Tax Hit vs Asset Allocation/Re-balancing?

[Midpack]

Thought this could be an interesting discussion here. Hope so.

I’m happy to say I didn’t sell any holdings during the ‘87, ‘00 and ‘08 market slides, and I slept just fine with minimal anxiety (I won’t say none). I even did a little buying but I’ve never held much cash, always all in essentially.

Though it was a conscious decision, I’ll admit the tax hit associated with taking large capital gains has made buy and hold in all markets much easier for me. I have probably let avoiding/deferring/minimizing taxes play too much of a role in my investment decisions. OTOH, I often see discussions about rebalancing on investing forums that rarely recognize taxes as a factor, that could be a mistake too.

I’m NOT talking about taking gains up to the tax bracket threshold you’re already in, or lower brackets where dividends and gains get favorable treatment - that’s pretty straightforward. I am talking about rebalancing that brings taxes in a given year up a couple brackets give or take - I know there are others here in that middle ground, not paupers and not top %ers. And clearly I’m talking taxable accounts, we’re overweight taxable despite taking advantage of 401k’s and IRA’s all along - tax deferred accounts can’t help.

Making a calculation of taxes vs losing fund appreciation isn’t really possible, seems akin to market timing.

So how do others keep accepting tax consequences in proper perspective? What role should taxes play in rebalancing/investing?

 

[ERD50]

I've seen studies that show re-balancing to be over-rated. It helps in some cases, hurts in others. I view it as pretty much a wash, I don't worry about it too much.

So I think a reasonable approach would be, to keep ones AA from getting too out of whack for their comfort level, to re-balance up to the top of their current bracket, and do it over several years if needed.

edit/add: Just so you don't think I overlooked this line: " I am talking about rebalancing that brings taxes in a given year up a couple brackets give or take ", I didn't. I'm saying that seems to be a false restriction for most people in most years. Just go up to top of the current bracket, and do it in stages (years) if that's what it takes.

-ERD50

 

[audreyh1]

You just have to look at surviving the decade 2000-2010 to see how much rebalancing can help during volatile times!

I’m NOT talking about taking gains up to the tax bracket threshold you’re already in, or lower brackets where dividends and gains get favorable treatment - that’s pretty straightforward. I am talking about rebalancing that brings taxes in a given year up a couple brackets give or take - I know there are others here in that middle ground, not paupers and not top %ers. And clearly I’m talking taxable accounts, we’re overweight taxable despite taking advantage of 401k’s and IRA’s all along - tax deferred accounts can’t help.

Making a calculation of taxes vs losing fund appreciation isn’t really possible, seems akin to market timing.

So how do others keep accepting tax consequences in proper perspective? What role should taxes play in rebalancing/investing?

In terms of rebalancing and tax hits:

Well - in 2008, for example, we were selling bonds and cash to buy stocks. Capital gains on bond funds tend to be quite low since you pay taxes as dividends are received anyway. There was little tax hit. So - in general you aren't punished tax-wise for selling bonds to buy stocks.

In 2010, I did a major rebalance as our equities had seriously recovered, and yes we got hit with some capital gains. But that year capital distributions were quite low so we had lower income than usual anyway.

Now some clever folks did some major tax loss harvesting in 2008 which set them up for several years of offsetting realized capital gains.

So, in practice I'm not seeing your scenario where rebalancing pushes up a couple of tax brackets. Importantly, you are almost always talking about long-term capital gains. MFJ you have to have taxable income exceeding $250K to go from 15% to 18.9% on cap gains, and $470K to go from 18.8% to 23.8% on cap gains.

So unless you have higher income than $470K, you are still paying at pretty low rates, and it doesn't impact your ordinary tax brackets, and you won't be paying AMT either, which was a problem in the past.

So maybe you need to review what the tax implications really are?

Tax implications have not prevented me from doing major rebalances. For minor rebalances - things just off by a % or two, I'll rarely bother. If I can take advantage of some straightforward tax loss harvesting I will do so.

Now if someone decides to change their AA from say 60/40 to 50/50, I can see how increased capital gains taxes would give them pause.

