Selecting tax lots efficiently can address and reduce the tax impact of your investments. When choosing which tax lots of a security to sell, our method factors in both cost basis as well as duration held.
When you make a withdrawal for a certain dollar amount from an investment account, your broker converts that amount into shares, and sells that number of shares. Assuming you are not liquidating your entire portfolio, there’s a choice to be made as to which of the available shares are sold. Every broker has a default method for choosing those shares, and that method can have massive implications for how the sale is taxed. Betterment’s default method seeks to reduce your tax impact when you need to sell shares.
Basis reporting 101
The way investment cost basis is reported to the IRS was changed as a result of legislation that followed the financial crisis in 2008. In the simplest terms, your cost basis is what you paid for a security. It’s a key attribute of a “tax lot”—a new one of which is created every time you buy into a security.
For example, if you buy $450 of Vanguard Total Stock Market ETF (VTI), and it’s trading at $100, your purchase is recorded as a tax lot of 4.5 shares, with a cost basis of $450 (along with date of purchase.) The cost basis is then used to determine how much gain you’ve realized when you sell a security, and the date is used to determine whether that gain is short or long term.
However, there is more than one way to report cost basis, and it’s worthwhile for the individual investor to know what method your broker is using—as it will impact your taxes. Brokers report your cost basis on Form 1099-B, which Betterment makes available electronically to customers each tax season.
Tax outcomes through advanced accounting
When you buy the same security at different prices over a period of time, and then choose to sell some (but not all) of your position, your tax result will depend on which of the shares in your possession you are deemed to be selling. The default method stipulated by the IRS and typically used by brokers is FIFO (“first in, first out”). With this method, the oldest shares are always sold first. This method is the easiest for brokers to manage, since it allows them to go through your transactions at the end of the year and only then make determinations on which shares you sold (which they must then report to the IRS.)
FIFO may get somewhat better results than picking lots at random because it avoids triggering short-term gains if you hold a sufficient number of older shares. As long as shares held for more than 12 months are available, those will be sold first. Since short-term tax rates are typically higher than long-term rates, this method can avoid the worst tax outcomes.
However, FIFO’s weakness is that it completely ignores whether selling a particular lot will generate a gain or loss. In fact, it’s likely to inadvertently favor gains over losses; the longer you’ve held a share, the more likely it’s up overall from when you bought it, whereas a recent purchase might be down from a temporary market dip.
Fortunately, the IRS allows brokers to offer investors a different default method in place of FIFO, which selects specific shares by applying a set of rules to whatever lots are available whenever they sell.
While Betterment was initially built to use FIFO as the default method, we’ve upgraded our algorithms to support a more sophisticated method of basis reporting, which aims to result in better tax treatment for securities sales in the majority of circumstances. Most importantly, we’ve structured it to replace FIFO as the new default—Betterment customers don’t need to do a thing to benefit from it.
Betterment’s TaxMin method
When a sale is initiated in a taxable account for part of a particular position, a choice needs to be made about which specific tax lots of that holding will be sold. Our algorithms select which specific tax lots to sell, following a set of rules which we call TaxMin. This method is more granular in its approach, and will aim to improve the tax impact for most transactions, as compared to FIFO.
How does the TaxMin method work? Realizing taxable losses instead of gains and allowing short-term gains to mature into long-term gains (which are generally taxed at a lower rate) generally results in a lower tax liability in the long run. Accordingly, TaxMin also considers the cost basis of the lot, with the goal of realizing losses before any gains, regardless of when the shares were bought. Lots are evaluated to be sold in the following order:
- Short-term losses
- Long-term losses
- Long-term gains
- Short-term gains
Generally, we sell shares in a way that is intended to prioritize generating short-term capital losses, then long-term capital losses, followed by long-term capital gains and then lastly, short-term capital gains. The algorithm looks through each category before moving to the next, but within each category, lots with the highest cost basis are targeted first. In the case of a gain, the higher the basis, the smaller the gain, which results in a lower tax burden. In the case of a loss, the opposite is true: the higher the basis, the bigger the loss (which can be beneficial, since losses can be used to offset gains). 1
A simple example
If you owned the following lots of the same security, one share each, and wanted to sell one share on July 1, 2021 at the price of $105 per share, you would realize $10 of long term capital gains if you used FIFO. With TaxMin, the same trade would instead realize a $16 short term loss. If you had to sell two shares, FIFO would get you a net $5 long term gain, while TaxMin would result in a $31 short term loss. To be clear, you pay taxes on gains, while losses can help reduce your bill.
| Purchase Price ($) | Purchase Date | Gain or Loss ($) | FIFO Selling order | TaxMin Selling order |
|---|---|---|---|---|
| $95 | 1/1/20 | +10 | 1 | 4 |
| $110 | 6/1/20 | -5 | 2 | 3 |
| $120 | 1/1/21 | -15 | 3 | 2 |
| $100 | 2/1/21 | +5 | 4 | 5 |
| $121 | 3/1/21 | -16 | 5 | 1 |
What can you expect?
TaxMin automatically works to reduce the tax impact of your investment transactions in a variety of circumstances. Depending on the transaction, the tax-efficiency of various tax-lot selection approaches may vary based on the individual’s specific circumstances (including, but not limited to, tax bracket and presence of other gains or losses.) Note that Betterment is not a tax advisor and your actual tax outcome will depend on your specific tax circumstances—consult a tax advisor for licensed advice specific to your financial situation.
Footnote
1 Note that when a customer makes a change resulting in the sale of the entirety of a particular holding in a taxable account (such as a full withdrawal or certain portfolio strategy changes), tax minimization may not apply because all lots will be sold in the transaction.
