Tax-Wise Portfolio Rebalancing
Studies indicate that savvy asset allocation may lead to long-term investment success. Individuals can find a desired mix of riskier asset classes, such as stocks, and relatively lower risk asset classes, such as bonds. Sticking with a chosen strategy might deliver acceptable returns from the volatile assets, as well as fewer fluctuations along the way from the stable assets. An asset allocation could consist of a simple blend of stocks and bonds, plus an emergency cash reserve. Alternatively, an asset allocation can include multiple asset classes, ranging from small-company domestic stocks to international mega corporations to real estate.
Investors may put together their own asset allocation, or they might work with an investment professional. Either way, the challenge is to maintain the desired allocation through the ups and downs of the financial markets. The answer generally recommended by financial advisors is to rebalance periodically.
Sell High, Buy Low
Once your asset allocation is in place, it can be reviewed at regular intervals or after significant market moves.
Example 1: Ellen King has a basic asset allocation of 60% in stocks and 40% in bonds. However, the bull market of recent years moved her portfolio to 75% in stocks and 25% in bonds. Ellen is uncomfortable with such a large commitment to stocks, which have crashed twice in this century.
One solution is for Ellen to move money from stocks to bonds, going back to her desired 60-40 allocation. Many investors are reluctant to follow such a plan, leaving a hot market for one that’s out of favor. Nevertheless, investors who follow market momentum—buying what’s been popular and selling what’s been devalued—historically have received subpar results. Going against the crowd by buying low and selling high may turn out to be more effective.
Rebalancing is inherently an inefficient tax process. Investors are always selling assets that moved above the desired allocation, which generally means taking gains. Such gains can be taxable and may add to an individual’s reluctance to rebalance.
How can investors rebalance their asset allocation without feeling whipsawed by taxes? Here are some possibilities:
Bite the Bullet
As long as the securities are held for more than 12 months, profits on a sale will qualify for long-term capital gains rates, which are lower than ordinary income tax rates. Paying some tax may be worthwhile if it reduces portfolio risk.
Also, if Ellen has a diversified mix of stocks and stock funds, she could selectively sell long-term shares with the least appreciation, resulting in the lowest tax bill, unless she believes there are investment reasons to sell her big gainers.
If there are no sales, no tax will be due.
Example 2: Assume that Ellen’s portfolio consists of $100,000 in bonds and $300,000 in stocks. Instead of selling stocks, Ellen could hold on to them and avoid a taxable sale. Meanwhile, her future investing could go entirely into bonds; dividends from her stocks and stock funds could be invested in bonds and bond funds. Gradually, her asset allocation would move from 75-25 to 70-30 to 65-35, heading towards her 60-40 goal.
Suppose that Ellen is retired, spending down her investment portfolio instead of building it up for the future. In this situation, Ellen could tap her stocks for income, decreasing her allocation. To hold down taxes, she could liquidate stocks selectively, as mentioned.
Investors may hold various positions in individual securities and funds, including some that have lost value since the original purchase. Health care stocks and funds, for instance, generally had losses in 2016, although the broad market had gains. When price drops on specific holdings are significant, a sale can generate a meaningful capital loss, perhaps making rebalancing easier in the future (see Trusted Advice column “Gaining From Losses”).
Use Tax-Favored Retirement Accounts.
Taking gains inside plans such as 401(k)s and IRAs won’t generate current taxes. Therefore, Ellen may be able to do some or all of her rebalancing, tax-free, by moving from stocks to bonds within her IRA. This tax-efficient flexibility may be one factor to consider when deciding whether particular investments should go into a taxable or a tax-deferred account. Holding a mix of asset classes on both sides may permit more tax-efficient rebalancing.
The methods described here are not mutually exclusive. You might find that combining tactics will help you rebalance and maintain your asset allocation without triggering steep tax bills.