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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.
  • If you have plans for charitable giving, donating appreciated shares can bring your overall allocation back toward the target without tax costs.

Assuming that none of the 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: If the gain would fall within the 15% bracket or below, there would be no tax on the gain. So if the additional income does not cause other undesirable tax consequences (e.g., making you ineligible for a particular credit or deduction), realizing a gain on purpose could be a good thing ]

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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