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- IRA – 98% stocks, 2% bonds
- Taxable Retirement Growth – 98% stocks, 2% bonds
One of my criticisms of Betterment was with respect to the fact that all accounts/goals are considered independent from an asset allocation perspective. Apart from a few different bond holdings and different secondary ETFs with an IRA account, taxable and tax-advantaged accounts had identical asset allocations. From a tax perspective, this method of asset location is simply inefficient. Taxable bonds should almost never be held in a long term taxable account when there exists room for them in tax-advantaged space as dividends are taxed as regular income (municipal bonds are one glaring exception as they are exempt from federal tax). Further, emerging market funds are notorious for very low qualified dividend income (QDI) percentages:
The lower a QDI percentage is, the more the dividends payed out are taxed as regular income. This matters a good deal as QDI is taxed at a lower rate than normal income.
On the other hand, US total market ETFs and large-cap value ETFs are incredibly tax efficient with QDI as high as 100%, making them excellent candidates to hold in a taxable account:
- VTI = 100%
- ITOT = 94.83%
- VTV = 100%
- IVE = 100%
Enter Betterment’s Tax‑Coordinated Portfolio that was just made available (to me at least) on September 7th, 2016. With their new portfolio tool, they seek to minimize taxes by following the principles of placing only the most tax efficient ETFs in the taxable account and considering all account types (Roth, IRA, and taxable) as a single, consolidated portfolio. When I saw this feature was rolled out, I must admit I did a little bit of a dance – I really think Betterment is a great thing for the masses and with the Tax-Coordinated Portfolio, it is actually more sensible to hold tax-advantaged accounts with them too.
The process of making the change was quite simple. They first asked me what accounts I would like to be considered part of the Tax-Coordinated Portfolio (TCP), then they asked me my desired allocation of stocks and bonds. As Betterment also markets itself for shorter-term goals, such as an emergency fund or large savings goals, you would want to exclude them from the TCP as they will likely have different time horizons and allocation targets.
The TCP Plan
Using Betterment’s simulator, this is what our accounts looked like beforehand:
And with TCP enabled, this is what Betterment simulates using a portfolio value of $75,000 ($50k IRA, $25k taxable):
The actual savings simulated are pretty small, largely because my desired bond position is so low. Betterment estimates that most accounts will benefit with 0.2% per year additional after-tax returns. If you are an existing Betterment user with taxable and tax-advantaged account(s) for retirement purposes, I don’t see any downside to implementing this feature. Whether you actually want to move assets to Betterment, specifically to utilize this feature is another question altogether and one you should definitely simulate out versus your existing setup (don’t forget that they have a fee for managing your money).
This simulator itself is pretty cool tool to give clear insight into what Betterment plans to do with your TCP. Once your taxable account value is full of US total stock and large-cap value ETFs, the simulator shows that the next funds are mid-cap value, then international medium quality bonds, then small-cap value, and then developed markets ETFs. Value funds in general are typically more tax efficient than growth or blend, with mid-cap being more efficient than small-cap. Developed market ETFs are pretty tax efficient and also provide opportunity for foreign tax credit so that makes sense.
Other observations after playing with the simulator:
- For a tax-exempt Roth IRA that is part of your TCP, emerging market assets will go there first. Any emerging markets that still need placed in your overall portfolio will then trickle up to other tax-deferred IRAs and finally to a taxable account as a last resort. Betterment appears to have gone with the mantra of placing the asset class(es) with the highest expected return here first.
- Whereas emerging markets go to the tax-exempt side first, bonds are located there as a last resort.
- They’ve adjusted their bond holdings for TCP-enabled accounts. Typically, there would be a US Total Bond Market holding in tax-advantaged accounts (BND or AGG). With TCP active, they are gone, replaced with additional Municipal Bonds in taxable account.
Asset Location Priorities with a 90/10 Allocation
- Taxable: US Municipal Bonds -> US Total Stock Market -> US Large-Cap Value Stocks -> US Mid-Cap Value Stocks -> International Medium Quality Bonds -> US Small-Cap Value Stocks -> International Developed Stocks
- Traditional IRA: Emerging Market Bonds -> Emerging Market Stocks -> US Medium Quality Corporate Bonds -> International Developed Stocks
- Roth IRA: Emerging Market Stocks -> Interational Developed Stocks
So, we implemented TCP but what actually happened? Immediately, not much. Betterment rebalanced our IRA side of things to start but nothing significant happened. They basically converted VTI holdings to ITOT and moved IEFA back to VEA. It looks like they are setting things up so that future taxable account contributions are towards VTI, with the IRA side of things only leveraging ITOT to maximimize tax-loss harvesting opportunities and minimize conflicts when future IRA rebalances are necessary. The IEFA to VEA move is less clear-cut, but I assume that they don’t acticipate me using taxable account space for new developed markets purchases so are using the rebalance event to get back into their preferred ETF for tracking developed markets. What I anticipate is that as I continue to add more to the taxable side of things, there will be a subsequent rebalance on the IRA side such that new taxable money only goes into VTI, VTV, and MUB.
Here is a breakdown of how things look right now:
At the moment, it looks pretty much like it always has with mirrored asset allocation across the two portions of the account. The portfolio view now shows this nice consolidated look of all the components of the TCP. We’ll see how it looks in a few months with new money added!
UPDATE: Since the original posting of this article, Betterment has made a number of tweaks to the simulator and verbiage. Also, we made a few deposits and quarterly dividends were re-invested. They did what we expected, and added only VTI, VTV, and Municipal Bonds (some MUB, some TFI) in our taxable side. BND was removed from the IRA side of things, which we did not initially expect.