Betterment portfolios and the systems that manage them are constructed from the ground up to be maximally tax efficient. This begins with security selection, where we use index tracking ETFs instead of mutual funds. Unlike actively managed funds, index tracking funds have significantly lower turnover resulting in materially lower incidences of capital gains being passed on to investors. In addition, the legal and administrative structure of most ETFs differs from mutual funds in the way that investors are insulated from each other rather than pooled together. As a result, ETF investors are only responsible for their own tax consequences rather than sharing in the collective tax burden through distributions. The end result of just holding ETFs is a portfolio with lower capital gains burden which is also entirely immune to mutual fund style administrator-driven distribution.
In addition, Betterment portfolios extract further efficiencies from asset class selection that varies by account tax status. For taxable accounts, Betterment portfolios employ municipal bonds as a major US bond component to lower investor tax burden. Municipal bonds are federally tax-exempt, and may be tax-exempt at the state level. Tax-deferred accounts do not benefit from the tax-exempt status of municipal bonds, so we use a diverse set of high-quality US bonds instead.
The tax impact of Betterment portfolios is also made more efficient through a number of automated day-to-day management features:
- All cash-flows are used to reduce the portfolio drift, which reduces future taxable rebalances. For example, a deposit from a dividend or automatic transfer will always buy the most underweight asset classes first. Similarly, a withdrawal will sell the most overweight assets first.
- Tax lot selection is optimized to reduce taxes. Lots with losses are always sold before lots with gains. Short term losses are preferred over long term losses, and long term gains are preferred over short term gains. Additionally, lots with the highest cost basis, and therefore the lowest embedded potential tax burden, are sold first.
- Rebalancing transactions and portfolio updates are tax aware, and always avoid short-term gains which are typically taxed at the highest rates.
- Tax-loss harvesting is employed to actively take advantage of portfolio losses to offset other gains and ordinary income on your tax return.