Harvesting Value

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One of the best things about not having advertising on my blog, is that I feel completely comfortable making recommendations.

There’s no money being made here.

There’s no conflict of interest.

And while my opinion may be flawed, it is certainly not corrupt.

It’s no secret that I think that Betterment is an excellent investment option, Particularly for low information investors. (Which is why I recommended it to both my father and my mother.)

Although my first preference is for everyone to read some investment books, and come up with a coherent individualized investment strategy, write an investment policy statement, and execute their vision, I recognize that this is not exactly realistic.

There are plenty of people out there investing in target date retirement funds, because they quite simply are not that interested in investment strategy, or modern portfolio theory.

And this is a shame. For if one thing was clear after the 2007 financial collapse, it is that target retirement date funds for those nearing retirement were all over the map with varying degrees of equity exposure (hence risk).

Let’s face it: if there’s one rule to remember when it comes to money management, it’s that nobody cares about your money as much as you do.

Which to me is where Betterment has added real value.

There is a legion of so-called “Robo-investment advisors.” Wealthfront, Betterment, Marketriders, Personal Capital, and many others have filled this space.

They all promise automation and algorithm as a replacement for personalized human advice. And in my mind this is a very good trade, since most financial advice is nothing more than the self-serving steering of the investors money towards the advisor’s pocket.  (There are exceptions to this observation, but not many.)

But in this space I have been most impressed by Betterment. I’m a big fan of their fee structure. I like their portfolio allocation. I like their transparency. And I like their automatic portfolio rebalancing algorithm.

In fact one of my only criticisms of Betterment, had been that their “fund of funds” structure made it impossible to tax loss harvest.

Which is why I was so happy (and surprised) to receive an email from Betterment this week announcing the launch of their TLH Plus program.

But before I get into the details of this program, I should probably define some terms.

It is no secret that I believe you should put every dollar of your money into tax protected accounts that you can.

And the reason for this belief is simple. In tax protected accounts you either get a tax break at the beginning of your saving (as in a traditional IRA or 401(k)), or you get to pull out your money tax-free (as in a Roth IRA or Roth 401(k) ), and you pretty much always get tax-free growth (you’re not taxed on your dividends and interest.)

And this tax-free growth is no small thing. In a taxable account pretty much all of the money that you’re fixed income is making you ends up being taxed at 15 to 20% if you’re not in the lowest tax bracket,as is every single one of your stock or REIT dividends. So all in all this can easily take away a percent or two of your growth per year.

And over the course of your career this drag from taxation can easily end up costing you thousands and thousands of dollars (and a hefty proportion of your ultimate retirement nest egg to boot.)

But there is one important way to level the playing field somewhat between tax preferred, and taxable accounts.

And this maneuver is called tax loss harvesting.

To understand tax loss harvesting, let’s imagine a $100 portfolio which is entirely taxable and has two assets in it: asset A and asset B. Each of these two assets makes up 50% of the portfolio.

After a month asset A doubles and asset B loses 50% of its value.

So you now have $100 worth of asset A, and $25 worth of asset B.

And your whole portfolio has now appreciated by 25%.

If you were to sell your portfolio now, you would have to pay capital gains taxes on the 25% appreciation of your portfolio.

Tax loss harvesting means that you sell only asset B after it has depreciated and buy a similar but not identical asset to asset B in its place.

Once you have done this, the amount of loss that you took ($25 in this case,) can be used to offset capital gains anywhere else in your taxable portfolio. In fact the first $3000 of tax losses harvested per year can be used to offset $3000 of ordinary income. (In my case this would mean about $1500 extra in my pocket at the end of the year.)

But it can get pretty complicated.

You must constantly monitor your portfolio to see which assets have depreciated relative to their purchase price (or basis).

You must make sure that the tax benefits of selling your assets outweigh the costs of the required transactions.

And you must make sure that you do not buy the same asset that you have just sold for a tax loss at any time, and anywhere in your portfolio, in the 31 days following your tax loss harvesting sale.

And these sorts of challenges that are presented by the execution of tax loss harvesting are the sorts of complexities that are best addressed by computer algorithms. Nothing can match a computer for this type of detailed busywork.

Which is where Betterments TLH plus comes in.

Based on this white paper, Betterment’s new algorithm addresses many of the challenges of tax loss harvesting (avoiding the wash sale rule, avoiding the negative consequences of switching back to your original asset, and avoiding short-term capital gains taxes.)

And based on Betterment’s calculations and their white paper, their algorithm would’ve saved a 70/30 portfolio 1.94% annually between 2000 and 2013.

I am not sure that this is a representative finding, as there were two huge Bear markets 2000 and into 2007 during which there were abnormally abundant tax losses to be harvested.

(Which incidentally is probably why Mitt Romney did not release any of his taxes aside from his 2011 taxes. He likely didn’t pay any taxes at all for a few years after harvesting his losses in 2007/8.)

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I am a proud member of the 47% who don’t pay income taxes

But I am very confident that the tax loss harvesting algorithm will more than cover the maximum 0.25% expense ratio charged by Betterment for their services on taxable accounts. (I suspect it will also easily cover the expense ratios of all of the underlying ETFs.)

