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Rebalancing, with an Eye on Tax Costs

A reader writes in, asking:

“How do you balance tax considerations with portfolio rebalancing? For example, one can have long-term equity holdings in taxable accounts, with large capital gains baked in. To rebalance from them might help one stay on an asset allocation target, but at the cost of a sizable tax bill. Is there a way to think about this trade off, based on some analysis?”

You’ve likely already thought of these, but just to make sure:

  • Rebalancing with new money (if you’re in the contribution stage) can bring your allocation back toward the target without tax costs.
  • Rebalancing by changing the allocation within tax-advantaged accounts can bring the overall allocation back toward the target without tax costs.

Assuming that neither of the two above points is sufficient to get your allocation back to your target allocation, then it’s usually a process of liquidating the specific shares with the smallest built-in gain until you’ve achieved an allocation that is again acceptable.

[Brief tangent/exception: In some cases, realizing a gain on purpose is a good thing. Specifically, if the gain would fall within the 15% bracket or below, there would be no tax on the gain.]

When going through the above process (i.e., liquidating shares with the lowest gains until you’re back at an acceptable allocation), there are a two primary factors that I would think about.

How Off-Target Is Your Allocation?

First, how dramatic is the difference between your current allocation and your desired allocation? For instance, is a huge part of the portfolio in one single stock? If so, tax considerations usually take a distinct back seat to risk considerations.

Conversely, if your portfolio consists entirely of holdings that you do indeed want to hold, and they’re simply off-target by a few percentage points here and there, the analysis is very different.

For example, below is a chart comparing the performance of Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX, in blue) with Vanguard’s LifeStrategy Conservative Growth Fund (VSCGX, in orange) over the last 10 years. While their allocations have changed somewhat over the period, the conservative fund has pretty consistently had about 20% more in bonds and 20% less in stocks than the moderate fund.

LifeStrategy funds

You’ll notice that, as expected, the moderate fund fell by a greater amount during the 2008-2009 crash than the conservative fund, and in recent years (with good market performance) it has grown somewhat more quickly. But an investor in one fund would not have had too wildly different an experience than an investor in the other fund. And that’s with a big (20%) difference in the most important part of the allocation (i.e., the stock/bond allocation).

So it’s safe to say that if something is a few percent out of whack, it’s not usually an urgent problem. And that’s especially true if the difference is within one asset class (e.g., you have too much international stock relative to domestic stock, but your overall stock allocation is about right).

Is Waiting Worthwhile?

The second consideration is whether you actually gain anything by waiting to rebalance.

For example, in the case of a person who is well into retirement or who is in very poor health, it would be worth thinking about whether the holdings with built-in-gains could simply be held until they’re eventually left to heirs (who would get a step-up in basis, thereby being able to avoid the tax cost completely).

Or, in some cases, rebalancing over two or three years rather than all at once might keep your tax rate lower (either because it keeps you in a lower tax bracket the whole time or because it keeps your adjusted gross income below some threshold, such that you stay eligible for a given credit/deduction).

Conversely, if you know that:

  1. You’ll have to rebalance at some point (i.e., the market isn’t going to rebalance for you, and your allocation is too far out of whack to consider simply holding it indefinitely),
  2. In order to rebalance you’ll have to liquidate shares with gains, and
  3. You don’t actually gain very much by waiting…

…then it often makes sense to just bite the bullet and incur the tax cost of fully rebalancing.

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Investing Blog Roundup: GOP Tax Bill

As you very likely read/heard yesterday, the House passed its version of the GOP tax bill.

So, from a political perspective, now’s the time to get on the phone and tell your senator your position on the Senate bill.

Conversely, from a financial planning perspective, I always think the best approach is to make as few tax planning decisions as possible until we know what the actual law will look like going forward. As of yet, we don’t know whether the Senate will pass a bill, what the bill will ultimately look like if it does pass one, or how differences between that bill and the House bill will be ironed out.

Other Money-Related Articles

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New Calculator: Solo 401(k) Contribution Limits

Self-employed retirement plans — SEP IRAs, SIMPLE IRAs, and solo 401(k)s — are one of the topics people ask me about most frequently. Of the three, people ask most often about solo 401(k) plans because:

  1. They have the highest contribution limits, and
  2. Calculating your contribution limit can be rather complicated.

There are plenty of online contribution calculators of course, but many of them (e.g., Fidelity’s or Bankrate’s) provide the wrong answer in some cases. There are some calculators (e.g., Vanguard’s or TurboTax) that get the right answer reliably, but they offer no accompanying explanation of where the answer came from, so they have limited usefulness as learning tools.

So I recently decided to make my own, which both calculates the contribution limit and explains how that limit was calculated. You can find the calculator here:

Please take a look at it. If you have any suggestions of ways to make it better, I’m all ears. (Though to be clear my coding skills — especially javascript, in which the calculator is written — are decidedly beginner-level.)

