly turns into overwhelming in a multi-asset portfolio—particularly with common deposits, dividends, and rebalancing.

An efficient loss harvesting algorithm ought to be capable to maximize harvesting alternatives throughout a full vary of volatility eventualities, with out sacrificing the investor’s world asset allocation. It ought to reinvest harvest proceeds into correlated alternate property, all whereas dealing with unexpected money inflows from the investor with out ever resorting to money positions. It also needs to be capable to monitor every tax lot individually, harvesting particular person tons at an opportune time, which can rely on the volatility of the asset. Tax loss harvesting was created as a result of no out there implementations appeared to resolve all of those issues.

Present methods and their limitations

Each tax loss harvesting technique shares the identical primary objective: to maximise a portfolio’s after-tax returns by realizing built-in losses whereas minimizing the detrimental impression of wash gross sales.

Approaches to tax loss harvesting differ primarily in how they deal with the proceeds of the harvest to keep away from a wash sale. Beneath are the three methods generally employed by guide and algorithmic implementations.

After promoting a safety that has skilled a loss, current methods would doubtless have you ever:

The hazards of switchbacks

Within the 30 days main as much as the switchback, two issues can occur: the substitute safety can drop additional, or go up. If it goes down, the switchback will understand an extra loss. Nonetheless, if it goes up, which is what any asset with a constructive anticipated return is predicted to do over any given interval, the switchback will understand short-term capital features (STCG)—kryptonite to a tax-efficient portfolio administration technique.

An try to mitigate this danger may very well be setting a better threshold based mostly on volatility of the asset class—solely harvesting when the loss is so deep that the asset is unlikely to thoroughly get better in 30 days. After all, there’s nonetheless no assure that it’s going to not, and the value paid for this buffer is that your lower-yielding harvests may even be much less frequent than they may very well be with a extra refined technique.

Examples of detrimental tax arbitrage

Adverse tax arbitrage with computerized 30-day switchback

An computerized 30-day switchback can destroy the worth of the harvested loss, and even enhance tax owed, relatively than scale back it. A considerable dip presents a wonderful alternative to promote a whole place and harvest a long-term loss. Proceeds will then be re-invested in a extremely correlated substitute (monitoring a unique index). 30 days after the sale, the dip proved short-term and the asset class greater than recovered. The switchback sale ends in STCG in extra of the loss that was harvested, and truly leaves the investor owing tax, whereas with out the harvest, they might have owed nothing.

Attributable to a technical nuance in the way in which features and losses are netted, the 30- day switchback can lead to detrimental tax arbitrage, by successfully pushing current features into a better tax price.

When including up features and losses for the yr, the foundations require netting of like in opposition to like first. If any long-term capital achieve (LTCG) is current for the yr, you should web a long-term capital loss (LTCL) in opposition to that first, and solely then in opposition to any STCG.

Adverse tax arbitrage when unrelated long-term features are current

Now let’s assume the taxpayer realized a LTCG. If no harvest takes place, the investor will owe tax on the achieve on the decrease LTCG price. Nonetheless, in case you add the LTCL harvest and STCG switchback trades, the foundations now require that the harvested LTCL is utilized first in opposition to the unrelated LTCG. The harvested LTCL will get used up fully, exposing your entire STCG from the switchback as taxable. As an alternative of sheltering the extremely taxed achieve on the switchback, the harvested loss received used up sheltering a lower-taxed achieve, creating far higher tax legal responsibility than if no harvest had taken place.

Within the presence of unrelated transactions, unsophisticated harvesting can successfully convert current LTCG into STCG. Some traders often generate important LTCG (as an illustration, by step by step diversifying out of a extremely appreciated place in a single inventory). It’s these traders, in actual fact, who would profit probably the most from efficient tax loss harvesting.

Adverse tax arbitrage with dividends

Adverse tax arbitrage can lead to reference to dividend funds. If sure situations are met, some ETF distributions are handled as “certified dividends”, taxed at decrease charges. One situation is holding the safety for greater than 60 days. If the dividend is paid whereas the place is within the substitute safety, it won’t get this favorable remedy: below a inflexible 30-day switchback, the situation can by no means be met. Consequently, as much as 20% of the dividend is misplaced to tax (the distinction between the upper and decrease price).

