As you think about your portfolio and asset allocation, over time you might run into situations where you want to rebalance your portfolio.
For example, perhaps you are doing 90% stocks and 10% bonds, and have noticed that bonds are only 1% of your portfolio.
Or perhaps you were investing in individual stocks and have experienced huge run-ups.
How do you approach rebalancing with tax cost in mind?
The main goal of rebalancing is to reduce risk caused by run-ups in your portfolio, and I just wanted to share some strategies you can think about:
1. Tax advantaged accounts
The first way to think about rebalancing is through tax-advantageous accounts (like 401ks, traditional IRAs, Roth IRAs, HSAs, etc).
The idea is simple – you avoid creating any taxable events in these accounts.
For example, say I have a portfolio allocation of 95% stocks and 5% bonds during the accumulation phase. I have a 401(k), Roth IRAs, and a taxable brokerage. Due to the recent market run-up, my bonds are only 1% of the portfolio.
Well, to fit with my goals and risk comfort, I need to rebalance.
Bonds ideally should be inside the tax-deferred (pre-tax 401(k)) account (see tax-efficient placement). I can then go ahead and sell a small portion of my equities inside the pre-tax account and repurchase bonds or other fixed products there. I just reduced my equity exposure and minimized any tax cost.
2. New money & dividends
Since I’m in the accumulation stage (and most of you are probably as well), another easy way to Rebalancing can also be done by just adding new capital.
For example, say you have 5 individual stocks and want to finally simplify your investing by buying index fund ETFs.
An easy way to start that approach would be to:
• Turn off automatic dividends on your 5 stocks
• Use dividends to invest in the index fund ETFs
• Stop adding any new money to the 5 stocks
• Start investing in the index fund ETFs
Over time, depending on the amount, your index fund ETFs will eventually become a bigger part of your portfolio.
3. Minimizing taxable events
In our prior example, what if those 5 stocks have grown so exponentially large that they make you uncomfortable?
It depends on income and circumstances, but long-term capital gains can be taxed up to 23.8% (20% LTCG + 3.8% NIIT) on the federal level, plus state taxes. So it could certainly be costly to rebalance.
To some, it may be worth it to sell, pay the tax, and move on.
To others, paying thousands in taxes might not be the best decision, so here are some strategies to consider:
- Sell gradually. For example, selling in chunks to manage up to 15% long-term capital gains tax. However, you run the risk of individual stocks dropping more the longer you wait.
- Tax-loss harvesting. Selling some shares at a loss and buying back similar shares can generate significant paper losses, especially via direct indexing. For example, sell S&P 500, buy Total Market, sell individual stocks at a gain, then rebalance into Total Market.
- Sell during lower-income years: Depending on how far away you are from retirement, it’s possible to harvest gains at a 0% long-term capital gains tax rate to live off.
- Tax-gain harvesting during low-income years
- Qualified opportunity zones
- Gifting strategies/donating
4. Timing
There are different methodologies for tracking rebalancing.
The two most common are bands and time-adjusted approaches.
For example, you can set up “bands” around your targets, where you start rebalancing when the allocation deviates 5% in either direction.
For instance, if your target is 90% stocks / 10% bonds, you could start rebalancing when the stock allocation is around 85% or 95% (a 5% band).
Alternatively, you can have a time-based checkup, where at least once a year you review your portfolio and ensure it still follows your investment plan.
Overall, rebalancing doesn’t have to be complicated. The key is just being intentional about your portfolio. Rebalancing is less about perfection and more about maintaining balance over the long term in a way that’s comfortable to you.