Review Betterment's Tax Time page for timelines and filing tips.
Individual ("Personal") or Joint Taxable Accounts
With taxable investment accounts, your client generally owes taxes each year on the dividends and other distributions paid to them that year. They may also owe taxes when they sell shares, depending on whether or not they’ve realized capital gains on the investment.
Taxation of Dividends
Most ETFs pay dividends, reported on Form 1099-DIV. These are generally taxable, typically at your client’s ordinary marginal tax rate (0-37%, Federal). For high earners, an additional 3.8% “net investment income tax” applies. Certain ETFs that hold stocks may distribute “qualified” dividends, which are potentially subject to lower tax rates (Box 1b). Some ETFs hold municipal bonds, which pay dividends that are partially or wholly exempt from federal and/or state tax (Box 11 of 1099-DIV).
Some ETFs make distributions where parts of which are not taxed as dividends, but rather as capital gains, or return of capital. Capital gains distributed are reported on Form 1099-DIV as well (Box 2a). These are usually minimal for index-based ETFs used by Betterment (indeed, this is one reason why ETFs are more tax-efficient than mutual funds). Return of capital is rare, but could apply, for example, to real estate ETFs that sell some of their holdings, and is reported in Box 3, 9 or 10 (See IRS Pub 17 for details).
Foreign Tax Paid
For ETFs with non-US holdings, the 1099-DIV can indicate foreign tax paid. This could happen when such ETFs have already paid foreign taxes on distributions made by companies in foreign jurisdictions, before passing them on to U.S. shareholders. To mitigate double taxation on the same income, the U.S. rules potentially allow for a deduction or tax credit for these amounts (Box 7).
Taxation of Capital Gains
At Betterment, we sell shares on your client’s behalf whenever they withdraw funds, change their allocation, or we rebalance, harvest losses, or assess their fee. When your client sells shares that have appreciated, your client realizes capital gains tax. If the investment has depreciated in value, your client realizes a capital loss, which is used to offset other gains that they have realized that year, and any excess loss may be deductible from their earned income, up to a threshold set by the IRS. Losses not used that year may be carried forward to future years. The amount of capital gains tax your client owes depends on their net gains (including losses carried over from prior years) and how long they held their investments before selling. Short-term capital gains tax applies if they sell shares they held for one year or less. The federal short-term capital gains tax rate is the same rate as their income tax rate (0-37%). Long-term capital gains tax applies if they sold shares held longer than a year, and ranges from 0-20%. For high earners, an additional 3.8% “net investment income tax” is added for both. For each ETF across their portfolio, Betterment's TaxMin algorithm automatically sells losses first (starting with shares which have the highest cost) and if realizing gains is unavoidable, it prefers long-term over short-term, which is likely to reduce their tax burden. Learn more about TaxMin. All sales, including sale price, cost basis, and holding period, are reported on Form 1099-B.
Traditional IRA or SEP IRA
Traditional and SEP IRAs may afford a deduction against your client’s ordinary income in the tax year during which they contribute funds, if they qualify based on their income. Any dividends they receive are automatically reinvested by Betterment, and grow tax-free until withdrawal. When they withdraw from the account, taxes are generally due at their ordinary income tax rate applicable at that time, both on earnings and on all contribution amounts that were previously deducted. Penalties may also be due if they don’t meet the withdrawal qualifications (e.g., you withdraw before age 59.5). Read more from the IRS on IRAs and SEP IRAs.
Roth IRA contributions are made with dollars they have already been taxed on -- they don't get a deduction. However, at retirement, as long as they have held the account for at least five years and met the other qualified withdrawal criteria, none of the amount withdrawn is taxed. Any dividends they receive are automatically reinvested by Betterment, grow tax-deferred, and are also withdrawn tax-free. Read more from the IRS on Roth IRAs.
Betterment is not a tax advisor, nor should any information in this article be considered tax advice. Please consult a tax professional.