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I'm investing $100 every month using Betterment or in some index fund. Assuming I make $10/month from the investment...

  1. If I withdraw $600 after 6 months, will I have to pay taxes on that?
  2. If I withdraw $660 (assuming the $10/month gain), will I only pay taxes on the gain or on the entire amount?
  3. Assuming I started investing on Jan 1st, at the end of 1 year, I will have $1,320. If I take out the full amount, will it be considered a long-term investment or short-term for tax purposes? That part that confuses me is, the first $100 is technically the only part of that investment that has been invested for 1 full year.

  4. What gets me very confused is if I continue to invest random amounts of money each month using Betterment, then I need to withdraw some cash, what are the tax implications.

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This question and your other one indicate you're a bit unclear on how capital gains taxes work, so here's the deal: you buy an asset (like shares of stock or a mutual fund). You later sell it for more than you bought it for. You pay taxes on your profit: the difference between what you sold it for and what you bought it for. What matters is not the amount of money you "withdraw", but the prices at which assets are bought and sold.

In fact, often you will be able to choose which individual shares you sell, which means you have some control over the tax you pay. For a simple example, suppose you buy 10 shares of stock for $100 each in January (an investment of $1000); we'll call these the "early" shares. The stock goes up to $200 in July, and you buy 10 more shares (investing an additional $2000); we'll call these the "late" shares. Then the stock drops to $150. Suppose you want $1500 in cash, so you are going to sell 10 shares.

The 10 early shares you bought have increased in value, because you bought then for $100 but can now sell them for $150. The 10 late shares have decreased in value, because you bought them for $200 but can now only sell them for $150. If you choose to sell the early shares, you will have a capital gain of $500 ($1500 sale price minus $1000 purchase price), on which you may owe taxes. If you sell the late shares, you will have a capital loss of $500 ($1500 sale price minus $2000 purchase price is -$500), which you can potentially use to reduce your taxes. Or you could sell 5 of each and have no gain or loss (selling five early shares for $150 gives you a gain of $250, but selling five late shares for $150 gives you a loss of $250, and they cancel out).

The point of all this is to say that the tax is not determined by the amount of cash you get, but by the difference between the sale price and the price you purchased for (known as the "cost basis"), and this in turn depends on which specific assets you sell. It is not enough to know the total amount you invested and the total gain. You need to know the specific cost basis (i.e., original purchase price) of the specific shares you're selling. (This is also the answer to your question about long-term versus short-term gains. It doesn't matter how much money you make on the sale. What matters is how long you hold the asset before selling it.)

That said, many brokers will automatically sell your shares in a certain order unless you tell them otherwise (and some won't let you tell them otherwise). Often they will use the "first in, first out" rule, which means they will always sell the earliest-purchased shares first.

To finally get to your specific question about Betterment, they have a page here that says they use a different method. Essentially, they try to sell your shares in a way that minimizes taxes. They do this by first selling shares that have a loss, and only then selling shares that have a gain. This basically means that if you want to cash out $X, and it is possible to do it in a way that incurs no tax liability, they will do that.

What gets me very confused is if I continue to invest random amounts of money each month using Betterment, then I need to withdraw some cash, what are the tax implications.

As my long answer above should indicate, there is no simple answer to this. The answer is "it depends". It depends on exactly when you bought the shares, exactly how much you paid for them, exactly when and how much the price rose or fell, and exactly how much you sell them for. Betterment is more or less saying "Don't worry about any of this, trust us, we will handle everything so that your tax is minimized."

A final note: if you really do want to track the details of your cost basis, Betterment may not be for you, because it is an automated platform that may do a lot of individual trades that a human wouldn't do, and that can make tracking the cost basis yourself very difficult. Almost the whole point of something like Betterment is that you are supposed to give them your money and forget about these details.

  • I'm asking for information, not because I think you're wrong, but is your talk of early and late shares how things work in the US? In the UK, the HMRC (=IRS) treat all shares in the same company as "indistinguishable" – you can't "choose" which ones you sell. Instead, the basis when you sell is determined by an "averaging" of all the "buy" events. – TripeHound Nov 8 '17 at 8:24
  • Preferentially realizing losses reduces your taxes now, but increases them in the future -- unless, as their 'tax loss harvesting +' page correctly notes, you plan to die and bequeath the account(s) or donate them in-kind to charity (and assuming 'tax reform' doesn't change those provisions). – dave_thompson_085 Nov 8 '17 at 14:42
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    @TripeHound FIFO is IRS default, there are methods for when multiple basis weren't tracked properly, but most modern brokerages handle matching up basis with shares sold for tax purposes. – Hart CO Nov 8 '17 at 14:43
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    @TripeHound: Yes, under US law you can track individual "lots" (groups of shares purchased for the same price at the same time) and buy and sell them specifically to influence your tax liability. However, as I mentioned in my answer, some brokers do not provide their customers a mechanism to exercise this flexibility, and will just use some default option like FIFO or the averaging method you mentioned. – BrenBarn Nov 8 '17 at 19:51
  • @dave_thompson_085: Yes, that's a potential downside of their loss-first method. I considered mentioning that but didn't want to add yet another complication. That said, the story becomes more complex if you're reinvesting frequently. If there are fluctuations in the share price, you may be buying in at a variety of prices, so may have wiggle room to extend the loss-harvesting for quite a while. It's tough to describe the "bottom line" effect of programs like Betterment, because they engage in lots of automated trades whose aggregate effect is difficult for humans to see with the naked eye. – BrenBarn Nov 8 '17 at 19:56
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No matter what, you owe taxes on the gains, known as capital gains. How much, depends on how long you invested it for. In your example, each month is treated separately - each month you contribute starts a new clock on that set of investments. If you hold it for longer than a year, the taxes are treated as long-term, and less than a year is short-term. Short term taxes are at your marginal rate, and long term taxes are different, usually 15%.

https://www.irs.gov/taxtopics/tc400/tc409

  • You might improve this answer by adding how dividend income is handled, since that's part of most ETF's and index funds. – Hart CO Nov 8 '17 at 14:38
  • Based on this answer, after 1 year of investing, I can withdraw $100 and incur no tax? If I withdraw $110, I will be taxed on the $10 gain as a long-term investment? This seems very complex considering I won't actually know how much I gained on my initial $100, right? – zechdc Nov 9 '17 at 4:46

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