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In the world of investing, the mantra “buy low, sell high” is not just a catchy phrase but a foundational strategy for wealth accumulation.
Yet, when it comes to the disciplined approach of portfolio rebalancing, investors often find themselves in a conundrum, particularly with the necessity of realizing capital gains.
Rebalancing, the process of realigning the weightings of a portfolio of assets, is critical for maintaining desired risk levels and investment outcomes. However, it often involves selling assets that have appreciated in value, thereby incurring capital gains taxes, a scenario many investors are loath to face.
But it’s also a pill that investors need to start preparing to swallow.
In this episode, I’m going to explain exactly what I’m seeing that makes me say that. Then I’ll be exploring the tradeoffs between taking capital gains and rebalancing your portfolio, which is considered an essential part of portfolio management.
Finally, I’ll conclude with strategies that help minimize the tax impact of regular rebalancing.
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How Recent Tax Loss Harvesting Contributed to Today’s Rebalancing Dilemma
To understand why rebalancing is going to result in capital gains for a lot of investors in the relatively near term, we must understand another portfolio management strategy: tax loss harvesting
Tax loss harvesting is a proactive measure to reduce overall tax liability and improve the after-tax return of a portfolio by selling securities at a loss to offset a current or future capital gains tax liability.
The process involves realizing a loss in one security and replacing the position with a security that has similar (if not nearly identical) exposure.
When done effectively, tax loss harvesting doesn’t really change anything about the makeup of your portfolio, but you walk away from the transactions with capital losses you can use to neutralize the taxes owed on gains from other investments.
This strategy is relevant to this conversation because the bear markets in 2020 and 2022 presented investors with a ton of tax loss harvesting opportunities. And if you were prudently harvesting those losses, that means a good amount of the proceeds from those sales got reinvested at low points in the market.
Fast forward to the present, the stock market (particularly U.S. stock market) has delivered very high returns since those bear market lows—and those positions taken as a result of tax loss harvesting trades now have large capital gain liabilities. Which brings us back to rebalancing and here’s what I’m seeing…
As of this recording, Plancorp manages $6.5 billion for roughly 1600 clients across the U.S. Every single day, our Portfolio Management Team looks at every single portfolio for rebalancing and tax loss harvesting opportunities.
What I see when reviewing our team’s reports is that equity weightings are generally above their target asset allocation, with the U.S. portion of the portfolio the most overweight. Not only do I see this across our client base, but I’m also seeing it in the investment statements of prospective clients as well as foundations where I’m a board member or Investment Committee member.
That suggests to me that anyone listening with a long-term, strategic asset allocation is in a similar position and ought to consider rebalancing.
See – EP.9: The Best Way to Rebalance Your Portfolio
The Imperative of Portfolio Rebalancing
Decades of financial research have overwhelmingly shown that asset allocation is the primary driver of differences in returns.
For all the amount of time investors, including myself, spend studying and debating investment strategies, no single choice will have a greater impact on returns than your mix of stocks and bonds.
Ideally your asset allocation is informed by a thoughtfully created financial plan that assumes you are regularly rebalancing, too. That’s because, in many ways, rebalancing is a risk management tool.
Over time, as some investments outperform others, the portfolio may become overweight in certain sectors or asset classes, inadvertently increasing exposure to specific risks contrary to the investor’s original risk tolerance.
Rebalancing helps in mitigating this risk drift by ensuring that the portfolio remains aligned with the investor’s financial goals and risk appetite.
The other potential benefit to rebalancing—although it’s very time period dependent—is that it can enhance returns.
By selling high and buying low, rebalancing forces investors to take profits on high-performers and invest in underperformers, potentially buying undervalued assets that may appreciate in the future. Although this strategy does not guarantee higher returns, it fosters the discipline necessary for long-term investment success.
For the vast majority of U.S. investors, that means selling from US equities where the gains are the biggest, and buying International equities and/or fixed income following a period in which they’ve dramatically underperformed U.S. markets.
And if you have a significant portion of taxable investments, that’s going to mean capital gains taxes.
The Tax Implications of Rebalancing
The necessity to realize capital gains, and thereby incur taxes, can be seen as a stumbling block.
