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. Greatest practices for TLH
5. How we calculate the worth of tax loss harvesting
6. Your customized Estimated Tax Financial savings instrument
7. Conclusion

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

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

Betterment’s tax loss harvesting service scans portfolios repeatedly for alternatives (non permanent dips that outcome from market volatility) for alternatives to understand losses which might be priceless come tax time. Whereas the idea of tax loss harvesting just isn’t new for rich traders, tax loss harvesting makes use of a variety of improvements that typical implementations could lack. It takes a holistic method to tax-efficiency, looking for to optimize user-initiated transactions along with including worth by way of automated exercise, akin to rebalances.

What’s tax loss harvesting?

Capital losses can decrease your tax invoice by offsetting positive aspects, however the one strategy to understand a loss is to promote the depreciated asset. Nevertheless, in a well-allocated portfolio, every asset performs an important position in offering a chunk of whole market publicity. For that cause, an investor shouldn’t need to surrender potential anticipated returns related to every asset simply to understand a loss.

At its most elementary stage, tax loss harvesting is promoting a safety that has skilled a loss—after which shopping for a correlated asset (i.e. one that gives related publicity) to exchange it. The technique has two advantages: it permits the investor to “harvest” a priceless 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 positive aspects you’ve realized in different transactions over the course of a yr—positive aspects on which you’d in any other case owe tax. Then, if there are losses left over (or if there have been no positive aspects to offset), you’ll be able to offset as much as $3,000 of unusual earnings 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 add worth by way of some mixture of those distinct advantages that it seeks to supply:

• Tax deferral: Losses harvested can be utilized to offset unavoidable positive aspects within the portfolio, or capital positive aspects elsewhere (e.g., from promoting actual property), deferring the tax owed. Financial savings which are invested could develop, assuming a conservative development charge of 5% over a 10-year interval, a greenback of tax deferred can 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 positive aspects right into a decrease tax charge: If you happen to’ve realized short-term capital positive aspects (STCG) this yr, they’ll usually be taxed at your highest charge. Nevertheless, when you’ve harvested losses to offset them, the corresponding achieve you owe sooner or later might be long-term capital achieve (LTCG). You’ve successfully turned a achieve that will have been taxed as much as 50% right now right into a achieve that will probably be taxed extra flippantly sooner or later (as much as 30%).
• Changing unusual earnings into long-term capital positive aspects: A variation on the above: offsetting as much as $3,000 out of your unusual earnings shields that quantity out of your prime marginal charge, however the offsetting future achieve will seemingly be taxed on the LTCG charge.
• Everlasting tax avoidance in sure circumstances: tax loss harvesting gives advantages now in trade for rising built-in positive aspects, topic to tax later. Nevertheless, beneath sure circumstances (charitable donation, bequest to heirs), these positive aspects could keep away from taxation fully.

At a excessive stage, the so-called “Wash Sale” rule disallows a loss from promoting a safety if a “considerably similar” safety is bought 30 days after or earlier than the sale. The rationale is {that a} taxpayer shouldn’t get pleasure from the good thing about deducting a loss if they didn’t really eliminate the safety.

The wash sale rule applies not simply to conditions when a “considerably similar” buy is made in the identical account, but in addition when the acquisition is made within the particular person’s IRA/401(ok) account, and even in a partner’s account. This broad utility of the wash sale rule seeks to make sure that traders can not make the most of nominally totally 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 accurately, wash gross sales can undermine tax loss harvesting. Dealing with proceeds from the harvest just isn’t the only real 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 strategy 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 method, nonetheless, would systematically hold a portion of the portfolio out of the market. Over the long run, this “money drag” might harm the portfolio’s efficiency.

Extra superior methods repurchase an asset with related publicity to the harvested safety that isn’t “considerably similar” 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 therapy of two index funds from totally different issuers (e.g., Vanguard and Schwab) that monitor the identical index. Whereas the IRS has not issued any steering to recommend that such two funds are “considerably similar,” a extra conservative method when coping with an index fund portfolio can be to repurchase a fund whose efficiency correlates carefully with that of the harvested fund, however tracks a distinct index.