• No publicity to short-term capital features in an try to reap losses. Via our proprietary Parallel Place Administration (PPM) system, a dual-security asset class strategy enforces desire for one safety with out needlessly triggering capital features in an try to reap losses, all with out placing constraints on buyer money flows.
• No detrimental tax arbitrage traps related to much less refined harvesting methods (e.g., 30-day switchback), making tax loss harvesting particularly suited to these producing giant long-term capital features on an ongoing foundation.
• Zero money drag. With fractional shares and seamless dealing with of all inflows throughout wash sale home windows, each greenback of your ETF portfolio is invested.
• Tax loss preservation logic prolonged to user-realized losses, not simply harvested losses, mechanically defending each from the wash sale rule. Briefly, consumer withdrawals all the time promote any losses first.
• No disallowed losses via overlap with a Betterment IRA/401(ok). We use a tertiary ticker system to remove the potential for completely disallowed losses triggered by subsequent IRA/401(ok) exercise.² This makes TLH superb for many who spend money on each taxable and tax-advantaged accounts.
• Harvests additionally take the chance to rebalance throughout all asset lessons, relatively than re-invest solely throughout the similar asset class. This additional reduces the necessity to rebalance throughout risky stretches, which implies fewer realized features, and better tax alpha.

Via these improvements, tax loss harvesting creates important worth over manually-serviced or much less refined algorithmic implementations. Tax loss harvesting is accessible to traders —totally automated, efficient, and at no extra value.

Parallel securities

To make sure that every asset class is supported by optimum securities in each major and alternate (secondary) positions, we screened by expense ratio, liquidity (bid-ask unfold), monitoring error vs. benchmark, and most significantly, covariance of the alternate with the first.¹

Whereas there are small value variations between the first and alternate securities, the price of detrimental tax arbitrage from tax-agnostic switching vastly outweighs the price of sustaining a twin place inside an asset class.

Tax loss harvesting encompasses a particular mechanism for coordination with IRAs/401(ok)s that requires us to choose a 3rd (tertiary) safety in every harvestable asset class (besides in municipal bonds, which aren’t within the IRA/401(ok) portfolio). Whereas these have a better value than the first and alternate, they aren’t anticipated to be utilized typically, and even then, for brief durations (extra under in IRA/401(ok) safety).

Parallel place administration

As demonstrated, the unconditional 30-day switchback to the first safety is problematic for quite a few causes. To repair these issues, we engineered a platform to help tax loss harvesting, which seeks to tax-optimize consumer and system-initiated transactions: the Parallel Place Administration (PPM) system.

PPM permits every asset class to comprise a major safety to characterize the specified publicity whereas sustaining alternate and tertiary securities which can be carefully correlated securities, ought to that end in a greater after-tax final result.

PPM offers a number of enhancements over the switchback technique. First, pointless features are minimized. Second, the parallel safety (may very well be major or alternate) serves as a secure harbor to scale back potential wash gross sales—not simply from harvest proceeds, however any money inflows. Third, the mechanism seeks to guard not simply harvested losses, however losses realized by the client as properly.

PPM not solely facilitates efficient alternatives for tax loss harvesting, but additionally extends most tax-efficiency to customer-initiated transactions. Each buyer withdrawal is a possible harvest (losses are bought first). And each buyer deposit and dividend is routed to the parallel place that would scale back wash gross sales, whereas shoring up the goal allocation.

PPM has a desire for the first safety when rebalancing and for all money movement occasions—however all the time topic to tax concerns. That is how PPM behaves below numerous situations:

Wash sale administration

Managing money flows throughout each taxable and IRA/401(ok) accounts with out washing realized losses is a posh downside.

Tax loss harvesting operates with out constraining the way in which that prospects favor contributing to their portfolios, and with out resorting to money positions. With the advantage of parallel positions, Betterment weighs wash sale implications of deposits,withdrawals and dividend reinvestment This method protects not simply harvested losses, but additionally losses realized via withdrawals.

Minimizing wash sale via tertiary tickers in IRA/401(ok)

As a result of IRA/401(ok) wash gross sales are significantly unfavorable—the loss is disallowed completely—tax loss harvesting ensures that no loss realized within the taxable account is washed by a subsequent deposit right into a Betterment IRA/401(ok) with a tertiary ticker system in IRA/401(Okay) and no harvesting is finished in IRA/401(ok).

Let’s take a look at an instance of how tax loss harvesting handles a doubtlessly disruptive IRA influx with a tertiary ticker when there are realized losses to guard, utilizing actual market knowledge for a Developed Markets asset class.

