Rebalancing (taxable) and taxes

[Midpack]

Though AA and rebalancing are often discussed, I don't recall seeing much discussion on the tradeoff between rebalancing taxable accounts and capital gains taxes (other than TLH). It's a no-brainer in sheltered accounts, but not so in taxable IMO.

Rebalancing often seems to be discussed as an almost automatic action not only here, but in many investing circles.

While I use the 5/25 rule to alert me (spreadsheet quarterly update) when to rebalance, the first thing I do is consider the capital gains tax impact, and often bend my IP rebalance rules to avoid taxes. I also consider TLH in the decision. Now that I'm retired is less of an issue, but still an issue.

So if you're willing to share, how do others prioritize rebalancing vs taxes (if at all)?

For this reason, the correct question may not be “How often should I rebalance?”, but rather “How far should I allow my asset classes to stray from their target allocations before I rebalance?”. Rebalancing only when an asset class reaches 150% of the target allocation, for example, will perhaps result in a more tax efficient and more profitable portfolio.

Not sure you can "see" this article in it's entirety (I couldn't).
ETF Investing Guide: Rebalancing Rules - Seeking Alpha

 

[MichaelB]

So if you're willing to share, how do others prioritize rebalancing vs taxes (if at all)?

A never-ending trade off. I let tax minimization outweigh rebalancing need in '01, much to my regret, and promised I would not repeat the same mistake. I'm not sure there is one right answer here, but I do feel that rebalancing discipline is most important.

 

[REWahoo]

I try not to allow the tax tail wag the investment dog unless the bite is unusually large.

 

[W2R]

So if you're willing to share, how do others prioritize rebalancing vs taxes (if at all)?

I rebalance as planned - - when my portfolio gets farther out of balance than my plan allows (seldom happens), and during the first week in January.

So what if you have to pay taxes - - that means that you made money when you sold high. If you didn't make money from doing it, you wouldn't have to pay taxes on it. At least, that's the way I look at it.

 

[LOL!]

Fortunately, our assets are about evenly split between taxable and tax-advantaged, so that rebalancing hasn't been a big issue. We also have substantial carryover losses from 2008-2009.

We have typically used a large 401(k) account for all rebalancing between US & Int'l, between stocks and bonds, and between large-cap and mid/small-cap. Thus, no tax consequences.

Furthermore, we do not automatically re-invest dividends from taxable account assets. These dividends have been used for expenses the past couple of years. We also have been selling small amounts from taxable to pay for expenses. In this case, we sell things with the highest cost basis, so that the gains are minimized. Our expenses will drop substantially though as one of the kids finishes college. So I expect those dividends to help with rebalancing in about a year.

A minor problem is that we have sold all US mid/small-cap from our tax-advantaged assets. If US small-cap keeps going up relative to other asset classes, then we will have to sell some shares from a taxable account. That's where the carryover losses are going to be used up. Or we will give shares away to charity to reduce our holdings.

But our taxable assets consist of basically 4 funds: US large-cap, US-small-cap value, Foreign Large-cap, and Foreign small-cap. We do not have any "total market" funds in taxable. So we sell whatever is overweighted when we need cash to pay expenses (with an eye on highest cost basis). Almost all the shares we own date from spring 2009, so they all have about the same percentage of unrealized cap gains.

Since we are gonna have to sell something anyways, we might as well rebalance on the fly.

But for us, taxes loom larger than rebalancing issues.

 

[Midpack]

I rebalance as planned - - when my portfolio gets farther out of balance than my plan allows (seldom happens), and during the first week in January.

So what if you have to pay taxes - - that means that you made money when you sold high. If you didn't make money from doing it, you wouldn't have to pay taxes on it. At least, that's the way I look at it.

I am hoping to time my capital gains to stay under the (current) threshold that allows 0% CG taxes, split across two years for example. If I am not mindful, I could easily pay 15% on at least part of the exact same capital gains by letting it all hit in one year.

That said, my actual batting average in doing the above is probably worse than I'd like to think.

It's a learning process, after so many years with employment income where I went to almost any length to avoid investment capital gains. Probably time to relax or lessen that mindset...hence post #1.

 

[W2R]

I am hoping to time my capital gains to stay under the (current) threshold that allows 0% CG taxes, split across two years for example. If I am not mindful, I could easily pay 15% on at least part of the exact same capital gains by letting it all hit in one year.

That said, my actual batting average in doing the above is probably worse than I'd like to think.

It's a learning process, after so many years with employment income where I went to almost any length to avoid investment capital gains. Probably time to relax or lessen that mindset...hence post #1.

Exactly! At least, in my case I have noticed that my taxes in retirement are delightfully small, compared with what I paid while working. I would pat myself on the back for being so clever, except that nearly everyone has the same delightful surprise when they retire. Being in a much lower marginal tax bracket helps, too.