Tax loss harvesting is mostly designed round this index-based logic and customarily seeks to cut 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 just isn’t at the moment a main, 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 have been beforehand a main, 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) wouldn’t 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 characteristic may additionally allow wash gross sales the place the anticipated tax advantage of the general harvest transaction sufficiently outweighs the affect 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. Belongings could nonetheless dip in worth however probably recuperate by the top of the yr, subsequently annual methods or rare harvests could go away many losses on the desk. The wash sale administration and tax lot accounting essential to assist extra frequent harvesting rapidly turns into overwhelming in a multi-asset portfolio—particularly with common deposits, dividends, and rebalancing.

An efficient loss harvesting algorithm ought to have the ability 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 have the ability 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 obtainable implementations appeared to unravel all of those issues.

Current 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 unfavourable affect 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. Under are the three methods generally employed by guide and algorithmic implementations.

After promoting a safety that has skilled a loss, current methods would seemingly 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 a further loss. Nevertheless, if it goes up, which is what any asset with a constructive anticipated return is anticipated to do over any given interval, the switchback will understand short-term capital positive aspects (STCG)—kryptonite to a tax-efficient portfolio administration technique.

An try and mitigate this threat might be setting the next threshold based mostly on volatility of the asset class—solely harvesting when the loss is so deep that the asset is unlikely to completely recuperate in 30 days. In fact, there’s nonetheless no assure that it’s going to not, and the worth paid for this buffer is that your lower-yielding harvests can even be much less frequent than they might be with a extra refined technique.

Examples of unfavourable tax arbitrage

Detrimental tax arbitrage with automated 30-day switchback

An automated 30-day switchback can destroy the worth of the harvested loss, and even improve tax owed, somewhat than cut 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 distinct index). 30 days after the sale, the dip proved non permanent and the asset class greater than recovered. The switchback sale leads to STCG in extra of the loss that was harvested, and really 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 positive aspects and losses are netted, the 30- day switchback can lead to unfavourable tax arbitrage, by successfully pushing current positive aspects into the next tax charge.

When including up positive aspects and losses for the yr, the principles require netting of like towards like first. If any long-term capital achieve (LTCG) is current for the yr, it’s essential to web a long-term capital loss (LTCL) towards that first, and solely then towards any STCG.

Detrimental tax arbitrage when unrelated long-term positive aspects 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 charge. Nevertheless, when you add the LTCL harvest and STCG switchback trades, the principles now require that the harvested LTCL is utilized first towards the unrelated LTCG. The harvested LTCL will get used up fully, exposing the complete STCG from the switchback as taxable. As an alternative of sheltering the extremely taxed achieve on the switchback, the harvested loss obtained used up sheltering a lower-taxed achieve, creating far larger 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 repeatedly generate vital LTCG (as an example, by steadily diversifying out of a extremely appreciated place in a single inventory). It’s these traders, actually, who would profit probably the most from efficient tax loss harvesting.

Detrimental tax arbitrage with dividends

Detrimental tax arbitrage can lead to reference to dividend funds. If sure circumstances 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 is not going to get this favorable therapy: beneath a inflexible 30-day switchback, the situation can by no means be met. Because of this, as much as 20% of the dividend is misplaced to tax (the distinction between the upper and decrease charge).

• No publicity to short-term capital positive aspects in an try to reap losses. By our proprietary Parallel Place Administration (PPM) system, a dual-security asset class method enforces choice for one safety with out needlessly triggering capital positive aspects in an try to reap losses, all with out placing constraints on buyer money flows.
• No unfavourable tax arbitrage traps related to much less refined harvesting methods (e.g., 30-day switchback), making tax loss harvesting particularly fitted to these producing massive long-term capital positive aspects 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, robotically defending each from the wash sale rule. In brief, person withdrawals all the time promote any losses first.
• No disallowed losses by way of overlap with a Betterment IRA/401(ok). We use a tertiary ticker system to eradicate the potential for completely disallowed losses triggered by subsequent IRA/401(ok) exercise.² This makes TLH best for individuals who spend money on each taxable and tax-advantaged accounts.
• Harvests additionally take the chance to rebalance throughout all asset lessons, somewhat than re-invest solely throughout the identical asset class. This additional reduces the necessity to rebalance throughout unstable stretches, which suggests fewer realized positive aspects, and better tax alpha.