 

[RunningBum]

If you're not trying for ACA subsidies, where there is a cliff involved and an extra $100 of income can cost you $1000s, my opinion is that you shouldn't let taxes influence your decision. I could be convinced that if you think you can always keep LTCGs from being taxed maybe you don't want to have some taxed at 15% now, but if you can select small gainers and only have a little taxed at 15% while bringing your AA back inline, I'd do it.

LTCGs don't affect your tax bracket, per se. There is a level of income at which you are not taxed for CGs, and an extra 3.8% NIIT, and a 20% rate with very high income, so maybe that's what you two are talking about with "the next bracket", but that's not really correct terminology.

The difference between 40% equities and 80% equities probably isn't that big in either performance and volatility, so you could argue that rebalancing isn't all that important, but if you have a plan to rebalance, I think you should. I think it does at least a little of "buy low, sell high".

Another way to look at it, do you want to be taxed 15% on gains while stocks are high, pocketing 85%, or do you want to have no tax liability but watch stocks sink back without putting any profits in your pocket? I'll take the 85% and not worry about paying the 15% tax. Of course stocks could keep going up and up but your question is about tax and rebalancing, not whether you are giving up potentially more gains by rebalancing.

 

[imoldernu]

Appreciate the thread for a selfish reason. Except for the first four years after retirement from '90, to 94, because we are poor cousins, we haven't had to pay either state or federal taxes. Didn't dodge and even now, we still file, but our finances are self sustaining. Looks like we may have to begin cashing in some assets soon, but so far have not helped too much in supporting the government.

Also... means I don't have to learn a lot of the acronyms in most threads.

 

[marko]

Thought this could be an interesting discussion here. Hope so.

Though it was a conscious decision, I’ll admit the tax hit associated with taking large capital gains has made buy and hold in all markets much easier for me. I have probably let avoiding/deferring/minimizing taxes play too much of a role in my investment decisions. OTOH, I often see discussions about rebalancing on investing forums that rarely recognize taxes as a factor, that could be a mistake too.

This is exactly the boat I'm in. I looked at moving some stuff around and after having done the tax calculation decided that "it's not that bad where it is". It would've been a massive hit.

Cramer, among others warns against letting taxes determine your moves but I'd rather wait for a 1) year that maybe I'm a little less into the tax man or 2) have a truly compelling reason to move. Taking a big hit to rebalance 2% or 3% one way or the other just isn't worth it.

 

[ERD50]

You just have to look at surviving the decade 2000-2010 to see how much rebalancing can help during volatile times!
....

And other times it will hurt, and we can't know in advance.

In a long, steady bull, re-balancing has you selling stocks along the way, missing some of those gains.

This link to www.portfoliovisualizer.com for SEPT2008-SEPT2018 shows a slight advantage to no re-balancing with a 60/40 (select/de-select the rebalance tab to compare).

https://goo.gl/BpkUpm


Edit/add: I went back to the JAN2000-JAN2010 time-frame you offered up, and I found re-balancing made almost no difference, and the delta was actually slightly negative for re-balancing:

https://goo.gl/uUxvch

Further edit/add: And the type of re-balancing made a difference too. Quarterly, Semi-Annual and Monthly did progressively worse. With a starting balance of $100,000:

No-REBAL ends @ $125,292
Monthly ends @ $121,139

What are you seeing?


-ERD50

 

[Midpack]

Now if someone decides to change their AA from say 60/40 to 50/50, I can see how increased capital gains taxes would give them pause.

Unfortunately that’s where we are, to be exact we’re at 59% and would rather be at 50% equity. I plan to start the AA change next year when DW’s income ends. But I’ll have to spread it out over several years to reduce a larger one time the higher bracket hit - risking it all happening during a significant market correction (and involuntary AA change).

And yes, I didn’t get in this fix overnight, hindsight is a wonderful thing? I have sold off some equity funds for fixed income, but nowhere near enough to offset appreciation - first world problems...

 

[audreyh1]

Unfortunately that’s where we are, to be exact we’re at 59% and would rather be at 50% equity. I plan to start the AA change next year when DW’s income ends. But I’ll have to spread it out over several years to reduce a larger one time the higher bracket hit - risking it all happening during a significant market correction (and involuntary AA change).

And yes, I didn’t get in this fix overnight, hindsight is a wonderful thing? I have sold off some equity funds for fixed income, but nowhere near enough to offset appreciation - first world problems...