 

[Stanley]

I try not to allow the tax tail wag the investment dog unless the bite is unusually large.

+1

 

[H2ODude]

We're about 50/50 between taxable and non; our AA is out of whack for our age (65/35) so we've been using this run-up to finally move more into fixed, but it's really tough to do with such low returns and the specter of rising interest rates and what it will do to bonds. Anyway, have been using the rebalancing to get more of the fixed (with the income) into the tax deferred accounts. Playing with starting to convert the IRA (where the bulk of non tax is) to ROTH although my accountant is a "never pay taxes sooner than you have to" guy. I realized some taxable gains in December in case CG rates went up with the Congressional drama. Obviously not a good move.

I'm often reminded of what a good friend who managed MF's and pension funds said once - nothing wrong with paying taxes as it means you've made money. His point was that you can get too wrapped up in tax avoidance and shouldn't let it rule your investment strategy.

 

[haha]

I'm often reminded of what a good friend who managed MF's and pension funds said once - nothing wrong with paying taxes as it means you've made money. His point was that you can get too wrapped up in tax avoidance and shouldn't let it rule your investment strategy.

True to a point, but if you make good investment decisions you will always have meaningful amounts of CG taxes on any changes. Since even the best guessing about future market movements can be quite wrong, it seems to me that it should be close to an ironclad rule never to take STCGs, except for example with options that will expire if not sold or exercised.

Also, I like to invest in situations that appear to me to have good long term market positions and earnings capability. If your choices have been favored, very shortly half or more of their market value will be capital gain. It is expensive to sell these positions, even with a 15% ltcg rate.


Ha

 

[steelyman]

True to a point, but if you make good investment decisions you will always have meaningful amounts of CG taxes on any changes. Since even the best guessing about future market movements can be quite wrong, it seems to me that it should be close to an ironclad rule never to take STCGs, except for example with options that will expire if not sold or exercised.

Ha

When I first learned about and used options (around 2006), I went wild in a taxable account and was thrilled... until it came time to fill out Schedule D. Now I only do options in my Roth IRA.

 

[haha]

When I first learned about and used options (around 2006), I went wild in a taxable account and was thrilled... until it came time to fill out Schedule D. Now I only do options in my Roth IRA.

You must be pretty successful. I hate losses in my Roth, so I am wary of that strategy.

Ha

 

[audreyh1]

I try not to allow the tax tail wag the investment dog unless the bite is unusually large.

I try not to. But the bite CAN be large. For us it can incur some sizable additional taxes, so we are careful. I've been reviewing this very issue!

I read somewhere that 18 months is more ideal for rebalancing in taxable accounts. That would be during the accumulation years, I think. A major way I rebalance is with the start of the year withdrawal after a ton of mutual fund distributions are paid at the end of the prior year. These distributions usually get things out of balance, and take care of part of the "trimming" we would likely do anyway. We take most of our withdrawal out of these taxable distributions and then rebalance to tidy things back up. So an annual rebalance (if really needed) right after withdrawal works best for us tax-wise and income-wise.

A problem for me rebalancing early or mid-year during a year with strong equity markets, is that the equity funds will probably pay out oversized capital gains distributions near the end of the year. And if I sell some early for rebalancing I just end up generating more income that year. I will STILL get those distributions paid out from the funds - these are only slightly reduced by trimming. So all this does is increase my reported income and thus my tax bill!

I'd really rather wait for mutual fund distributions to be paid out before rebalancing to minimize the tax effects. This might mean I miss short-duration run-ups or corrections, but that's OK. It's the bigger/longer ones that matter. The small blips really don't.

I have a pretty high rebalance threshold. This is actually more about avoiding what happened to me in 2008 where I ended up rebalancing like 3 times because the markets kept dropping. Of course it all gained back in 2009 during the recovery, so it did pay off. But I think less often is better .

I'm less than half way to my rebalance threshold this year anyway. For me a category has to be at least 8% out or 10% max to rebalance. For example - say equity target was 50%. I wouldn't rebalance until it reached at least 54% (that's 8% over), and definitely at 55% (10% over).

It can be kind of tough to sit here and see that the retirement fund is up over 5.3% YTD already, and part of the instinct is "take profits now!". But our equities are only 3.3% above target and bonds only 4.2% below target, so I just need to be patient and "sit on my hands" for now. If the equity markets stay up the rest of the year, it's very likely that the capital gains distributions will take care of most of the equity "trimming" for me.

If total joint income for the year is less than $250K you don't have to worry about issues like the Medicare surtax or limits on deductions/exemptions. But a large capital gains jump from rebalancing could still push you into paying extra due to AMT.

