How to rebalance with tax-deferred accounts?

[soupcxan]

Apologies if this is an obvious question...but how do I rebalance to acheive my AA plan when some of my asset classes are in tax-deferred/restricted accounts (IRA and 401k)? The problem being that I can't move additional cash in/out once I've reached my annual contribution limits.

For example, let's say I have my REIT fund and my commodities fund in my Roth account. They're each 5% of my total porfolio at the beginning of the year. At the end of the year, they've gone up while other assets have gone down, so they're each 7%. I could sell part of each of them and bring them back down to 5%, but the cash from the sale would still be stuck in my Roth account, and worse it would be stuck earning lousy MM interest rates. If I wanted to make my annual contribution on the first day of the next year, I would have even more cash in the account that I couldn't invest without throwing off my AA plan.

The other solution would be to increase the investment in my other funds (in other accounts) so that the 7% moves back down to 5%. However, I could run into the same problem with my 401k - once I've put in my $14k for 2005, I can't add any more cash...so I couldn't increase the value of the funds in the 401k (making the roth funds a smaller percentage of the overall portfolio). The only solution I see is to hold identical funds in a taxable account, where I can easily tweak the amount up or down as necessary...but that's not advisable for tax-inefficient funds like REITs and bonds. And sitting on idle cash is no fun at all...so what do I do?

The problem isn't as bad if both funds decline to 3%, since I can make my contribtion on the first day of the next year and hopefully bring them back up to 5%.

But still the question remains...how do I keep my AA plan intact given the limitations of moving funds in/out of my tax-restricted accounts?

[Hyperborea]

Basically, you do the best that you can.

In more detail what you need to do is hold some of the same asset classes in different accounts. Each account doesn't have to hold all of the asset classes but there must be some overlap. My 401k holds my small-cap value and when it grows larger than my allocation then I divert some of my 401k contributions or sell some of the SCV and buy into something else like S&P500 or bonds. You won't be able to get it exact but you try to get it close enough.

So, in your case what you would need to do is take some of the "excess" Roth money and buy into one of the laggards in your AA - perhaps that would be S&P500 or something else. Try to buy into a fund that needs purchased that is tax inefficient (tax deferred account is the best place for these) and that has low costs so that when you can you will rebalance back from it.

The more asset classes that you have and the more accounts to balance across the more difficult it can become. So, try not to let the total number grow too much. Try and get the most benefit from the smallest number of funds. Personally, I've got 6 though I'm looking into commodities and China as specific owned asset classes and that would take me to 8.

[charlie]

I assume you want to hold your stock/bond/cash
ratios fixed as well.

You might consider using a balanced index fund
like Vanguard's Target Retirement or Life Strategy
with your desired allocation in your taxable account.
This will do the rebalancing for you automatically
and avoid "tax events". Just add new cash as needed
to adjust the balance of your taxable vs. tax sheltered
accounts if that is a concern.

Then use bonds and cash in your sheltered accounts
to achieve your desired mix vs. your REIT and
commodities, etc. Since you can't move money
back and forth between your Roth and 401k you
would need to establish your desired stock/bond/cash
mix in each account separately. Add new money to
one account or the other to achieve an overall
balance between accounts and rebalance the individual
assets within each account as desired.

I hope this helps.

Cheers,

Charlie

[Berkshire_Bull]

if you buy stocks in both taxable and tax-deffered accounts, then you can get tricky with minimizing taxes via selling stock in Roth after a runup, while maintaining position in taxable account, so you can "tax-free" lock in some of your gain. now if it goes down.... well, don't think about that *knock on wood*

[Hyperborea]

Just looking into my rebalancing for the year (along with maybe adding a fund or two) and I thought of one other "trick". What you want to do is be careful of what you buy in which account in more than just a simple tax inefficient funds inside tax deferred accounts.

The funds in my taxable account are meant to be "buy and hold" and I rebalance with purchases and that is still reasonably easy because I put more money into this account than into all other accounts combined. What I want here are asset classes that make up the bulk of my holdings and that are reasonably tax efficient. In my case much of this is "total US market" and "total international market".

In my rollover IRA I can buy and sell without taxable implications but I want to make sure that whatever I buy has little to no fees since there will be no new money here except for dividends etc. What I put into here is either some sort of core of the tax inefficient funds that won't be bought/sold or free to get out of (certain mutual funds).

In my 401k I have no costs at all to rebalance but I have a fixed number of investment choices and only a limited amount of cash inflow. I can use this account to freely rebalance as long as the asset class that needs extra is available in my 401k plan.

So, in the accounts which will cost you to buy/sell you want to keep the core part of an asset class that will likely never need to be sold and in those accounts which have no to little cost to buy/sell (taxes or fees) you want to keep the final portion of an asset class that you will use for rebalancing. Just some thoughts.

[ESRBob]

Hyper,
Sounds like you have a brokerage acct and are perhaps buying stocks to be concerned about trading fees? (i'm sure you're not buying load funds!)

One thing my schwab acct lets me do, (as they charge me $25 for some of the DFA trades) is to choose whether I want the $25 taken out of the proceeds or added on top of it. Easy for funds when you have a specific amt of cash to reinvest or are swapping between funds.

Another technique is to pick one or more funds and choose to not reinvest dividends or capgains distributions -- not only will this give some cash to either withdraw or use for brokerage fees, but more importantly, it gives you cash to reinvest in other funds come rebalancing time, without needing to sell other funds (triggering capgains). Your dividends and capgains distributions were taxable in any case, so it is convenient and, at the margin, tax-efficient.

ESRBob

[Hyperborea]

Quote:

Hyper, Sounds like you have a brokerage acct and are perhaps buying stocks to be concerned about trading fees? *(i'm sure you're not buying load funds!)

Yeah, my taxable account is a brokerage account with TD Waterhouse. I buy ETFs on a "lumpy" basis a couple of times a year when I sell off stock options, employee stock purchase plan sales, get bonus money, etc. I'm not always going to be a US tax resident and the US mutual fund companies don't like that very much at all so I'm keeping to ETFs for my taxable accounts. IRAs and 401ks they can't kick you out of so easily so those are in low cost (no load + low ER) funds such as Vanguard.

The taxable account is essentially "buy and hold" and I rebalance the asset classes held in it by either buying more of other classes in that account or through the buy/sell in my tax deferred accounts. The capital gains in my taxable account will essentially be tax free once I leave the US too so I won't be realizing any until then.