Re-balancing & Taxes

[JJac]

As I have been researching my target FIRE portfolio, I wanted to understand the tax implications of rebalancing. I used data shown on Harry Browne's website for the Permanent Portfolio as a reference. Mr. Browne, like everybody else (including FIREcalc), assumes "no taxes." Well, I don't have a huge tax deferred portfolio so that isn't a good assumption for me.

Source of data: http://harrybrowne.org/PermanentPortfolioResults.htm

I assumed:
1 million USD portfolio
4% withdrawal rate with 3% inflation per year
2.5% dividends on stock
10% cap gains taxes and 15% interest taxes
25% in each of the Permanent Portfolio buckets (gold, stocks, bonds, cash) starting in 2000.

I'm not sure how to insert an html table, so manually:

2000 Start End
Stock: 250,000 222,000
Bond: 250,000 288,000
Gold: 250,000 233,750
Cash: 250,000 246,250

Taxes paid on dividends and bond/cash interest: $5125.
Now I need to rebalance to 25% per asset class, which involves selling about 40,000 worth of bonds with the impact of 4,000 more in Tax. Total tax paid in 2000 = $9,175
Each asset class now has 246,487.50

2001 End values
Stock: 210,993.30
Bonds: 237,120.98
Gold: 249,938.33
Cash: 238,070.34

Taxes paid on dividends and cash/bond interest: $4609.32
I have to sell some bonds and some gold to re-balance, resulting in $2303 more tax
Each asset class now has $234,030.73. Total tax paid for 2001: $6913

2002 End values:
Stock: 176,161.79
Bonds: 269,602.10
Gold: 287,777.52
Cash: 204,796.35

Taxes paid on dividends and cash / bond interest: $1840
Another bad year for stocks. Selling a lot of bonds and gold to buy more stocks and fill up the cash bucket. Total tax paid this year: $10,661,92


I didn't make allowances in these calculations for deducting losses against the gains, although when looking at this it didn't seem to make much difference (buying stock every year, selling bonds every year, and a big gold sale in 2002). Thus there was no opportunity to significantly offset gains with losses when rebalancing


In each of these 3 years, total tax paid was 9175, 6913, and 10662, or 23%, 17%, and 26.7% of a 40,000 withdrawal, respectively. I would need to either raise my withdrawal rate to cover this, or learn to live on significantly less, neither of which is a welcome thought.

[Red-y]

I think you may be forgetting that there are exemptions and deductions when filing a tax return; not every dollar from Dollar 1 in withdrawals from a portfolio is taxed.

As a single filer, you don't pay a penny in tax on the first $8450 in income this year (the $3300 personal exemption plus the $5150 std. deduction).

Then Dollar 8451 is taxed at 10% until you have $7550 in TAXABLE income. Dollar 16001 is taxed at 15% and so on....that's what they mean by "marginal tax rates": the tax rate on the last dollar you're taxed on, not the first.

Thus the real tax rate is lower than the marginal, when you factor in the dollars in income you pay no tax on at all. For a better estimates of tax liabilities on withdrawals, try http://www.dinkytown.net/java/Tax1040.html

[TromboneAl]

I'm not sure I completely understood your post (are you posting via time warp from 2003? ). But here's a comment that might be relevant:

You don't have to have a huge tax-deferred portfolio, you just need enough in your tax-deferred acccounts to perform the rebalancing. For example, I have much of my equity portion in a non-tax-exempt fund, but when I rebalance out of stocks next January, I'll move money out of one of my SEP-IRA stock funds.

Let's say you have a million, and you have to correct a 5% stock imbalance. In that case you only have to sell $20,000 worth of stock, so if you have at least 20K in a tax-deferred stock account you're all set.

[JJac]

Originally Posted by Red-y

I think you may be forgetting that there are exemptions and deductions when filing a tax return; not every dollar from Dollar 1 in withdrawals from a portfolio is taxed.

As a single filer, you don't pay a penny in tax on the first $8450 in income this year (the $3300 personal exemption plus the $5150 std. deduction).

Then Dollar 8451 is taxed at 10% until you have $7550 in TAXABLE income. Dollar 16001 is taxed at 15% and so on....that's what they mean by "marginal tax rates": the tax rate on the last dollar you're taxed on, not the first.

Thus the real tax rate is lower than the marginal, when you factor in the dollars in income you pay no tax on at all. For a better estimates of tax liabilities on withdrawals, try http://www.dinkytown.net/java/Tax1040.html

Yes, I understand the marginal tax rates. I estimated so I didn't have to calculate them, because the exact dollar amount wasn't the thing I was interested in. I used the tool at the link above, and it says I estimated too low. Actual taxes would be 9615.

What I wanted to know was would redistributing have a seriously negative impact due to taxes. I think the answer is yes

This forum won't allow me to upload an xls file, but if anybody wants it please PM me.

