re-balancing versus capital gains tax

[medved]

I realize there is no "right answer" to this question, but I am interested in your collective wisdom. I am in early to mid 50s. I will probably retire in a few years. (Best guess = 3 more years). My portfolio is around 63% equities. That is more risk than I want/need to take. If I could snap my fingers and change the allocation, it would be 50/50. But that snap would cost me a lot of money in capital gains tax.

I have been investing all new $$ in fixed income, and selling a little stock. But I have not been doing much stock selling because I don't want to incur the tax.

How do you wise people think about balancing the competing goals of achieving the allocation that you think is right for you against minimizing capital gains taxes?

You can assume I have done the most obvious stuff, like reallocating within my tax deferred accounts, gifting appreciated stock to charity, investing new dollars on the fixed income side.

Would you achieve the allocation you feel comfortable with and damn the tax consequences (as my T&E lawyer says "don't let the tax tail wag the investment dog")? Or live with more risk, for now, and hope that capital gains tax rates might go down - generally or for me? Or do a little bit each year?

Of course, I cannot guess what will happen in the stock market. (Or, I mean, I can guess, but my guess is worthless), but even 50/50 is probably more risk than I need to take. So I am keen to reduce equity exposure. But I don't like the price of doing so.

How you do all think about this issue? Thank you!

 

[LOL!]

Are your tax-deferred accounts at 100% fixed income? If not, then you have a ways to go.

If so, then I would use Specific Identification on the taxable account equities and go from there. Also I have practiced tax-loss harvesting for decades and have carryover losses to offset any gains required by rebalancing. I haven't paid any cap gains taxes since 1999 I think and don't intend to have to until 2099.

You aren't automatically reinvesting dividends from your equity funds, are you? If so, stop that.

 

[RunningBum]

One more step you can do that you may not have thought of is to not reinvest dividends, but rather take the cash and invest in fixed income or bonds.

Beyond that, I would do as LOL says, look at specific shares and sell anything I can at a loss, breakeven, or small gain. Larger gains, it depends.

What are your prospects of getting 0% on LTCGs in retirement? And are you above 15% now? 15% (+ possible state tax) doesn't really seem that bad, especially if you'll still be paying 15% in retirement. I'd be inclined to go ahead and take the larger gains now, at least getting closer to your target AA.

 

[audreyh1]

I take all distributions in cash.

But if you are going from 63 to 50, then it's going to be hard to avoid cap gains. Sell the highest basis of the long-term shares first.

 

[SecondCor521]

This is not the question you asked, but if I were in your shoes I would figure out how I got out of whack in the first place and then try to avoid making that similar kind of mistake in other areas going forward.

For example, maybe you just weren't paying attention. I would then start paying attention in other areas, like making my will, and I would advise my kids to also pay attention so they don't end up in my situation.

Personally I would advise making sure of your AA and then I would get there fairly aggressively by doing all the things recommended here. I'd try to get there this year, but that would be too much to one end for many here.

 

[walkinwood]

Being 13% more in stock than the allocation you want is a big deal, imho. If the market tanks, by definition, you'll be very uncomfortable and may do something rash & suffer irrecoverable damage.

If I were in your shoes, I would plan to get within 5% of your target AA as soon as possible (I used a 5% band to rebalance). Tax consequences be damned. While no one know when the market will drop or even if it will, I think it is safe to say that current valuations are at high end of historical values.

Good luck.

 

[medved]

Thanks for the thoughts. To respond to a few questions, I am in the highest capital gains tax bracket and unless the law changes I don't see that changing. I am moving all dividends and distributions from the equity side (stocks and equity funds) to the fixed income side. None of that gets reinvested. I have sold all the stock that I can sell with a loss or an immaterial gain. All my tax deferred money is in fixed income other than one account that I do not have control over, which is about 40/60. But there is nothing I can do about that. How I got in this position? A combination of my thoughts changing on what I want my asset allocation to be, and the stock market going up a lot, and my being reluctant to incur much capital gains tax. I guess very recently I have been lucky that I did not move more aggressively toward 50/50. But as I said I am taking more risk at this point than I need/want to.

 

[LOL!]

A 13% extra allocation to equities would result in

… a 1.3% lower performance if equities dropped 10%.


… a 2.6% lower performance if equities dropped 20%.

You can compare those numbers to the difference (2.42%) in performance so far YTD between two funds both with 65/35 asset allocation:
8.77% VWENX Wellington with 65/35 and
11.19%VTTVX Target Retirement 2025 with 65/35

My point is that a 13% change may not be as big a deal as some make it out to be.