The client begins with a place in VEA, the first safety, in each the taxable and IRA accounts. We harvest a loss by promoting your entire taxable place, after which repurchasing the alternate safety, SCHF.

Loss harvested in VEA

Two weeks go, and the client makes a withdrawal from the taxable account (your entire SCHF place, for simplicity), aspiring to fund the IRA. In these two weeks, the asset class dropped extra, so the sale of SCHF additionally realized a loss. The VEA place within the IRA stays unchanged.

Buyer withdrawal sells SCHF at a loss

Just a few days later, the client contributes to his IRA, and $1,000 is allotted to the Developed Markets asset class, which already comprises some VEA. Even supposing the client not holds any VEA or SCHF in his taxable account, shopping for both one within the IRA would completely wash a beneficial realized loss. The Tertiary Ticker System mechanically allocates the influx into the third possibility for developed markets, IEFA.

IRA deposit into tertiary Ticker

Each losses have been preserved, and the client now holds VEA and IEFA in his IRA, sustaining desired allocation always. As a result of no capital features are realized in an IRA/401(ok), there isn’t any hurt in switching out of the IEFA place and consolidating your entire asset class in VEA when there isn’t any hazard of a wash sale.

The consequence: Prospects utilizing TLH who even have their IRA/401(ok) property with Betterment can know that Betterment will search to guard beneficial realized losses at any time when they deposit into their IRA/401(ok), whether or not it’s lump rollover, auto-deposits and even dividend reinvestments.

Good rebalancing

Lastly, tax loss harvesting directs the proceeds of each harvest to rebalance your entire portfolio, the identical means {that a} Betterment account handles any incoming money movement (deposit, dividend). A lot of the money is predicted to remain in that asset class and be reinvested into the parallel asset, however a few of it might not. Recognizing each harvest as a rebalancing alternative additional reduces the necessity for added promoting in instances of volatility, additional lowering tax legal responsibility. As all the time, fractional shares permit the inflows to be allotted with precision.

There are two common approaches to testing a mannequin’s efficiency: historic backtesting and forward-looking simulation. Optimizing a system to ship the very best outcomes for under previous historic durations is comparatively trivial, however doing so could be a basic occasion of knowledge snooping bias. Relying solely on a historic backtest of a portfolio composed of ETFs that permit for 10 to twenty years of dependable knowledge when designing a system meant to supply 40 to 50 years of profit would imply making quite a few indefensible assumptions about common market conduct.

The superset of choice variables driving tax loss harvesting is past the scope of this paper—optimizing round these variables required exhaustive evaluation. Tax loss harvesting was calibrated through Betterment’s rigorous Monte Carlo simulation framework, spinning up hundreds of server situations within the cloud to run via tens of hundreds of forward-looking eventualities testing mannequin efficiency. We’ve calibrated tax loss harvesting in a means that we imagine optimizes its effectiveness given anticipated future returns and volatility, however different optimizations might end in extra frequent harvests or higher outcomes relying on precise market situations.

Particularly, we don’t advise you to make use of tax loss harvesting in case you can presently understand capital features at a 0% tax price. Below 2025 tax brackets, this can be the case in case your taxable revenue is under $48,350 as a single filer or $96,700 in case you are married submitting collectively. See the IRS web site for extra particulars.

Graduate college students, these taking parental depart, or simply beginning out of their careers ought to ask “What tax price am I offsetting at present” versus “What price can I moderately anticipate to pay sooner or later?”

The Scattered Portfolio: Tax loss harvesting is rigorously calibrated to handle wash gross sales throughout all property managed by Betterment, together with IRA property. Nonetheless, the algorithms can not take note of info that isn’t out there. To the extent {that a} Betterment buyer’s holdings (or a partner’s holdings) in one other account overlap with the Betterment portfolio, there may be no assure that tax loss harvesting exercise won’t battle with gross sales and purchases in these different accounts (together with dividend reinvestments), and end in unexpected wash gross sales that reverse some or all the advantages of tax loss harvesting. We don’t suggest tax loss harvesting to a buyer who holds (or whose partner holds) any of the ETFs within the Betterment portfolio in non-Betterment accounts. You possibly can ask Betterment to coordinate tax loss harvesting together with your partner’s account at Betterment. You’ll be requested to your partner’s account info after you allow tax loss harvesting in order that we may help optimize your investments throughout your accounts.

