The primary purpose of portfolio rebalancing is to maintain the target risk exposure of your portfolio, but it is also a method of systematically buying low and selling high. This year’s run-up in equity prices makes it a textbook opportunity to sell higher-priced stocks and buy lower-priced bonds — in other words, buy low and sell high.
Although rebalancing sounds simple, there are a few important tax considerations:
1. Realize losses to offset current year gains and income.
If you have already realized taxable gains in your portfolio or from your other life activities (such as selling a business), then you may consider using taxable accounts to realize losses in the process of rebalancing.
Even if you don’t have taxable gains to offset, you can deduct up to $3,000 of your losses from your income. Any losses in excess of realized taxable gains can be carry forward to offset capital gains in future years. Taking losses in this fashion is commonly referred to as “tax loss harvesting.”
Although tax loss harvesting has many benefits, it isn’t always optimal for rebalancing. For example, harvesting a loss on an individual security that is having a bad year can come back to bite you if the stock rebounds after you sell it — in this case you’ve essentially paid for the risk without realizing the return. Another consideration is that it may be better to reduce exposure to a company that has appreciated to the point that it is overvalued or too large a position for the portfolio.
Don’t forget to utilize tax-advantaged accounts too. If you don’t have substantial capital gains or income to offset, then you may want to rebalance in your tax-advantaged accounts, such as an IRA, when selling appreciated securities.
2. Apply asset location strategies to minimize future taxes.
When rebalancing your portfolio back to its target stock/bond allocation, take the time to place assets in accounts that they minimize future taxes.
Different types of investments get different tax treatments. For example, the interest paid by bonds are taxed as ordinary income whereas dividends and capital gains paid by stocks are taxed at more favorable rates. In addition, you have control over the timing of realizing capital gains since you can wait to sell a security and realize a gain — the major exception here is with capital gain distributions from mutual funds or ETFs.
Applying asset location strategies to maximize after-tax returns requires an investor to determine which securities belong in a tax-deferred account and which should be held in taxable accounts.
3. Make charitable gifts prior to rebalancing.
If you are charitably inclined, then donating appreciated securities from your portfolio increases the bang for your buck when it comes to taxes. Not only do you get the income tax deduction from the donation, but you avoid capital gains taxes on the securities you donate.
Charitable goals can influence the securities you buy and sell in the process of rebalancing. It can also affect the timing of the rebalancing process. If you engage in regular charitable giving, then make sure that your advisor is aware of these goals well in advance of the end of the year so that your portfolio can be optimally positioned.
Similarly, if you are charitably inclined but never discussed this with your advisor, make it a point of discussion in 2017. This is particularly applicable if you are writing checks to the same organizations year in and year out.