 

[pb4uski]

I wonder it there is some derivative strategy that you could use that would have the effect of making your portfolio have the risk of a 50/50 portfolio without selling those appreciated equities. Perhaps an equity swap for your 13% in equities that you would prefer not to have.

Total Return Equity Swaps and Equity Forwards

If it were me, I would just live with the 13% difference and stay the course.

 

[gcgang]

I'm in very similar situation.

I haven't found a good answer. I thought I'd try writing covered calls this year, thinking that would provide a little cushion against downturns. So far, I've let a few positions get called, but have been mostly rolling up and out, incurring losses buying back positions after stocks continue to rise. The sales when called amount to less than what the rest of the portfolio has appreciated, so not doing a good job of reducing equity.

So far, I've decided to avoid the immediate pain of anteing up the sure cost of taxes due on stock sales, and hope I can live with the million dollar "paper" (its all paper, or rather, digital now, isn't it) losses when the inevitable bear market comes.

On the gifting front, last year was my last buyout payment, so we made some large deferred gift annuities, basically selling those stocks, receiving tax deductions while our bracket was highest, and setting up an income stream in a few years. That might be something to look at while you still have highest income years.

 

[medved]

I did sell some covered calls. In my simple way of thinking, if you are going to sell a stock anyway, then writing a covered call is not a bad idea -- because you either get the premium "for free" (if the option is not exercised), and then can write another covered call on the same stock, or just sell the stock at market, or the call option gets exercised, in which case you have done what you set out to do -- sold the stock -- and got paid something for doing so. But you are still incurring capital gains tax, when you sell, so it had not achieved my (perhaps unachievable) goal of reducing equity exposure while minimizing capital gains tax.

as pb4 says, there are some derivative strategies -- but they can be complicated (I like simple) and they can be expensive.

 

[45th Birthday]

You didn't ask for an opinion on your asset allocation, but I'm going to give one anyway. I think you should consider whether 50/50 at your age is too conservative. There is no correct answer, but when you wrote "but even 50/50 is probably more risk than I need to take" I had to pause. You seem to be a pretty knowledgeable investor, and I don't know your situation, but it is something to consider.

There are several good articles on the subject on the Financial Samurai site, including this one https://www.financialsamurai.com/the-proper-asset-allocation-of-stocks-and-bonds-by-age/

BTW, I think all the steps others have mentioned and you are already doing are about all you can do without feeling the tax pain.

 

[RunningBum]

Here's another thought on it. If the market drops enough that you get down to 50/50, are you going to keep it at 50/50, or are you going to take advantage of the (probably) recovery to get back to where you were?

If you're going to keep it at 50/50, then you should definitely sell and take the tax hit, rather than lose the entire amount that you have in excess equities.

It makes more sense to me to actively take some of the gains off the table and give some if it back in taxes, than it does to passively watch those gains go completely away. Selling high with taxes is better than selling lower with fewer taxes. Of course, that correction may never come, but you've said yourself that you feel over-exposed.

Otherwise, you should consider whether a 60-65/35-40 AA is acceptable to you, and make that your new baseline.

 

[ace8]

Here an out of the box idea.

Lobby for US tax code reform to tax LTCG at real value not nominal. That would be worth a ~70% step up on basis since 1990.

Good Luck

 

[walkinwood]

A 13% extra allocation to equities would result in

… a 1.3% lower performance if equities dropped 10%.


… a 2.6% lower performance if equities dropped 20%.

You can compare those numbers to the difference (2.42%) in performance so far YTD between two funds both with 65/35 asset allocation:
8.77% VWENX Wellington with 65/35 and
11.19%VTTVX Target Retirement 2025 with 65/35

My point is that a 13% change may not be as big a deal as some make it out to be.

A very good point. Thanks.

 

[medved]

You didn't ask for an opinion on your asset allocation, but I'm going to give one anyway. I think you should consider whether 50/50 at your age is too conservative. There is no correct answer, but when you wrote "but even 50/50 is probably more risk than I need to take" I had to pause. You seem to be a pretty knowledgeable investor, and I don't know your situation, but it is something to consider.

There are several good articles on the subject on the Financial Samurai site, including this one https://www.financialsamurai.com/the-proper-asset-allocation-of-stocks-and-bonds-by-age/

BTW, I think all the steps others have mentioned and you are already doing are about all you can do without feeling the tax pain.