The Portfolio Technique Collector: Electing completely different portfolio methods for a number of Betterment objectives could trigger tax loss harvesting to establish fewer alternatives to reap losses than it would in case you elect the identical portfolio technique for your whole Betterment objectives.

The Speedy Liquidator: What occurs if all the extra features as a consequence of harvesting are realized over the course of a single yr? In a full liquidation of a long-standing portfolio, the extra features as a consequence of harvesting might push the taxpayer into a better LTCG bracket, doubtlessly reversing the advantage of tax loss harvesting. For individuals who anticipate to attract down with extra flexibility, good automation will probably be there to assist optimize the tax penalties.

The Imminent Withdrawal: The harvesting of tax losses resets the one-year holding interval that’s used to differentiate between LTCG and STCG. For many traders, this isn’t a problem: by the point that they promote the impacted investments, the one-year holding interval has elapsed and so they pay taxes on the decrease LTCG price. That is significantly true for Betterment prospects as a result of our TaxMin function mechanically realizes LTCG forward of STCG in response to a withdrawal request. Nonetheless, in case you are planning to withdraw a big portion of your taxable property within the subsequent 12 months, you must wait to activate tax loss harvesting till after the withdrawal is full to scale back the potential for realizing STCG.

Different impacts to contemplate

Buyers with property held in numerous portfolio methods ought to perceive the way it impacts the operation of tax loss harvesting. To study extra, please see Betterment’s SRI disclosures, Versatile portfolio disclosures, the Goldman Sachs good beta disclosures, and the BlackRock goal revenue portfolio disclosures for additional element. Shoppers in Advisor-designed customized portfolios via Betterment for Advisors ought to seek the advice of their Advisors to know the constraints of tax loss harvesting with respect to any customized portfolio. Moreover, as described above, electing one portfolio technique for a number of objectives in your account whereas concurrently electing a unique portfolio for different objectives in your account could scale back alternatives for TLH to reap losses, as TLH is calibrated to hunt to scale back wash gross sales.

Attributable to Betterment’s month-to-month cadence for billing charges for advisory providers, via the liquidation of securities, tax loss harvesting alternatives could also be adversely affected for purchasers with significantly excessive inventory allocations, third social gathering portfolios, or versatile portfolios. On account of assessing charges on a month-to-month cadence for a buyer with solely fairness safety publicity, which tends to be extra opportunistic for tax loss harvesting, sure securities could also be bought that would have been used to tax loss harvest at a later date, thereby delaying the harvesting alternative into the long run. This delay could be as a result of TLH instrument’s effort to scale back situations of triggering the wash sale rule, which forbids a safety from being bought solely to get replaced with a “considerably comparable” safety inside a 30-day interval.

Components which can decide the precise advantage of tax loss harvesting embody, however will not be restricted to, market efficiency, the scale of the portfolio, the inventory publicity of the portfolio, the frequency and dimension of deposits into the portfolio, the supply of capital features and revenue which may be offset by losses harvested, the tax charges relevant to the investor in a given tax yr and in future years, the extent to which related property within the portfolio are donated to charity or bequeathed to heirs, and the time elapsed earlier than liquidation of any property that aren’t disposed of on this method.

All of Betterment’s buying and selling selections are discretionary and Betterment could resolve to restrict or postpone TLH buying and selling on any given day or on consecutive days, both with respect to a single account or throughout a number of accounts.

Tax loss harvesting shouldn’t be appropriate for all traders. Nothing herein ought to be interpreted as tax recommendation, and Betterment doesn’t characterize in any method that the tax penalties described herein will probably be obtained, or that any Betterment product will end in any specific tax consequence. Please seek the advice of your private tax advisor as as to whether TLH is an appropriate technique for you, given your specific circumstances. The tax penalties of tax loss harvesting are complicated and unsure and could also be challenged by the IRS. You and your tax advisor are liable for how transactions carried out in your account are reported to the IRS in your private tax return. Betterment assumes no duty for the tax penalties to any consumer of any transaction.

See Betterment’s tax loss harvesting disclosures for additional element.

Then, we pulled the full charges charged to the customers on the account in query that had been accrued in 2022 and 2023 from our charge accrual information and in contrast that to the tax invoice discount. If the tax invoice discount was higher than the charges, we thought-about tax loss harvesting to have not directly paid for the charges within the account in query for the taxpayer in query. This was the case for 69% of consumers.2