Better yet, no matter how many fees are incurred by the tax loss harvesting transactions as a result of this algorithm, the expense ratio does not change at all for the customer, who plays 0.15% to 0.25% in expense ratios to Betterment regardless of whether or not he enrolls in tax loss harvesting (Assuming at least $25,000 under management.)

The pertinent details are that this feature is only available for accounts with greater than $50,000 under management. (And is only likely to make a big difference if you have a decent amount of taxable accounts.)

But I continue to be incredibly impressed by this company.

Their fees are more than fair, their user interface is unmatched in its simplicity and its transparency, and their portfolio is very evidence-based, low-cost, and passive.

And what impresses me most is that they continue to innovate. They are not resting on their laurels content to provide good service for a fair price.

They are offering more and more to their customers despite charging nothing extra.

My only hesitation about Betterment at this point, is that they are a smallish company, which means that they are at higher risk for bankruptcy during a financial crisis than larger companies with more assets (like Vanguard and Fidelity.)

And if they were to go bankrupt, I might have to sell my assets, and incur unwanted capital gains.

But I’m so bullish on their product, that I will likely roll over my personal accounts at Motifinvesting to Betterment in order to take advantage of their new algorithm.

Now more than ever, in my judgment, investing with Betterment represents a terrific value play.

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5 Responses to “Harvesting Value”

  1. Robert June 30, 2014 at 7:10 am #

    Alexi, that’s a great new feature from Betterment! I like that they are facilitating this tax strategy. Please allow me to nit-pick your generally good blog post, though. I think we may have discussed this before (I’m too lazy to review past blogs), but I do think that your advice on putting as much money into tax-deferred accounts as possible is biased by your income level; people need to make a more sophisticated analysis before blindly following this assumption (as I did for many years). For many readers, there is an argument to be made for keeping more money in taxable accounts (tax loss harvesting being one of them). Some of the confusion may be due to inaccuracies in this statement of yours: “In a taxable account pretty much all of the money that you’re fixed income is making you ends up being taxed at 15 to 20% if you’re not in the lowest tax bracket, as is every single one of your stock or REIT dividends.” The fact is that you don’t have to be in the lowest tax bracket to avoid capital gains tax. In fact, the exemption extends to the lowest TWO tax brackets (10 and 15%). http://www.bankrate.com/finance/taxes/no-capital-gains-due-for-some-investors-1.aspx. Note that the $72,500 ceiling for married filing jointly (in 2013) is well above the $51,017 median household income (2012) so many people fall in this capital gains tax-free category. The other inaccuracy in your statement is that it says dividends are taxed, but remember that qualified dividends are not taxed for these same 10/15% bracket people.
    Of course, it is more complicated that this. As you approach retirement, this investment income could impact Social Security benefits/taxation (“tax torpedo”), at lower income thresholds than the 15% tax bracket ceiling. So, determining the best allocation of assets between taxable, traditional IRA, and ROTH IRA accounts requires some pretty careful analysis, probably with a professional advisor (fee-based independent).

    • Miles Dividend M.D. June 30, 2014 at 10:17 am #

      Robert,

      You’re certainly right that I am biased by my own tax bracket.

      There are instances when a lower income person can actually benefit from having their money in taxable accounts.

      The only point I would make is this, if you are in the 15% tax bracket then it will be very easy for you to load all of your savings into your 401(k). And if you max your 401(k) you’re very likely saving well more than 50% of your take-home pay for retirement.

      And that’s before contributing anything to a health savings account.

      I can’t really think of any instances where you would not be wise to take your tax breaks right now and amplify your effective savings by maxing out your 401(k) and HSA prior to investing a penny in a taxable account.

      But I do take your point that for someone with a lower income, contributing to a Roth IRA versus contributing to a taxable account, could be debatable in some instances.

      I just think that for people in the 15% tax bracket, this issue rarely comes up due p to the limitations of savings amount on a lower income.

  2. mike October 23, 2014 at 9:47 am #

    Alexi,

    Does using TLH with betterment change your asset allocation any? For example, are there certain investments you add to your betterment account (as opposed to something like vanguard) because they are more likely to need TLH? Interested in your thoughts and/or experience with that idea.
    Thanks,
    Mike

    • Miles Dividend M.D. October 23, 2014 at 5:50 pm #

      Mike,

      Betterment’s asset allocation is pretty much modern portfolio theory 101: A low cost globally diversified allocation with small and value tilts, (So not really; that was already my focus.)

      The one thing you do control tis he stock/bond split.

      What I can tell you is that I have already harvested enough tax losses on my Betterment account to more than cover all Betterment fees and underlying ETF fees for the next 2 years. ( I am in the 39.6% tax bracket.) So at least this year Betterment is cheaper for me than Vanguard for taxable accounts.

      The amazing thing about Betterment is that I never have the urge to tinker with my portfolio. This is unique to my Betterment account, I assure you.

      AZ

  3. mike October 24, 2014 at 7:49 am #

    Thanks Alexi, I’m going to give it a try. Mike

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