OK - that's different. That's not rebalancing. That's changing the asset allocation.

One way to reduce the tax impact is to make the change gradually.

But it you are concerned about market valuation, then taking the tax hit at once or spread over Dec and Jan seems like a small insurance to pay.

And it's not like you are paying 15% on the whole amount - just on the unrealized gains. You can also reduce it by selling your highest cost shares first.

You can also look at whether gifting appreciated shares to a DAF or a charity might be an alternative to cash you usually contribute to charity.

 

[Sunset]

Unfortunately that’s where we are, to be exact we’re at 59% and would rather be at 50% equity. I plan to start the AA change next year when DW’s income ends. But I’ll have to spread it out over several years to reduce a larger one time the higher bracket hit - risking it all happening during a significant market correction (and involuntary AA change).

And yes, I didn’t get in this fix overnight, hindsight is a wonderful thing? I have sold off some equity funds for fixed income, but nowhere near enough to offset appreciation - first world problems...

We are holding off, a little bit taking large CG, for the extra reason of being in IL, (like OP).
I'd rather be in a State without income tax, than give 5% to IL on top of whatever the Feds get.

 

[RunningBum]

Unfortunately that’s where we are, to be exact we’re at 59% and would rather be at 50% equity. I plan to start the AA change next year when DW’s income ends. But I’ll have to spread it out over several years to reduce a larger one time the higher bracket hit - risking it all happening during a significant market correction (and involuntary AA change).

What higher bracket are we talking about here? Like we've pointed out, LTCGs are changing your base tax rates from 12% to 22%, for example.

And what's this risk you are talking about? Is it doing the full adjustment today, and then having a big market correction which puts you under 50% equity? Because that's not really a problem. If a market correction is going to happen, you actually want to be selling all the extra stock now and taking the profit, rather than letting a correction balance things out for you. If you fall under 50%, that becomes a buying opportunity through rebalancing. Remember--sell high, buy low.

Say a 20% correction is coming. Compare a full AA adjustment today vs. only going about 10% before the correction comes. If you have $1M at 59/41 today with 50/50 desired:

Today 590K/410K

Full adjustment 500K/500K
20% correction 400K/500K = $900K total
You might adjust that back to 450K/450K, still $900K total

Partial adjustment 580K/420K
20% correction 464K/420K = $884K total--$16K worse.
and you are still a bit off, so you may or may not adjust to 442K/442K.

 

[MichaelB]

If the tax impact is a couple of brackets it may also affect Medicare IRMAA. Just one more variable to consider.

 

[audreyh1]

If the tax impact is a couple of brackets it may also affect Medicare IRMAA. Just one more variable to consider.

I think we are trying to explain that the tax impact shouldn't be a couple of ordinary income brackets and capital gains do not affect ordinary income tax brackets.

However, it definitely can affect your Medicare IRMAA.

Is it better so see things go poof instead?

 

[Another Reader]

I have a different perspective than most people here. I'm not really a total return investor. I prefer to invest for income. I will never rely on liquidating an asset base to eat. That's above my acceptable risk level.

One of my objectives is to minimize taxes. I try not to sell anything in taxable paper asset accounts unless it is a dud with a loss. I buy for the long term. I buy whatever asset class that I want to own when it is on sale and I have the money. Over time, there is some rebalancing effect by buying what's on sale. However, I don't own much in corporate bonds, except through the W funds that are in IRA's. Most of the rebalancing is among equities, real estate and treasuries.

A large percentage of my investments are in real estate. Income and favorable tax treatment are the objectives, although I have sold when there it made sense and had minimal tax consequences. When I sell, I usually try to enhance the remaining income by paying off mortgages.

I had substantial income and sold two of the weaker properties in 2017. My 2017 federal taxes? Zero.

 

[kite_rider]

Another way to look at it, do you want to be taxed 15% on gains while stocks are high, pocketing 85%, or do you want to have no tax liability but watch stocks sink back without putting any profits in your pocket? I'll take the 85% and not worry about paying the 15% tax. Of course stocks could keep going up and up but your question is about tax and rebalancing, not whether you are giving up potentially more gains by rebalancing.

This was a good response and I really try to take the last paragraph (quoted above) to heart. However, depending on where you live; keeping 85% is really just a pipe dream. Where I live I get to add a 9% state income tax to this and don't forget that the larger MAGI also phases out a large number of tax credits and deductions.

