Robo advisors can help investors lower their tax bills. Asset location helps investors maximize the benefits of tax-sheltered accounts. Municipal bonds avoid taxes entirely. Some robo advisors also offer tax-loss harvesting. Let's value these services one at a time, starting with asset location.
For investors in the 25 percent tax bracket, ordinary income costs 10 percent more than qualified dividends or long-term capital gains, which are taxed at 15 percent. If yields revert to their five-year average of 5 percent, this slippage will cost 0.50 percent per year.
Wealthfront, Betterment and FutureAdvisor crunch the variables to optimize precious tax-sheltered account space. There are plenty of variables, too.
The higher that yields climb, or the higher your tax rate, the greater the asset-location advantage. Long-term asset growth rates matter too, because of capital gains on the nonsheltered assets. The amount of capacity in tax-sheltered accounts plays a part, as does your expected trading frequency, your life expectancy and your expected cash needs.
Munis For Tax Avoidance
Since 1990, broad-based munis have yielded an average 54 basis points per year more after tax than the Barclays U.S. Aggregate Bond Index, for investors in the 25 percent federal tax bracket. Add in a few more basis points for state tax and the ability to shelter qualified dividend income, and we can estimate the muni advantage at 60 basis points per year. Munis often carry more interest-rate risk and sometimes more credit risk than investment-grade taxable bonds—the tax advantage isn't risk-free.
Here's how muni use provides savings in the robo portfolios. The muni advantage is scaled by the weight of munis in the 60/40 portfolios:
|Firm||Munis Tax Savings 25% Tax Bracket Scaled To Portfolio Weight|
Wealthfront's taxable bond portfolios hold muni bonds, and nothing else. Betterment and Invessence's greater diversification means less tax savings.