Asset Allocation: Add to positions instead of rebalancing?

[inquisitive]

During years when the stock market is up, rebalancing in a normal account will result in long-term capital gains. This is going to add up over the years. Does it make sense to rebalance only for assets that have had losses (if it needs to be rebalanced) and add new funds over the following year in lieu of rebalancing? If done consistently over time it almost seems like mimicking the benefits of a retirement account! Also since no asset will consistently do well and thus even out on their own somewhat, maybe it could be possible to achieve the same allocations just by adding new funds? (I am primarily an equity investor so will not have stocks outpacing bonds)

Since I only invest in ETFs and mutual funds, largely index, I could see myself holding them for the long-term, as opposed to individual stocks, which I might have to sell.

Has anyone been doing this?

 

[LOL!]

Anything goes when it comes to rebalancing. I don't want to have any costs when I rebalance: No taxes, no fees, no commissions, etc. and so far I have been successful.

In a taxable account, take the dividends in cash and use them to rebalance. Generally, all those index funds of yours will pay out about 2% in dividends, so that will reduce their value automatically every year if you do not reinvest in the same fund. See where the money should go and put it there.

There are all kinds of good rebalancing tips in this article from Larry Swedroe:
http://seekingalpha.com/article/2130243-portfolio-rebalancing-the-whys-and-the-hows

See also: http://www.bogleheads.org/wiki/Rebalancing

In addition, one should be tax-loss harvesting in a taxable account whenever possible and it makes sense. Those capital losses (and carryover capital losses) allow one to realize gains tax-free when selling with a gain is the only way to rebalance.

 

[growing_older]

Yes, while you are accumulating, getting your asset allocation back into the desired range by adding to under-represented asset classes is an easy way to avoid tax implications of rebalancing. For people with assets in retirement accounts, where the tax considerations are not so important, using new money to bolster under-represented asset classes is still one of the easier ways to get your asset allocation back to your desired plan.

 

[inquisitive]

Anything goes when it comes to rebalancing. I don't want to have any costs when I rebalance: No taxes, no fees, no commissions, etc. and so far I have been successful.

In a taxable account, take the dividends in cash and use them to rebalance. Generally, all those index funds of yours will pay out about 2% in dividends, so that will reduce their value automatically every year if you do not reinvest in the same fund. See where the money should go and put it there.

There are all kinds of good rebalancing tips in this article from Larry Swedroe:
Portfolio Rebalancing: The Whys And The Hows | Seeking Alpha

See also: Rebalancing - Bogleheads

In addition, one should be tax-loss harvesting in a taxable account whenever possible and it makes sense. Those capital losses (and carryover capital losses) allow one to realize gains tax-free when selling with a gain is the only way to rebalance.

Thanks, some nice ideas all.

I don't understand the idea about reinvesting dividends. Swedroe seems to state that it will avoid taxation, but this isn't the case:

https://turbotax.intuit.com/tax-too...xes/Guide-to-Taxes-on-Dividends/INF19201.html
Will I Have to Pay Tax on Dividends If I Reinvest Them into Buying More of That Stock?

The benefit is being able to use those funds to rebalance instead of having to sell stock, pay a capital gains tax, and then use that to rebalance.

Might start using the 5/25 rule.

 

[LOL!]

Swedroe is simply saying that you avoid selling shares that you may have just purchased by automatically re-investing dividends. He is not saying that you avoid taxes on dividends paid to you. He is saying what you wrote:

"The benefit is being able to use those funds to rebalance instead of having to sell stock, pay a capital gains tax, and then use that to rebalance. "

 

[inquisitive]

So mutual funds that pay higher dividends should go into tax-advantaged retirement accounts since there will be no taxes on the dividends?

 

[Midpack]

So mutual funds that pay higher dividends should go into tax-advantaged retirement accounts since there will be no taxes on the dividends?

You're on the right track, but it depends on what other asset classes you hold. There are other asset classes that are even less tax efficient than equity income funds (higher dividends) that you'd put in tax-advantaged (tax-free, tax-deferred) first.

Might be more helpful for you to look at the overall picture re: placing your holdings in taxable vs tax-deferred accounts.

Principles of tax-efficient fund placement - Bogleheads

 

[LOL!]

So mutual funds that pay higher dividends should go into tax-advantaged retirement accounts since there will be no taxes on the dividends?

It really depends on the kind of dividends.

1. Tax-exempt bond fund dividends are tax-exempt, so fit in non-tax-advantaged accounts.

2. Qualified dividends get a special lower tax rate (as low as 0%), so would not be bad in taxable account if taxed at 0%.

3. Non-qualified dividends, taxed at your marginal income tax rate, so if they can go into a tax-advantaged account that would be good. Some high-dividend paying funds of ordinary dividends such as REIT and bond funds may need to be avoided in a taxable account.

4. Dividends from foreign funds that have foreign taxes removed. One could get a credit for those foreign taxes paid if in a taxable account, but not in a tax-advantaged account.

So it is not simple and will depend on your own personal situation when it comes to dividends and the kinds of dividends that you might get. Also some funds are more or less tax efficient than they were the year before, so sometimes you cannot plan ahead because things change.

 

[inquisitive]

I didn't realize it was so complex, thanks for the great information. All the points apply to ETFs as well, right? I will be sure to keep my real estate ETFs in a retirement account.

In my reading on qualified dividends, it looks like the main defining criteria is the holding period? So since I am a buy and hold investor, after a certain period of time all my US investments will produce qualified dividends?

I have a lot of foreign ETFs. I looked up the data and noticed that each one has an annual dividend yield listed. I could rank them by the dividend yield and put the ones that are higher preferentially in a taxable account since presumably international taxes will be removed from each one (looking up each country's taxation is getting excessive but I can do this at some future point)? Eg looking at Sweden (EWD, 3.82% dividend yield) and Brazil small caps (BRF, 4.92%), I would preferentially want BRF in the taxable account? More accurately, I should not rank them by dividend yield % but rather I should use dividend yield % multiplied by my holdings?

 

[LOL!]

Dividends on ETFs and mutual funds are taxed the same way, except for perhaps precious metals ETFs.

On the holding period for qualified dividends, it can be complicated. One has their own personal holding period that must be met, but an ETF or fund must also meet a holding period for the underlying stock that pays the dividend.

On the foreign taxes thing, it is tricky. One pays the foreign taxes no matter what, so these things may be tax inefficient no matter what account they are in. While some advocate putting foreign equities in taxable to get the foreign tax credit, if the yield is high, they might be better putting them in tax-advantaged.

 

[pb4uski]

I put international in taxable account. I benefit from the foreign tax credit and a high proportion of dividends are qualified dividends that attract preferential tax rates (0% or 15%).

 

[inquisitive]

Have a lot of reading to do. Thx for pointing me in the right direction.

Presumably ETF historical published returns are net of foreign taxes as well? So the last 1 yr return, eg, would be the return left after the foreign taxes were paid, meaning that I could possibly do better if I claimed anything at all in foreign taxes (depending on the dividend issue)?

 

[pb4uski]

Yes, I'm pretty sure that published returns assume that the investor receives no tax benefit from the foreign taxes paid.

 

[LOL!]

Here's a problem with published international fund returns: Suppose the dividend was reported to be $2 for the whole year. When your 1099-DIV comes, it will show the dividend as higher than $2 with foreign taxes paid. For example, it might be $2.15 with $0.15 per share in foreign taxes. That $0.15 per share increases your AGI which you might not have been expecting since it was nowhere to be found on your brokerage statements.