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  • Business retirement plans: What the different types are, and which one is best for you,
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Investing Blog Roundup: Open Enrollment Season

It’s open enrollment season on Healthcare.gov. If you don’t have health insurance through another source (e.g., your employer, spouse, Medicare), now’s the time to start picking a plan.

Open enrollment lasts through December 15. The process can take a while though, so it’s usually a good idea to get started early. (Frankly even for those of us with financial backgrounds, it’s not usually obvious which plan is the best choice for our circumstances.)

If you do not qualify for premium subsidies or cost sharing reductions, you may also want to search for plans on ehealthinsurance.com, though it’s critical to be aware that any plans there other than those described as “major medical insurance” will cover quite a bit less than a plan that meets Affordable Care Act requirements.

Other Money-Related Articles

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Mean vs. Median Life Expectancy for Retirement Planning

A reader writes in, asking:

“Your discussion of life expectancies this week got me thinking. I believe that the life expectancy that is often discussed is the ‘mean’ life expectancy. Is that true? And if so, how do the ‘median’ and ‘mode’ life expectancies compare? Is mean life expectancy really the best thing to use for retirement planning?”

Yes, it is true that life expectancy refers to mean (i.e., average) life expectancy unless explicitly stated otherwise. And it is true that, as with many other things, it can be informative to look median and mode life expectancies as well.

However, in short, when it comes to retirement planning (at least for somebody retiring at a typical age) mean life expectancy does in fact do a pretty reasonable job of expressing how long the average person is likely to live.

As a brief refresher for anybody who hasn’t used these terms in a while:

  • Mean refers to what we normally call “average,”
  • Median refers to the middle data point in our set, and
  • Mode refers to the most common value.

So with regard to lifespans:

  • Mean life expectancy would be the average age at death,
  • Median life expectancy would be the age which 50% of people will die prior to reaching, and which 50% of people will live past, and
  • Mode life expectancy would be the most common age at death.

Mean, Median, Mode Life Expectancy at Birth

According to the SSA’s 2014 period life table*, male life expectancy at birth is 76 years. That’s the mean value. The median life expectancy is just past age 80. And the mode (i..e, most common) age at death is age 86.

Why the difference?

It occurs because with a life expectancy of 76 years, there is of course a chance that a person dies far, far before reaching that life expectancy. For instance, infant mortality is tragic but unfortunately not super rare. About 0.6% of babies die before their first birthday. In such a case, a person will have fallen 75 years short of their life expectancy.

There is, on the other hand, basically no chance that a person will live 75 years past their life expectancy (i.e., to age 151). So in order for the mean to be the mean, there must be many more people living past it in order to balance out the smaller number of people who come nowhere near to reaching it.

You can see this phenomenon in the following chart, which shows frequency of male deaths at various ages. There is a narrow but long tail to the lefthand side of the distribution, representing all the people who die long before reaching their life expectancy. There is no such tail on the righthand side.

Chart1

The blue line in the chart shows mean life expectancy. As you can see, it occurs well before the mode age at death (i.e., the point at which the chart peaks, at age 86).

The same relationship holds true for females at birth, for the same reasons. Specifically, according to the SSA’s 2014 period life table:

  • Mean life expectancy at birth is 81 years,
  • Median life expectancy at birth is roughly 84.5 years, and
  • Mode age at death is 89 years.

Overall point being: a person’s life expectancy at birth somewhat understates how long they are actually likely to live.

Mean, Median, Mode Life Expectancy for Retirement Planning

But when it comes to retirement planning, the differences are much smaller.

For instance, for a 60 year old male:

  • Mean age at death is 81.5 years,
  • Median age at death is 82.5 years, and
  • Mode at age death is 86 years.

And for a 60 year old female:

  • Mean age at death is 84.5 years,
  • Median age at death is 86 years, and
  • Mode age at death is 89 years.

The reason the differences are much smaller here is that, if you’re already age 60, that long lefthand tail on the distribution turned out not to apply to you. The remaining distribution is much more symmetrical. In other words, you’re now about as likely to die before reaching your life expectancy as you are to live past your life expectancy.

Overall point being: for the sake of retirement planning, mean life expectancy does a decent job of representing how long you are likely to live.

*Of note: All of the data in this article comes from the SSA’s 2014 Period Life Table. I’m using it here because it provides the most accessible data to work with, and because it can accurately demonstrate the relationship between mean, median, and mode. However, as we discussed last week, period life tables (and therefore all of the figures used here) somewhat understate a person’s life expectancy.

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Investing Blog Roundup: What’s Your Uncertainty Score?

In the realm of financial planning, it’s rare for a decision to be anything more than an educated guess — and that’s true even for those of us who work on this stuff for a living.

As Christine Benz writes this week, it’s important to understand the degree of uncertainty involved in each decision, as some decisions are more uncertain than others. Benz also provides some tips for dealing with very high degrees of uncertainty (e.g., “focus on the known knowns” — focus your efforts on the things you can truly control, such as your savings rate).

Other Money-Related Articles

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