If you haven’t touched your portfolio in a few years, it may be time to rebalance. Consider this: If you started with a portfolio allocated to 60% stocks and 40% bonds at the bottom of the financial crisis in March 2009 and never rebalanced, your current asset allocation through July 2017 would be 75% stocks and 25% bonds.* That’s quite a drastic change in your portfolio’s risk profile!
If you’re like many investors, you know rebalancing is something you need to do—but you might not know how to minimize the tax bite. Here are a few general guidelines on how you can rebalance your portfolio’s overall asset allocation:
Use tax-advantaged accounts
If you have a tax-advantaged retirement plan, such as a 401(k) or an IRA, consider rebalancing in those accounts. As long as you rebalance within these tax-advantaged accounts, there aren’t any tax consequences. That means from a tax standpoint, rebalancing in these accounts is essentially “free.”
Take required minimum distributions (RMDs) strategically
If you’re age 70½ or older, mandatory distributions from your tax-deferred retirement accounts are a reality. While the IRS mandates the amount you must take annually, the funds from which you decide to withdraw that amount is up to you. Here are a few things to consider:
- If you’re taking your RMDs for spending needs, pull from an overweight asset class. Since you’ll have to pay taxes on any withdrawals of earnings and pre-tax contributions, it’s beneficial to pare down the heavy part of your portfolio relative to your target asset allocation. If you have a balanced portfolio of stock and bond investments, your stock allocation may likely have trended upward, so don’t be surprised if that’s the first place you trim.
- If you’re in the fortunate position where you don’t need your RMDs, and you intend to reinvest the net proceeds in a nonretirement account, be mindful of your asset allocation. Choose tax-efficient investments like broad-market stock index funds or municipal bonds funds (if you’re in a high marginal income tax bracket).
- If you’re charitably inclined, take advantage of a qualified charitable distribution (QCD). For example, you can have your 2017 RMD made payable to the charity of your choice (provided it meets the IRS definition of a qualified charity), and then designate it as a QCD on your tax return. You’ll satisfy your RMD, you won’t pay income taxes on the money, and the charity gets the full benefit … all while rebalancing!
Gift with your heart and wallet
Charitable giving can be an effective strategy outside your retirement accounts too.
- If you’re gifting from your nonretirement accounts, consider gifting shares of appreciated assets to charity. It’s tax-efficient, cost-effective, and helps you rebalance. To learn more about this planning strategy, read Jim Rowley’s blog about his personal experience.
- You can also take advantage of annual gifting to friends or family. In 2017, you can gift up to $14,000 to as many individuals as you like (up to $28,000 if you’re married filing jointly) without gift tax consequences. Consider gifting low-basis shares instead of cash. Doing so will allow you to transfer the gain to the recipient (since the taxable basis will carry over) while rebalancing your portfolio.
Direct cash flows
Consider directing money you invest in your portfolio—a lump sum (such as a year-end bonus or tax refund) or dividends—to an underweight asset class. The latter may take longer to restore your asset allocation, but given that stocks are likely to outperform bonds over the long term, automatically directing any stock dividends to your bond investments may be one way to keep your portfolio balanced.
I’ll be the first to admit that rebalancing is tough. It translates to an unappealing prospect—selling your winners to buy your losers. But think about it this way: We might feel regret when we trim our winners, but we’re also avoiding the regret we’d feel if stock prices tumble and we’d failed to rebalance in the first place.
Special thanks to Jenna McCleary for her contributions to this blog.
*Stocks are represented by the MSCI AC World IMI Index from March 31, 2009 through July 31, 2017. Bonds are represented by the Bloomberg Barclays Global Aggregate Bond Index (USD hedged) from 3/31/2009 through 7/31/2017.
- All investing is subject to risk, including the possible loss of the money you invest.
- Investments in bonds are subject to interest rate, credit, and inflation risk.
- When taking withdrawals from a tax-deferred plan before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- We recommend that you consult a tax or financial advisor about your individual situation.