Facet tax optimized model implementation (TOMI)
A balanced approach.
At Facet, we understand that you want to optimize your portfolio but also avoid unnecessary tax burdens. Our solution is a two-part approach:
Strategic algorithm.
We use a unique algorithm* to analyze your holdings and recommend which ones to keep, sell, or buy. This helps you gradually transition your portfolio toward our recommendations.
Tax-conscious planning.
The algorithm considers tax implications when making recommendations. This allows you to spread out any capital gains taxes over multiple years, minimizing the overall tax impact.
By combining these strategies, you can benefit from Facet’s investment expertise while keeping your tax bill under control.
How it works.
Here's an example portfolio to show TOMI in action:
Given the member's risk tolerance and situation, we've determined their allocation should be 70% stocks and 30% bonds.
In the first year, TOMI aims to only realize capital gains in an agreed budget. For this example, we’ll use 15% of the portfolio’s value, or $15,000. In most cases, tax on capital gains is 20%, resulting in about $3,000 in Federal taxes. We often recommend members retain cash in their portfolio to assist paying these taxes when filing returns.
First...
TOMI takes the following actions:
- Maps each holding to a Facet allocation. The algorithm estimates which of Facet’s recommended ETFs each holding resembles most closely when looking at investment objectives and underlying holdings. For example, the Disney stock might be closest to the Vanguard Value fund, while the Amazon stock might be closer to the iShares MSCI Quality Factor fund.
- Determines any holdings that are considered the same as Facet recommendations. If a holding is so similar to a recommended ETF that we don’t think making the switch is worth realizing a gain, we won’t do it. For example, we may find the iShares MSCI EAFE ETF to be similar enough to our International ETF recommendation that we decide not to switch.
- Harvests losses. The active bond fund has a $1,000 loss. This is sold entirely. In order to offset other capital gains or taxable income, we may sell off holdings at a loss (like the active bond fund in the example above.)
Then...
With a $15,000 capital gains budget, TOMI determines which assets to buy and sell to bring the portfolio as close as possible to Facet's recommendation.
(Note: Since we already realized a $1,000 loss, we can realize up to $16,000 in gains and still be within budget.)
Here's an example of steps we'd take given the sample portfolio above:
- Eliminate the real estate fund. Facet currently has no allocation to real estate. This sale realizes $2,300 in gains.
- Sell Amazon stock and part of the active growth fund. The system determined that the biggest overweight in this account is growth-style US stocks. It sells enough of these funds to bring that into balance. That realizes $10,500 in gains.
- Sell half of the emerging markets fund. The next biggest overweight is emerging markets. This sale realizes $1,250 in gains.
- Sell half of Disney stock. The last overweight is US value-style stocks. Since Disney is mapped as value, selling half of this holding brings that weighting in line. This realizes $1,950 in gains.
These sales result in $15,000 in net gains ($16,000 in gains, $1,000 in losses).
Lastly...
TOMI will choose which funds should be purchased with the sale proceeds. These are determined based on the asset categories that are most underweight. Our sales totaled $53,374. In this example, that would be distributed into:
- Vanguard Total Stock Market ETF: $8,500
- iShares MSCI USA Quality Factor ETF: $424
- iShares Core S&P US Growth ETF: $4,200
- Vanguard Mega Cap Growth Index ETF: $2,800
- iShares Russell 2000 Value ETF: $2,800
- Vanguard FTSE Developed Markets ETF: $450
- iShares MSCI EAFE Growth ETF: $4,200
- iShares National Muni Bond ETF: $30,000
We estimate these new funds will best balance stocks and funds that remain in your portfolio.
This is where tax-loss harvesting comes in. If a stock you own is losing value, we can sell it and buy a similar one*, allowing you to claim a tax deduction and offset gains. This strategy helps us move your portfolio closer to our recommendation without exceeding your capital gains budget.
If no tax-loss harvesting opportunities arise, we’ll repeat this process in the next tax year until the whole portfolio reflects our recommendation.
Generally we recommend aligning your portfolio toward our recommended allocation as quickly as possible. The lower the capital gains budget, the longer it takes to allocate the portfolio properly and the longer it typically stays out of balance.
Why pay taxes at all?
There’s usually only one way to avoid paying tax on your investments: continuously losing money. Since no one wants that, you should approach investing with the expectation that you’ll pay taxes on gains.
All else being equal, delaying taxes is a good idea. However, when all else is not equal, it is more important to focus on getting to the right allocation as quickly as possible. Facet works to achieve this by reviewing the unrealized gains in an account and will implement our full model allocation when the gains are below $10,000.
In the example above, the portfolio was under-allocated to bonds, had concentration risk in certain asset types, and owned a lot of high-priced funds. Just by selling parts of these funds, the portfolio reduces its overall expense ratio from 0.57% to 0.39%, saving approximately $180 in the first year. That savings will increase as the portfolio grows.
Lastly, remember stocks usually go up over time. The longer you wait to make a change like this, the more taxes you’ll probably owe. It’s better to get your portfolio in the right allocation now before it gets even more expensive.