So as a stock picker and market timer (which usually doesn't make me popular on this forum); I have to weigh a near 25-30% tax hit when considering a re-balancing or shift in AA.

My advice to the OP, take the tax hit and consider yourself fortunate...

 

[hesperus]

So how do others keep accepting tax consequences in proper perspective? What role should taxes play in rebalancing/investing?

I have often teetered between decisions based purely on tax implications or making the best decision for strictly investment purposes. Our allocation is in the range I'm comfortable with at 65% equities, but in 2018 I finally decided to eliminate quite a few individual stock holdings that I inherited in the taxable portion of our portfolio. I have been slowly doing this for years, but until now had held up on selling the big positions that had the highest gains. I saw how these positions were adversely affecting returns when I did some comparison modeling, so I was ready to make the change.
So, this year we bit the bullet and liquidated the remainder of these individual stocks, ($575K proceeds with about $250K in realized gains) and moved that into a Dimensional Fund equity fund. It was essentially a trade off, equities for equities, but now that money is in a much more diversified fund that I am much more comfortable with. This was a move that I had avoided almost entirely for tax purposes, but I realized it was affecting the overall performance of the portfolio. The portfolio wasn't performing like a portfolio with 65% equities should. Tax time will certainly be a hit, but I realized in the long run it was a move that I wanted to make. There was no market timing interests at work here.

 

[audreyh1]

And other times it will hurt, and we can't know in advance.

In a long, steady bull, re-balancing has you selling stocks along the way, missing some of those gains.

This link to www.portfoliovisualizer.com for SEPT2008-SEPT2018 shows a slight advantage to no re-balancing with a 60/40 (select/de-select the rebalance tab to compare).

https://goo.gl/BpkUpm


Edit/add: I went back to the JAN2000-JAN2010 time-frame you offered up, and I found re-balancing made almost no difference, and the delta was actually slightly negative for re-balancing:

https://goo.gl/uUxvch

Further edit/add: And the type of re-balancing made a difference too. Quarterly, Semi-Annual and Monthly did progressively worse. With a starting balance of $100,000:

No-REBAL ends @ $125,292
Monthly ends @ $121,139

What are you seeing?


-ERD50

OK - you were right for that time period - not a large difference. Jan 1 2000 to Dec 31 2009 the annual rebalancing does slightly better $133,216 versus $130,407 for rebalancing and with slightly higher volatility. Over that period of time your AA in the non-rebalancing case must be going all over the map. Jan 1 2008 to Dec 31 2017 shows $201,532 for rebalancing versus $195,144 for no rebalancing in spite of most of the later years being a strong rising equity market overall.

The portfolio survival models we use to select a target AA and safe withdrawal rate are based on annual rebalancing. When you select a target AA you are choosing an annual volatility you think you can live with versus the long-term return tradeoff of maintaining that asset allocation. You are really comparing that against a different AA - preferring 60% stocks versus say 80% stocks or 100% stocks.

And then there is the issue of annual withdrawals. You have to take them from some asset. If not rebalancing, what do you do?

In terms of rebalancing frequency - you need some time for assets to diverge. Some studies have shown that more frequent rebalancing than annual doesn't provide any benefit. In fact for taxable accounts, 18 months is the better timing, but that's really not practical for someone withdrawing from a portfolio annually.

Bogle was not a fan of rebalancing, preferring to buy and hold and just let the equities ride as over the very long run, the rising equity allocation should boost the return. This is certainly understandable in accumulation phase. I was mostly stocks anyway. But many folks panic if their equities get hit hard, seeing many years of gains go poof, and unfortunately some of them bail. For these folks maintaining some asset allocation they can live with is wise.

 

[pb4uski]

Unfortunately that’s where we are, to be exact we’re at 59% and would rather be at 50% equity. I plan to start the AA change next year when DW’s income ends. But I’ll have to spread it out over several years to reduce a larger one time the higher bracket hit - risking it all happening during a significant market correction (and involuntary AA change).

And yes, I didn’t get in this fix overnight, hindsight is a wonderful thing? I have sold off some equity funds for fixed income, but nowhere near enough to offset appreciation - first world problems...