By these improvements, tax loss harvesting creates vital worth over manually-serviced or much less refined algorithmic implementations. Tax loss harvesting is accessible to traders —absolutely automated, efficient, and at no further value.

Parallel securities

To make sure that every asset class is supported by optimum securities in each main 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 unfavourable tax arbitrage from tax-agnostic switching vastly outweighs the price of sustaining a twin place inside an asset class.

Tax loss harvesting contains a particular mechanism for coordination with IRAs/401(ok)s that requires us to select 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 the next value than the first and alternate, they don’t seem to be anticipated to be utilized usually, and even then, for brief durations (extra beneath in IRA/401(ok) safety).

Parallel place administration

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

PPM permits every asset class to comprise a main safety to signify the specified publicity whereas sustaining alternate and tertiary securities which are carefully correlated securities, ought to that lead to a greater after-tax consequence.

PPM gives a number of enhancements over the switchback technique. First, pointless positive aspects are minimized. Second, the parallel safety (might be main or alternate) serves as a protected harbor to cut 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 shopper as effectively.

PPM not solely facilitates efficient alternatives for tax loss harvesting, but in addition 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 cut back wash gross sales, whereas shoring up the goal allocation.

PPM has a choice for the first safety when rebalancing and for all money circulate occasions—however all the time topic to tax issues. That is how PPM behaves beneath varied circumstances:

Wash sale administration

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

Tax loss harvesting operates with out constraining the way in which that clients desire contributing to their portfolios, and with out resorting to money positions. With the good thing about parallel positions, Betterment weighs wash sale implications of deposits,withdrawals and dividend reinvestment This technique protects not simply harvested losses, but in addition losses realized by way of withdrawals.

Minimizing wash sale by way of 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(Ok) and no harvesting is finished in IRA/401(ok).

Let’s take a look at an instance of how tax loss harvesting handles a probably disruptive IRA influx with a tertiary ticker when there are realized losses to guard, utilizing actual market information 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 the complete taxable place, after which repurchasing the alternate safety, SCHF.

Loss harvested in VEA

Two weeks cross, and the shopper makes a withdrawal from the taxable account (the complete SCHF place, for simplicity), desiring 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

A number of days later, the shopper contributes to his IRA, and $1,000 is allotted to the Developed Markets asset class, which already incorporates some VEA. Even supposing the shopper now not holds any VEA or SCHF in his taxable account, shopping for both one within the IRA would completely wash a priceless realized loss. The Tertiary Ticker System robotically allocates the influx into the third choice for developed markets, IEFA.

IRA deposit into tertiary Ticker

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

The outcome: Clients utilizing TLH who even have their IRA/401(ok) property with Betterment can know that Betterment will search to guard priceless realized losses every time 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 the complete portfolio, the identical approach {that a} Betterment account handles any incoming money circulate (deposit, dividend). Many of the money is anticipated to remain in that asset class and be reinvested into the parallel asset, however a few of it could not. Recognizing each harvest as a rebalancing alternative additional reduces the necessity for extra promoting in occasions of volatility, additional lowering tax legal responsibility. As all the time, fractional shares enable 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 most effective outcomes for less than previous historic durations is comparatively trivial, however doing so can be a traditional occasion of information snooping bias. Relying solely on a historic backtest of a portfolio composed of ETFs that enable for 10 to twenty years of dependable information when designing a system meant to supply 40 to 50 years of profit would imply making a variety of indefensible assumptions about common market conduct.