Taxes on capital gains are triggered when an investment is sold for more than its purchase price, and these can significantly eat into the investor’s returns. For long-term investments held for more than a year, the U.S. federal tax rates on capital gains can range from 0% to 20%, depending on the investor’s income, with additional state taxes possibly applicable.
Despite the tax implications, the avoidance of realizing capital gains can lead to a misaligned portfolio, exposing the investor to unintended risks and possibly long-term underperformance. Therefore, investors should view tax considerations as one just factor in the broader context of maintaining a balanced and strategically aligned portfolio.
Strategies to Mitigate Tax Impact of Rebalancing
While the realization of capital gains is a necessary part of portfolio management, there are strategies investors can employ to minimize their tax impact:
- Use of Tax-advantaged Accounts: Whenever possible, rebalancing within tax-advantaged accounts such as IRAs or 401(k)s can avoid immediate tax implications, as transactions within these accounts do not trigger capital gains taxes. The challenge is that eventually you can get less than optimal asset location, which is different than asset allocation. Asset location is placing investments in accounts that maximizes after tax return. For example, you wouldn’t want your Roth IRA to only hold bonds because that is the account you want the most growth. Similarly, over reliance on tax-advantaged accounts can lead to them being all U.S. or all international, which can be disruptive if and when you eventually need the money from these accounts.
- Harvesting Tax Losses: The very strategy that likely has investors with a whole bunch of gains, particularly in U.S. stocks, is the same strategy that can be used to mitigate the tax impact of rebalancing. If you haven’t used the losses taken in 2020 and/or 2022 (and I keep using those years, but obviously an investor could have harvested losses in other recent years), then you can apply those past losses to this year’s gains as well as gains in the future. Some people wait until the end of the year to do tax loss harvesting, but really you should be looking for opportunities all throughout the year because losses often disappear by year end.
- Holding Periods: Holding investments for more than a year ensures that any gains are taxed at the lower long-term capital gains tax rates rather than the higher short-term rates applicable to investments held for less than a year. So all else equal, focus on positions subject to long-term capital gains if possible.
- Gifting Appreciated Securities: Instead of selling appreciated assets, investors might consider gifting them to qualified charities or family members in lower tax brackets. This strategy can avoid capital gains taxes while fulfilling philanthropic goals or aiding in wealth transfer.
- Harvest Losses Inside Separately Managed Accounts (SMAs): More and more people are referring to this as direct indexing, which I covered extensively in EP.95: What is Direct Indexing?. To quickly summarize, using an SMA is like having a mutual fund or ETF for just one person. The benefit from a tax perspective is that the manager can tax loss harvest at the individual security level. So instead of buying a S&P 500 Index fund that you can only tax loss harvest when the entire S&P 500 is down, an SMA tracking the S&P 500 can harvest losses of the holdings within the index whether the entire market is up or down.
- Change Your Allocation: I say this one lightly and really to a specific demographic, namely investors in their 70s or older. In general, investors over the age of 70 who expect to pass on wealth at death often have too conservative of an asset allocation. In reality, a portion of this demographic’s portfolio is really for the next generation who has a longer time horizon, so the asset allocation should reflect that. So while I’m very hesitant to change an asset allocation solely to avoid taxes, my tolerance for the idea increases as investors age. Plus, current tax law says that basis will reset at death, so the incentive to avoid taxes later in life is much higher. One more caveat to what I’m saying, it’s important to stress test your financial plan before making such an adjustment. But most people who are comfortably financially independent and over the age of 70 probably have the ability to take on more risk if they want.
Concluding Thoughts
So while I’m opening the door to a certain demographic for conversations about changing allocations, my overwhelming feeling is that taxes should not negate asset allocation, which is the single largest driver of long-term returns. Because if you start to ignore asset allocation, then you are ignoring your financial plan.
And just like I would tell you to stay the course during a market downturn because it’s been accounted for in your financial plan, I think you should stay the course and rebalance because it’s in your financial plan as well. Taxes are a very important consideration in investment management, but they should only be one of many factors dictating your decisions.
As always, thanks for listening. And until next time, to long-term investing!
Resources:
- EP 95: What Is Direct Indexing?
- EP 9: The Best Way to Rebalance Your Portfolio
- My Firm: Plancorp, A Top Financial Advisory Firm
The Long Term Investor is edited by the team at The Podcast Consultant
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