Assuming that you have 9% in tax-deferred accounts in equities, couldn't you just sell them and buy bonds in tax-deferred accounts to get from 59/41 to 50/50?

I have substantial capital gains in our taxable accounts (gains are ~50% of balances) but rebalancing is no problem because I rebalance in my tax-deferred accounts.

Since we are currently living on taxable account funds we have some gains each year as I sell taxable account equities to raise case for livlng expenes, but since I manage our income to top of the 12% tax bracket those LTCG are tax-free.

 

[Midpack]

Assuming that you have 9% in tax-deferred accounts in equities, couldn't you just sell them and buy bonds in tax-deferred accounts to get from 59/41 to 50/50?

Nope. Our tax deferred accounts are 100% fixed income and a REIT, that’s always been a factor in our chosen AA. Until recently our taxable accounts were mostly equity funds (for tax efficiency), but I had to sell equity funds and buy munis to avoid an even higher equity AA. We’ve also let our cash allocation increase like never before. But as others have said, there’s probably no way around paying more 15% LTCG than I’d like...

 

[pb4uski]

I guess that I would swap the REIT for fixed income since the REIT is equity-like... that would drift you towards 50/50.

Do you have any Roths? If so you could swap equity for fixed income there.

But it sounds like you only have taxable and tax-deferred... in which case it sounds like you are stuck. Still 15% isn't really that bad.

 

[TwoByFour]

I've seen studies that show re-balancing to be over-rated. It helps in some cases, hurts in others. I view it as pretty much a wash, I don't worry about it too much.
-ERD50

Depends on what you mean by "helps in some cases". If you are trying to maximize return, then I agree, rebalancing is iffy for that purpose. But for me, I rebalance to maintain a fairly constant risk profile and I think it works well for that purpose. I certainly sleep well at night.

As to the tax consequence of rebalancing - I have taxes in the back of my mind but rarely do they have an impact on what I do. The main tax effect for me would be capital gains and that does not affect my tax bracket anyway, and I am too far removed from AMT to worry about that. I do keep an eye out for opportunities to tax-loss-harvest though.

 

[Midpack]

As to the tax consequence of rebalancing - I have taxes in the back of my mind but rarely do they have an impact on what I do. The main tax effect for me would be capital gains and that does not affect my tax bracket anyway, and I am too far removed from AMT to worry about that. I do keep an eye out for opportunities to tax-loss-harvest though.

I can't remember the last time I sold any fund without taking the opportunity to pair it with a loss (though not a complete offset), has to be more than 20 years ago. That'll be relatively new for me too...

 

[TwoByFour]

Last week was a good opportunity to TLH any bond funds you have. Most of them took a pretty good hit downward.

 

[audreyh1]

As to the tax consequence of rebalancing - I have taxes in the back of my mind but rarely do they have an impact on what I do. The main tax effect for me would be capital gains and that does not affect my tax bracket anyway, and I am too far removed from AMT to worry about that. I do keep an eye out for opportunities to tax-loss-harvest though.

Yeah pretty much for us too.
In terms of AMT - in prior years we would be hit every time by AMT simply because our income was mostly qualified dividends and capital gains.

Now, and through 2025, the AMT phaseout threshold has been moved so high ($1M for MFJ) that we are no longer subject to AMT.

I suppose that’s also an advantage of annual rebalancing - you don’t let your AA get so far out of whack that you’re facing a major tax hit down the road when you decide to get back to the original AA.

If I only need to sell say $2K of a fund to rebalance, I usually won’t bother figuring I’m close enough. However, if an asset has outperformed considerably, I do trim it and take the tax hit, and reinvest in the laggard assets.

 

[HI Bill]

Last year, I had Vanguard comlete a retirement plan for myself and my wife. They recommended moving $100K in a taxable account from VUG to buy some bonds, with a resultant $20.6K in capital gains. Since I'm not needing the $ in the next several years or so, I moved money around in different ways (different accounts), slowing moving a little closer to a more traditional AA without incurring taxes. This year, I waited until my short term capital gains were slightly negative in one fund, sold it, and repurchased new ETFs, without incurring any taxes (sell low, buy low, so it's a wash).

Taxes are a certain expense. Potential losses are not. In this case, I saved paying $3K in federal taxes.

Just my 2 cents (how old am I?).