Betterment offers a variety of processes to limit the tax impact of your investments, depending on your situation. Let's demystify these powerful strategies.
We understand that the mix of account types can make it difficult to decide which account to deposit or withdraw money from at any given time.
Let's understand more about the following.
- What accounts are available and why you should choose them
- Advantages of receiving dividends
- Betterment's powerful tax-friendly features
How are various investment accounts taxed?
taxable account
Taxable investment accounts are usually the easiest to set up and have the least restrictions.
You can easily donate and withdraw your account at any time, but there are trade-offs. Taxable accounts are funded with after-tax dollars, and capital gains from the sale of assets and dividends received are taxed annually.
Although there is no income deferral like in a retirement plan, there are special tax benefits available only in taxable accounts, such as reduced tax rates on long-term gains, qualified dividends, and municipal bond income.
Key considerations
- You want the option to withdraw at any time without IRS penalties.
- You've already contributed the maximum amount to all your tax-advantaged retirement accounts.
Traditional account
Traditional accounts include traditional IRAs, traditional 401(k)s, traditional 403(b)s, traditional 457 government plans, and traditional thrift savings plans (TSPs).
Traditional investment accounts for retirement are typically funded with pre-tax dollars. Investment income received is deferred until the time of distribution from the plan. Assuming all contributions are funded with pre-tax dollars, distributions are fully taxed as ordinary income. Investors under age 59.5 may be subject to an additional 10% early withdrawal penalty unless an exemption applies.
Key considerations
- You expect your tax rate to be lower in retirement than it is now.
- You acknowledge and accept the possibility of early withdrawal penalties.
loss account
This includes the Roth IRA, Roth 401(k), Roth 403(b), Roth 457 Governmental Plan, and Roth Thrift Saving Plan (TSP).
Roth-type retirement investment accounts are always funded with after-tax dollars. Qualified distributions are tax-free. If you are an investor under age 59.5, your earnings may be subject to ordinary income tax and an additional 10% early withdrawal penalty unless an exemption applies.
Key considerations
- You expect your tax rate to be higher in retirement than it is now.
- You expect your modified adjusted gross income (AGI) to be less than $140,000 (or $208,000 jointly filed).
- You want the option to withdraw your contributions tax-free.
- You acknowledge that you may be subject to a penalty on early withdrawal proceeds.
Beyond determining account type, dividends are also used to minimize tax implications.
4 ways Betterment reduces your tax impact
Additional cash will be used to rebalance the portfolio
When cash is deposited into your account through dividends or deposits, we automatically identify how to use the funds to restore your target weights for each asset class.
Dividends are your share of a company's earnings. Not all companies pay dividends, but if you're a Betterment investor, your money is invested in thousands of companies around the world, so you'll almost always receive a dividend.
Your dividends are an essential part of the tax-efficient rebalancing process. When you receive dividends in your Betterment account, you not only make money as an investor, but you also quickly micro-rebalance your portfolio with the goal of lowering your year-end taxes.
Additionally, if market fluctuations cause your portfolio's actual allocation to deviate from your target allocation, we automatically use the dividends or deposits you receive to purchase more stocks in the laggard portion of your portfolio.
This allows you to return your portfolio to your target asset allocation without having to sell stocks. This is a sophisticated financial planning technique, traditionally only available for large accounts, but our automation makes it possible to perform it on accounts of all sizes.
S&P 500 performance with dividends reinvested
sauce: bloomberg. Performance is provided for illustrative purposes to represent broad market returns. [asset classes] Not available in all Betterment portfolios. of [asset class] Performance is not attributable to the actual Betterment portfolio and does not reflect the performance of any particular Betterment. Therefore, no management fees will be deducted. The performance of the specific funds used for each asset class in the Betterment Portfolio will differ from the performance of the returns of the broad market index reflected here. Past performance is not indicative of future results. You cannot invest directly in an index. The content is for educational purposes only and is not intended to be taken as advice or recommendation for any particular investment product or strategy.
“Harvest” investment losses
Tax loss recovery allows you to reduce your tax bill by “capturing” investment losses for tax reporting purposes while keeping the full investment.
When you sell an investment that has appreciated in value, you pay a tax on the gain, known as capital gains tax. Fortunately, the tax code considers all investment gains and losses together when assessing capital gains taxes. This means that any losses (even on other investments) will reduce your profits and tax liability.
In fact, if your losses exceed your gains in a tax year, you can eliminate your capital gains claim entirely. Any remaining losses can be used to reduce your taxable income by up to $3,000. Finally, losses not used in the current tax year can be carried forward indefinitely to reduce capital gains and taxable income in later years.
So how do you do it?
If an investment falls below its initial value, which is very likely to happen to even the best investments at some point during the investment period, you may want to sell that investment to realize a tax loss and sell it on the market. Purchase related investments to maintain exposure. .
Ideally, you would buy back the same investments you sold. After all, you still consider it a good investment. However, IRS rules prevent you from recognizing a tax loss if you buy back the same investment within 30 days of selling it. Therefore, you end up buying related but different investments to maintain your overall investment exposure. Consider selling Coke stock and then buying Pepsi stock.
Overall, tax loss recovery helps reduce your tax bill by recognizing losses while maintaining your overall market exposure. With Betterment, all you have to do is turn on Tax Loss Harvesting+ in your account.
Take advantage of asset location
Asset location is a strategy that moves your least tax-efficient investments (usually bonds) into a tax-efficient account (an IRA or 401k) while maintaining the overall composition of your portfolio.
For example, an investor saves for retirement in both an IRA and a taxable account, and his overall portfolio is 60% stocks and 40% bonds. Rather than holding both accounts 60/40, an investor using an asset placement strategy would place less tax-efficient bonds in an IRA and more tax-efficient stocks in a taxable account. Masu.
Doing so protects the interest income from the bonds, which is normally treated as ordinary income and is subject to higher tax rates, from the IRA's taxes. Qualified dividends from stocks in a taxable account, on the other hand, are taxed at a lower rate, the capital gains tax rate, rather than at ordinary income tax rates. The overall portfolio still maintains a 60/40 ratio, but the underlying accounts move assets between each other to reduce the portfolio's tax burden.
Use ETFs instead of mutual funds
Have you ever paid capital gains taxes on a mutual fund that declined over the year? This frustrating situation can occur when the fund sells investments within the fund for a profit, even if the value of the entire fund has declined. It happens in case. IRS rules require that taxes on these gains be paid to you, the ultimate investor.
The same rules apply to exchange-traded funds (ETFs), but the structure of ETF funds makes it much less likely that such taxes will be charged. In most cases, you can find an ETF that has a similar or identical investment strategy to a mutual fund and has lower fees.