The superset of resolution 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 1000’s of server situations within the cloud to run by way of tens of 1000’s of forward-looking eventualities testing mannequin efficiency. We’ve calibrated tax loss harvesting in a approach that we imagine optimizes its effectiveness given anticipated future returns and volatility, however different optimizations might lead to extra frequent harvests or higher outcomes relying on precise market circumstances.

Specifically, we don’t advise you to make use of tax loss harvesting when you can at the moment understand capital positive aspects at a 0% tax charge. Below 2025 tax brackets, this can be the case in case your taxable earnings is beneath $48,350 as a single filer or $96,700 if you’re married submitting collectively. See the IRS web site for extra particulars.

Graduate college students, these taking parental go away, or simply beginning out of their careers ought to ask “What tax charge am I offsetting right now” versus “What charge can I moderately count on 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. Nevertheless, the algorithms can not take note of info that isn’t obtainable. To the extent {that a} Betterment buyer’s holdings (or a partner’s holdings) in one other account overlap with the Betterment portfolio, there might be no assure that tax loss harvesting exercise is not going to battle with gross sales and purchases in these different accounts (together with dividend reinvestments), and lead to unexpected wash gross sales that reverse some or all the advantages of tax loss harvesting. We don’t advocate 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’ll be able to ask Betterment to coordinate tax loss harvesting along 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 will help optimize your investments throughout your accounts.

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

The Fast Liquidator: What occurs if all the further positive aspects attributable to harvesting are realized over the course of a single yr? In a full liquidation of a long-standing portfolio, the extra positive aspects attributable to harvesting might push the taxpayer into the next LTCG bracket, probably reversing the good thing about tax loss harvesting. For individuals who count on to attract down with extra flexibility, sensible 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 difficulty: 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 charge. That is significantly true for Betterment clients as a result of our TaxMin characteristic robotically realizes LTCG forward of STCG in response to a withdrawal request. Nevertheless, if you’re planning to withdraw a big portion of your taxable property within the subsequent 12 months, it is best to wait to activate tax loss harvesting till after the withdrawal is full to cut back the potential for realizing STCG.

Different impacts to think about

Traders with property held in numerous portfolio methods ought to perceive the way it impacts the operation of tax loss harvesting. To be taught extra, please see Betterment’s SRI disclosures, Versatile portfolio disclosures, the Goldman Sachs sensible beta disclosures, and the BlackRock goal earnings portfolio disclosures for additional element. Shoppers in Advisor-designed customized portfolios by way of Betterment for Advisors ought to seek the advice of their Advisors to know the restrictions 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 distinct portfolio for different objectives in your account could cut back alternatives for TLH to reap losses, as TLH is calibrated to hunt to cut back wash gross sales.

Attributable to Betterment’s month-to-month cadence for billing charges for advisory providers, by way of the liquidation of securities, tax loss harvesting alternatives could also be adversely affected for purchasers with significantly excessive inventory allocations, third occasion portfolios, or versatile portfolios. Because 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 can be as a result of TLH instrument’s effort to cut back situations of triggering the wash sale rule, which forbids a safety from being bought solely to get replaced with a “considerably related” safety inside a 30-day interval.

Elements 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 measurement of deposits into the portfolio, the supply of capital positive aspects and earnings which might 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 determine 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 just isn’t appropriate for all traders. Nothing herein must be interpreted as tax recommendation, and Betterment doesn’t signify in any method that the tax penalties described herein will probably be obtained, or that any Betterment product will lead to any specific tax consequence. Please seek the advice of your private tax advisor as as to if TLH is an acceptable technique for you, given your specific circumstances. The tax penalties of tax loss harvesting are advanced and unsure and could also be challenged by the IRS. You and your tax advisor are answerable for how transactions performed 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 entire charges charged to the customers on the account in query that have been accrued in 2022 and 2023 from our payment accrual information and in contrast that to the tax invoice discount. If the tax invoice discount was larger 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