Tax-Efficient Strategies for Rebalancing

Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.

Christine Benz: Hi I'm Christine Benz from Morningstar.com. Investment experts often counsel about the virtues of rebalancing, but doing so can also trigger a tax bill. Joining me to discuss some tax-efficient strategies for rebalancing is Maria Bruno. Maria is head of U.S. wealth planning research at Vanguard, leading a team responsible for conducting research and analysis on a wide range of retirement, wealth planning, and portfolio construction topics.

Maria, thank you so much for being here.

Maria Bruno: Thank you Christine, good to be here.

Benz: Maria, let's talk about rebalancing generally before we get into rebalancing different account types. What are the main benefits of rebalancing?

Bruno: Really, I think it's a good way to start and think about why should you rebalance? Our research shows, and industry supports it as well in that the risk return profile of a portfolio is largely driven by its asset allocation. What happens over time is that the higher performing parts of the portfolio will increase, and while you may have higher return expectations, that comes with higher risk as well.

The question then becomes are you overexposed to that part of the market? It opens the door for regret if you don't rebalance. Rebalancing basically is going back to the target asset allocation selling from your overweight assets and putting the proceeds into your underwight part of the assets. It's really one of the most effective ways to maintain the risk return profile of the portfolio.

Benz: It won't necessarily enhance return, but it seems like its main benefit does come in the realm of risk reduction, especially as we're all getting older over the years. We probably want our portfolios to become a little less volatile, right?

Bruno: Right. It's not from a return enhancement perspective, because really what you're doing there is you're selling the areas of the portfolio that have been performing well. Intuitively that's a difficult decision for an investor to do that, it's emotionally difficult, so it does take a lot of discipline to maintain that profile.

Benz: Let's bring this to the timely because we have a lot of investors who are maybe looking at their portfolio today and wondering, where should I go to do this rebalancing. How would you suggest that they approach it, and what asset classes are likely to be enlarged at this juncture?

Bruno: When you look at the markets as a whole, the markets have been up this year. I think through the end of September, we're probably looking at a 10 plus return on a diversified stock portfolio. In those situations, it probably makes sense to rebalance. I did a little bit of numbers review before chatting with you this morning, Christine, and if we go back and look at the global financial crisis when the market hit the bottom, in March of 2009, if we look up to this point the markets have been up probably over 250%. So, it's a pretty sizable runup.

Now, conceivably investors should be rebalancing along the way. If not, if you look at somebody who is a 60/40 investor, 60% stocks, 40% bonds, they're probably closer to 80/20 today. So, that investor is really overexposed, and when there is a market correction what will happen is they're overexposed--and we saw this during the global financial crisis--they're overexposed during the downturn, and then during the recovery they're underexposed. So, if you rebalance then that helps you be more aligned and much more disciplined along the way.

The question is, well how do you go about doing that? You certainly want to be strategic in how you do that, because when you are moving parts of the portfolio, particularly if they're in taxable accounts, you could be triggering either income taxes or capital gain situation, so you want to be mindful of that.

What I like to encourage investors to do is really look first and foremost at their tax advantaged accounts, be they their 401(k)s, or their IRAs.

Benz: So, set aside those taxable accounts, or certainly don't start there if I have assets in a taxable account.

Bruno: Most investors will have both, a portfolio of tax advantaged accounts, and taxable accounts. Take a look first to see how much are you overweight, and then take a look well where am I holding those securities, and if they're in a tax advantaged account use that as the first place to pare back, because you can do so without triggering income taxes.

So it's almost a "free rebalancing" if you will. And then you can also look--a couple things. One is are you dealing with cash flows? Either are you directing monies into your portfolio? If you are, then direct those proceeds into the underweight asset class. So, for instance if you do need to allocate toward bonds, then put those cash flows toward the bond part of the allocation. Flip side, if you're making withdrawals, then be mindful how you take those withdrawals, because that could also be an opportunity to rebalance the portfolio.

Benz: If you're in retirement and you're going to be pulling from the portfolio anyway, that you should concentrate your withdrawals from those appreciated asset classes.

Bruno: Yes, if you can, that's a great way, Because you're rebalancing the portfolio, you're meeting potentially your required minimum distribution as well, so you're getting a two-fer for there in terms of taking the distribution and doing so as a way to rebalance. That could help minimize any tweaks that you need to make in your nonretirement accounts that could trigger taxes.

Benz: People who are charitably inclined also have the opportunity to maybe knit their giving in with rebalancing. Let's talk about that.

Bruno: Oh, you know that's a good point, because if you are making moves within your taxable part of the portfolio, there's a couple ways. One could be if you need to liquidate assets, basically do some rebalancing, take a look at your cost basis, and see if there's high basis shares that you can sell. That'll help minimize the liability. Tax loss harvesting, potentially. Maybe investors aren't really seeing that this year, because of-

Benz: Maybe individual stock investors can find.

Bruno: Yeah. Maybe you might. There may be a couple there, right? So you can offset some of that, potentially. It gives some flexibility in certain situations. The other is if you're charitably inclined, you actually could benefit from giving assets that have low basis, meaning high gains. If you're charitably inclined, what happens is if you donate appreciated assets, the charity gets the benefit of the full amount, but you as a taxpayer get to offload those low basis shares. So, you get the value of the tax deduction, but then you also basically are, for lack of better terms, wiping out those gains. It's beneficial both for the charity but also for you as an individual.

The other thing too is if you're gifting to family members, for instance--2018 there's the annual gift exclusion, it's $15,000 per individual, per donee--for instance, if you might have parents how might be gifting shares to children who might be in a lower tax bracket, you could also be mindful to gift to those low-basis shares as well.

Benz: One point I always like to make on that $15,000 amount, if you happen to exceed that amount that you give to someone, you're not automatically subject to gift tax, right?

Bruno: Oh, no. We have lifetime exclusion, and what that does is potentially, if you gift in a particular year greater than the annual exclusion amount, you may consume some of that lifetime exclusion.

Benz: Good to know. Maria, interesting and timely topic. Thank you so much for being here.

Bruno: Thank you Christine.

Benz: Thanks for watching, I'm Christine Benz from Morningstar.com.