In 2000, the actual detals (where the tax comes from):
Cash interest - 15,000
Bond interest - 15,000
Stock dividends - 6,250 (assumed 2.5%)

All of this money gets spent (40,000 a year) plus an additional 3750 taken from cash.

To rebalance, it is necessary to sell 40,500 in bonds, resulting in long term capital gains.
Total tax - over 9,000

Originally Posted by TromboneAl

I'm not sure I completely understood your post (are you posting via time warp from 2003? ). But here's a comment that might be relevant:

You don't have to have a huge tax-deferred portfolio, you just need enough in your tax-deferred acccounts to perform the rebalancing. For example, I have much of my equity portion in a non-tax-exempt fund, but when I rebalance out of stocks next January, I'll move money out of one of my SEP-IRA stock funds.

Let's say you have a million, and you have to correct a 5% stock imbalance. In that case you only have to sell $20,000 worth of stock, so if you have at least 20K in a tax-deferred stock account you're all set.

I went way back in the wayback machine :P
The 2000 - 2003 periods were the only years where performance data was provided by asset class in the link I provided. Since I was interested in the principal as opposed to most recent data, I didn't try to find more recent data.

TromboneAl, do you have assets from each asset class that you carry in both your taxable and tax-deferred accounts? For example in 2000, I would have had to sell over 40k worth of bonds to redistribute. In 2002, I would have had to sell 35k in bonds and 53k of gold


I think this is the poster child for why you need tax-deferred accounts. I was debating if I should contribute to an IRA this year, even though it would be after-tax since I am close to FIRE. This tells me I should

Another thing I learned is that holding each asset class in both taxable and tax-deferred accounts is probably a good thing. Gold should be the classic example of an asset that should be held in taxable accounts (no interest and no dividends.) It is pure capital gain/loss. This is great until you have to sell a lot of it to rebalance, at which point you get hit with a killer tax bill that needs to either come out of your 4% (reducing standard of living) or increase your withdrawal rate


Does anybody have a history of doing annual re-balancing that can share examples of how much tax is paid?

[LOL!]

When you sell $40,000 in bonds, I doubt you would pay $4,000 in tax on them. The cost basis of the bonds is not $0.

If you go from $250K in bonds to $288K in bonds, that means if you sell $40,000 in bonds, the cost basis of that $40K is $34.7K with a capital gain of $5.3K and a tax of $527.78 using your rates.

I just saved you almost $3500 in taxes.

[audreyh1]

Yeah - I think you are forgetting your cost basis - makes all the difference!

Try this on instead:

I have found that on my taxable portfolio, taxes average out to about 0.5% of the total value of the portfolio. Calculated over several years. This is AVERAGE - some years more, some years less. This is due to rebalancing, but MORE to distributions. Distributions usually cause the biggest tax hit.

And if you plan right, you can use distributions to do your rebalancing, minimizes sales fund shares for that purpose.

And my taxes are probably high - I'm often hit with the AMT, and my portfolio is not that tax efficient. Other people probably pay less.

So, that means I have to knock 0.5% off my withdrawal rate to calculate my after tax income. That's just the way it is for me.

Audrey

[Saver]

I don't think that this was mentioned earlier: another way to avoid/lessen a rebalancing-induced tax bill is to have "percentage bands" within which your asset classes must remain (instead of exact percentages). For example, instead of weighting four mutual funds at exactly 25% of the portfolio each year, one could simply keep each of the four funds within a range of 20% - 30% of the portfolio. This way, you may be forced to rebalance less often. The rebalancing will be done for you in some years as the previous year's winner pulls back or visa versa.

Saver

[JJac]

Originally Posted by audreyh1

I have found that on my taxable portfolio, taxes average out to about 0.5% of the total value of the portfolio. Calculated over several years. This is AVERAGE - some years more, some years less. This is due to rebalancing, but MORE to distributions. Distributions usually cause the biggest tax hit.

And if you plan right, you can use distributions to do your rebalancing, minimizes sales fund shares for that purpose.

After I fixed my "small" error I came up with a similar 0.5% number.
Adding a spouse to the mix reduces that number a bit, but mileage will vary on whether that is cheaper in the long run :P

Originally Posted by LOL!

When you sell $40,000 in bonds, I doubt you would pay $4,000 in tax on them. The cost basis of the bonds is not $0.

If you go from $250K in bonds to $288K in bonds, that means if you sell $40,000 in bonds, the cost basis of that $40K is $34.7K with a capital gain of $5.3K and a tax of $527.78 using your rates.

I just saved you almost $3500 in taxes.

Oops! The beauty of the internet is you can make mistakes in front of the whole world. I learned something though! Thanks for the tax savings LOL!