What if you could increase your after-tax investment returns by 15% over 30 years? Betterment is claiming you can do just that with their Tax-Coordinated Portfolio. What’s more, they claim that it can even work across several accounts at the same time.
Interested? Read on…
Who is Betterment?
Betterment is a robo-advisor. In fact, it is the largest independent robo-advisor in the US, with more than 175,000 customers and more than $5 billion in assets under management.
As a robo-advisor, Betterment is an automated, technology-driven investment platform that creates and maintains a diverse portfolio for each of its investors. They do this by compiling what they believe will be the best mix of exchange traded funds (ETFs) in your portfolio. They use index based ETFs because they are both low cost and tax efficient (their low turnover minimizes the amount of short-term capital gains generated).
Your entire portfolio is constructed of just 13 different ETFs — six stock ETFs and seven bond ETFs — which essentially represent the global financial markets as a whole.
Betterment’s investment management method is based on Modern Portfolio Theory, or MPT. The theory holds that proper asset allocation is more important in portfolio management than individual security selection. This is also why Betterment uses broad based index funds in creating your asset allocation. The right asset mix will provide both a maximum rate of return while keeping risk to a minimum.
Your portfolio is constructed only after Betterment determines your investment horizon, goals, and risk tolerance. This will enable them to include the appropriate blend of both stocks and bonds to fit your investment profile.
Once your portfolio is established, it is fully automated – including regular rebalancing – so that you don’t need to get involved in the process at all. Your sole responsibility is to fund your account to help it grow.
Betterment offers both taxable and tax-sheltered (retirement) accounts, so that you can do all of your investing on the platform.
Best of all are the very low fees that they charge. They are just a fraction of what typical traditional investment advisors charge to perform essentially the same service.
The fee is based on a percentage of the amount of money that you have invested on the platform. It is a single, annual fee, as there are no separate charges for transactions or rebalancing. There are three fee tier levels, based on account balance:
- Less than $10,000: 0.35% of your average annual balance. There is no minimum initial account balance required. However, you must commit to a $100/month minimum automatic deposit. You will be charged a flat rate of $3 per month otherwise.
- $10,000 to $99,999: 0.25% of your average annual balance.
- $100,000 or more: 0.15% of your average annual balance.
What is the Tax-Coordinated Portfolio?
Betterment’s Tax-Coordinated Portfolio, or “TCP,” is based on the use of an automated strategy referred to as asset location. Within that strategy, they manage multiple accounts as a single portfolio. That includes placing assets that are taxed at higher rates into more favorably taxed accounts, like those for retirement. Betterment’s research has estimated that TCP can produce an average annual benefit of between 0.10% to 0.82%.
Using one generalized scenario, TCP boosted after-tax returns by 0.48% per year. After 30 years, this provided an additional 15% for retirement. That’s an impressive benefit, considering you don’t need to do anything extra in order to utilize its advantages.
Betterment came up with TCP through their team of quantitative analysts, tax experts, software engineers, designers, and product managers, who spent more than a year building the service. They believe that they are the first investment service to offer such a product, and are now making it available to all investors on the platform.
How Betterment’s Tax-Coordinated Portfolio Works
The Tax-Coordinated Portfolio places high tax assets in tax sheltered accounts, such as IRAs. Lower taxed assets are then held in taxable accounts.
That means that high dividend yielding stocks would be held in an IRA to reduce what is called tax drag.Tax drag refers to the reduction in return on investment that comes from the tax liability generated by an investment.
In order to take advantage of TCP you need to have both a taxable account and either a tax-deferred account, like an IRA, or a tax-exempt account, such as a Roth IRA. The benefit will not extend to any non-Betterment accounts.
This means that if you want to take advantage of TCP, you will have to roll outside accounts into your Betterment account. That includes your taxable and tax-deferred investment accounts. Part of the reason that TCP requires at least one retirement account is that Betterment can make larger rebalances in such accounts without increasing your tax liability.
You will still have the ability to change your allocation in your TCP, right on the investment platform. However, any time you do, you run the risk of causing “taxable events,” so Betterment recommends against this. If you do make changes, you can use Betterment’s Tax Impact Preview feature (see below), which will show you a real-time tax estimate before you confirm any allocation changes.
TCP is available to all Betterment investors. However, it is generally not recommended for those whose federal tax bracket is 15% or less. You should also be aware that TCP does not have any impact on any investment accounts that you hold outside of Betterment.
Betterment Tax-Coordinated Portfolio Components and Tools
TCP is comprised of three major components, including:
Tax Impact Preview – This tool provides a real-time tax estimate for a withdrawal or allocation change, and you can use it before you confirm the transaction. It will show you the information you should be focusing on to make an informed decision, before you actually make the changes. It has the potential to lower your tax bill as a result.
Tax Impact Preview will consider if the benefits of the change will outweigh the costs, or if you might consider waiting in order to avoid short-term capital gains. It may also ask you to consider if there is another source of funds you can access that will not have any impact on your tax liability.
TaxMin – This tool will help you select the most tax-efficient lots, selling losses first, and short-term gains last. TaxMin considers the cost basis of the lot, realizing all losses for any gains, regardless of when the shares were purchased.
Lots are sold in the following order, so as to minimize the tax impact:
- Short-term losses
- Long-term losses
- Long-term gains
- Short-term gains
The algorithm exhausts each category before moving to the next. Within each category, lots with the highest cost basis are sold first. With a gain, the rule is as follows: the higher the basis, the smaller the gain. This results in a lower tax burden. In the case of a loss, the opposite is true: the higher the basis, the bigger the loss. This can, of course, offset gains.
Tax Loss Harvesting (TLH) – This service is available on taxable investment accounts only, since tax-sheltered accounts don’t need it. According to Betterment’s Tax Loss Harvesting White Paper, Betterment’s TLH service generates as much as 1.94% in annual tax offsets. This compares to 0.95% by other automated investment services.
In general, tax loss harvesting involves selling securities that have sustained losses, then buying correlated assets – those that provide similar exposure – to replace the securities that have been sold. The strategy generates capital gains losses, but keeps the portfolio consistent with its intended target allocation mix.
Should You Invest With Betterment Tax-Coordinated Portfolio?
What can you say about a service that has the potential to improve your investment performance by an average of almost 0.50% (OK, 0.48%) per year? Oh, and it charges no extra fee for the benefit.
With the growing popularity of robo-advisors, and Betterment being the largest in the field, TCP makes the case for using this platform more compelling than ever. This is one of those rare situations in your investment life where you will have nothing to lose, but much to gain.
Betterment offers a compelling combination of automated professional investment management, along with TCP. It also has one of the lowest fee structures in the industry. And you can invest on the platform with both your taxable accounts and your retirement accounts.
You owe it to yourself to check Betterment out.
Updated October 24, 2016 and originally published October 17, 2016.