I guess that if things run up far enough to reach rebalance thresholds, then I'm willing to pay the extra taxes incurred by rebalancing. Otherwise I'm going to firmly sit on my hands.

 

[truenorth418]

This is a timely thread as I am looking at a similar situation in my own portfolio. If I rebalance and have to make a big tax payment on my CG, it will force me to increase my WR% for the year unless I cut back spending on something else. I haven't hit my rebalancing bands yet but something I am keeping my eye on.

 

[steelyman]

You must be pretty successful. I hate losses in my Roth, so I am wary of that strategy.

Ha

Well, it seems to work for me. There must be a name for this strategy, but I am no options expert. Using cash in the account, I sell cash-covered out of the money puts and collect the premium. If it gets put to me, I flip around and sell out of the money covered calls against it. Then I do it again. The thing I had to learn was to not freak out and be patient. If the trade doesn't happen, that's OK.

I select a strike price for the put about 8% below the current stock price and about 4% above the current price for the calls, 3 months out. I use a pretty liquid ETF (in my case, IWM).

Helps prevent me from "falling in love" with a stock, which always got me into trouble. But it may not be for everyone.

 

[FIREd]

I try to avoid short term capital gains at all cost as we are in the top tax bracket. Combining federal and state taxes, our marginal tax rate now exceeds 50%. I am not against realizing some long term capital gains, but even that has become an expensive proposition in California (20% federal income tax + 3.8% Medicare surtax + 10.3% CA income tax).

About 70% of our portfolio is in taxable accounts and 30% is in retirement accounts. I hold a mixture of stocks and municipal bonds in taxable and a mixture of cash, taxable bonds, and a smidgen of equities in our retirement accounts. I try to rebalance our retire portfolio using the cash and equities in our IRA as much as possible.

 

[haha]

If total joint income for the year is less that $250K you don't have to worry about issues like the Medicare surtax or limits on deductions/exemptions.

This may be incorrect WRT Medicare. I have paid this surcharge several times, and for singles it is strikes at >$85,000 magi. This figure is not indexed.

Medicare Premiums: Rules For Higher-Income Beneficiaries. These surtaxes apply to both part B and part D.

Ha

 

[walkinwood]

Prior to ER, I rebalanced using new funds rather than selling anything.

After ER, I have been using up the capital losses that I harvested in 2008/09.

After I exhaust those losses, I'll have to revisit this post.

 

[Midpack]

Prior to ER, I rebalanced using new funds rather than selling anything.

Exactly what I did once I was all mutual funds (vs individual stocks). Now that I'm no longer accumulating, I have to confront rebalancing more directly, no surprise.

 

[tdv2]

I did some re-balancing last year and moved some assets out of actively managed funds. In addition, I had income from a bonus and a large dividend from company stock. I really took a big hit on the tax bill......It stings pretty bad. About 2/3 of my assets are in taxable 1/3 in 401/ira so I need to be smart about how I do things going forward.

I really want to pull the plug when I hit 50 at the end of the year. DW has a $32k pension she can draw from right now if she calls it quits too. My SWR will be around 2.5%. At the moment fear of the unknown is keeping me in the rat race.....also the "you are too young to retire" from others. What do they know....right?

 

[Animorph]

I rebalance as needed. Long-term gains only, and I try to balance out gains with losses. I will start spending down the taxable accounts next year, so it won't be a problem for long.

 

[audreyh1]

This may be incorrect WRT Medicare. I have paid this surcharge several times, and for singles it is strikes at >$85,000 magi. This figure is not indexed.

Medicare Premiums: Rules For Higher-Income Beneficiaries. These surtaxes apply to both part B and part D.

Ha

I'm taking about the new 3.8% Medicare Surtax on net investment income above $250,000 (joint filers). This applies to everyone, not just current Medicare beneficiaries. It has nothing to do with Medicare premiums.

 

[haha]

I'm taking about the new 3.8% Medicare Surtax on net investment income above $250,000 (joint filers). This applies to everyone, not just current Medicare beneficiaries. It has nothing to do with Medicare premiums.

I see, I misunderstood. Thanks for the clarification.

Ha

 

[clifp]

I don't rebalance. My projected dividend and interest income provide me with a budget and monthly withdrawal from my brokerage account to my checking account.

I do monitor my AA, and use index funds in my IRA to make any fine tune adjustment but not any type of time based system.

The three times I have made conscious changes to my AA, 2000 more bonds, 2008/9 more stocks, 2011 less bonds/more real estate. Tax considerations were a pretty minor factor. (In the case of 2008/9 I had plenty of losses to balance my modest bond capital gains)

I am definitely guilty of hanging onto to individual stocks too long because I don't want to pay cap gains. But since generally I buy to early and sell to soon, this really hasn't hurt me too much.