Thanks. I will look at the article and (although I did not ask) I am happy to receive advice on the optimal asset allocation. Here's the thing: I have saved more money than I ever thought I would. I feel like, at this point, any upside will go to some combination of my kids and charities, while downside, if substantial enough, could impact me and wife. When I run FireCalc simulations, they show -- using a 50/50 allocation -- 100% chance of success, even assuming annual expenses that are more than twice what we currently spend (after adjusting for taxes that we pay now but would not pay to the same extent in retirement). Indeed, I probably could live fine for the rest of my life with no equity exposure and a 100% TIPs portfolio. All that makes me inclined not to take too much risk. But who knows -- I could be wrong. Certainly happy to receive thoughts from others.

 

[RunningBum]

I would bet 60/40 or 65/35 shows the same success rate, including for double the expenses.

 

[Texas Proud]

Sometimes you just have to take the hit...

I was heavy equities when I got laid off a few years back... needed to get some cash in my taxable account so sold a bunch... it did cost me more than I was expecting as I had more income than I was anticipating, but in the end it was OK...

I could have re-balanced in my ROTH, but did not want to take money out of that account...

I did what others have suggested, stop reinvesting all divis in my taxable account... they all go to my ST bond fund so I can use the money...

But, because of needing more money this year to redo the bath and I am going to purchase my sisters car I have now taken out from the ROTH... the ACA credits are what I am pursuing now...

 

[big-papa]

I'm at the point now where about 60% of my holdings are in deferred accounts and 40% are in taxable accounts. I no longer automatically reinvest dividends and capital gains but direct them towards my cash holding. Then, depending on what is most out of whack from my AA, I direct the cash accordingly. Just had a dividends/capital gains payout from one of my stock funds on Friday. My equity holdings were higher than I wanted them to be, so I redirected it towards my bond holdings. It moved the needle a couple of percentage points - not quite where I want it to be but at least in the right direction. Historically this fund also does another one of these in the December timeframe. Will do the same thing then as well.

 

[gerntz]

I take all distributions in cash.

Us too. Also use IRA withdrawals to re-balance. It's all after tax then.

 

[medved]

I think one area I may be somewhat different than many people is around 85% of what I have is in taxable accounts -- so I don't have as much flexibility as many others have to reallocate within tax deferred accounts.

 

[audreyh1]

Plenty of folks here with mostly taxable accounts, us included.

I have made AA changes gradually in the past, over several years. Otherwise you just have to bite the bullet and pay the taxes.

 

[LOL!]

I think one area I may be somewhat different than many people is around 85% of what I have is in taxable accounts -- so I don't have as much flexibility as many others have to reallocate within tax deferred accounts.

I'll just say you have to pay attention more, but the opportunities are there.

1. Tax-loss harvest whenever you can and build up carryover losses.

2. Use tax-exempt muni bond funds in your tax bracket. Even these funds can be tax-loss harvested as was the case last December.

3. Take dividends and distributions in cash. Most index funds of equities are paying out about 2% a year, so that knocks back the value of these funds at around a rate of 2% a year. Use the cash for buying the things that are underweighted.

4. And of course when adding to taxable, don't buy more equity funds; buy those tax-exempt muni bond funds instead.

5. Charitable giving is not done with cash, but through your Donor-Advised Fund and you only donate appreciated shares held long-term to your DAF.

 

[Blue Collar Guy]

....... If the market tanks, by definition, you'll be very uncomfortable and may do something rash & suffer irrecoverable damage.

Good luck.

Im looking for a comfortable spot on my floor where I can curl up and cry when the air goes out of the balloon. Im hearing the air trying to escape as I type this.

 

[medved]

I'll just say you have to pay attention more, but the opportunities are there.

1. Tax-loss harvest whenever you can and build up carryover losses.

2. Use tax-exempt muni bond funds in your tax bracket. Even these funds can be tax-loss harvested as was the case last December.

3. Take dividends and distributions in cash. Most index funds of equities are paying out about 2% a year, so that knocks back the value of these funds at around a rate of 2% a year. Use the cash for buying the things that are underweighted.

4. And of course when adding to taxable, don't buy more equity funds; buy those tax-exempt muni bond funds instead.

5. Charitable giving is not done with cash, but through your Donor-Advised Fund and you only donate appreciated shares held long-term to your DAF.

What did I say that suggested to you that I am not doing these things and therefore "need to pay attention more"? In fact, I am doing all of these things, with the possible exception that I might be able to allocate more of my portfolio to municipal bonds or municipal bond funds than I currently am.