You’ve heard the exhortation from me and countless others: Nearly 11 years into stocks’ current rally, most hands-off investors are overdue to prune their appreciated equity holdings.
That’s because inertia has rewarded them with higher equity weightings--and arguably higher risk. A hands-off portfolio that was 60% U.S. equity/40% bond when stocks began to rally in early March 2009 would be 85% equity today. De-risking is especially important for people who are within 10 years of retirement because a too-heavy equity weighting can leave their retirement plans vulnerable if an equity shock occurs early in their retirements.
Yet suggesting rebalancing is simple. Implementing a rebalancing plan is less so, largely because it entails selling appreciated securities, which may trigger a tax bill unless you're careful. If you know you need to take action to correct an imbalance in your portfolio, here are some tax-efficient ways to go about doing so.
Strategy 1: Start with tax-sheltered accounts. This is the dead-obvious starting point if you need to trim appreciated positions in your portfolio. In contrast with your taxable accounts, where selling appreciated securities often triggers a tax bill, you won't owe taxes on any repositioning you do within your tax-sheltered account, provided all the funds stay inside the account. It's not as though the IRS is keeping a tally of your sales of appreciated winners inside those accounts. Instead, the taxes you owe will depend on your account's value at the time you pull the money out, and in the case of Roth accounts, you won't owe any taxes at all on qualified withdrawals in retirement. That means for investors with most of their wealth in IRAs, 401(k)s, and other tax-advantaged vehicles, scaling back on appreciated positions and steering those proceeds to positions that haven't performed as well won't trigger any tax costs at all. This rebalancing strategy should be the first line of defense in most situations.
Strategy 2: Let withdrawals do some of the work. If you're retired and in the mode where you're withdrawing assets from your tax-sheltered accounts--for example, you're post age 70 1/2 and taking RMDs--one of the simplest ways to correct portfolio imbalances is to concentrate those withdrawals on appreciated positions. After all, your taxes on those distributions are what they are, so you might as well take advantage of the opportunity to improve your portfolio's risk/reward profile at the same time. Of course, your distribution amount may not be enough to get your portfolio's asset allocation in line with where you think it should be. But if it isn't sufficient, you can still rebalance the holdings that remain as described above.
As with any RMD, you can be deliberate about which securities you prune; there’s nothing saying that you need to give all of your holdings a haircut, as long as you take the right RMD amount from your IRAs overall. For example, a retiree whose overall equity exposure is higher than he would like can raise the funds for the RMD by paring back the most highly appreciated holdings that likely need a trim because of valuation considerations.
Strategy 3: Employ a Qualified Charitable Distribution. A related strategy if you're older than age 70 1/2 and own accounts that are subject to required minimum distributions is to take advantage of a qualified charitable distribution. Using this strategy, you can steer your RMD from your IRA, up to $100,000, into the charity or charities of your choice. (RMDs from company retirement plans aren't eligible for the QCD.) The QCD amounts don't affect your taxable income as would an RMD that you took and spent or reinvested. From a tax standpoint, it is as though you didn't take your RMD at all, even though you've fulfilled your obligation to the IRS. The QCD is particularly compelling given the current, higher standard deduction amounts. That's because many fewer taxpayers will benefit from itemized deductions, including charitable contributions, than in the past.
The QCD delivers a “four-fer" from a tax- and portfolio-planning perspective. First, you’ll fulfill your RMD obligation to the IRS, and you may even lower your tax bill. You’ll also be able to help a charity you believe in, and if you pull from the holdings that you wanted to trim anyway, the QCD can help improve your portfolio.
Strategy 4: Use new contributions to correct imbalances. If your taxable accounts are out of balance, you have fewer levers for correcting that issue in a tax-efficient way than you have with tax-sheltered accounts. The simplest, most tax-efficient way to rebalance your taxable accounts is to simply stop contributing to the highly appreciated positions (assuming you're contributing to them via a dollar-cost averaging plan) and contribute new dollars only to the underweight positions. The big drawback to this strategy, of course, is that if you've been investing in the taxable account for a long time and have built up a sizable sum, it could take a while for your new contributions to the underweighted positions to meaningfully affect your total portfolio's asset allocation.
Strategy 5: Reinvest dividend or capital gains distributions into underweight positions. Another way to correct portfolio imbalances tax-efficiently--or at least to not add to your tax bill--is to not reinvest dividends and capital gains back into the overweight holdings that are making the distributions. Instead, you can direct the amount of the distributions into holdings you'd rather add to, effectively using the distributions to correct your portfolio's positioning. This can be a particularly effective strategy for rebalancing if a holding that you'd like to lighten up on is about to make a big capital gains distribution. Just act quickly; capital gains distributions are coming fast and furiously in December.
Strategy 6: Donate appreciated securities from your taxable account to charity. If you're charitably inclined but too young to take advantage of the QCD discussed above, you can still use charitable contributions of holdings in your taxable account to improve your portfolio's overall positioning. For example, perhaps your taxable portfolio is too equity-heavy overall, and it's also concentrated in a handful of holdings. (Employer stock is a common culprit.) By tying in your taxable investment portfolio with your "bunched" charitable gifts, you can achieve multiple goals: You can reduce problem spots in your portfolio, eliminate the tax burden associated with those appreciated holdings, and of course make charitable gifts. You may even be able to deduct your contribution, provided your total charitable and other itemized deductions exceed the standard deduction amount.
The key to making this strategy benefit you, taxwise, is to go big. You’ll still be able to remove the capital gains obligation from your portfolio regardless of how much you donate, but if you want the contribution to be deductible, you need your total deductible expenses to be greater than the standard deduction. (In 2019, that’s $12,200 for single filers and $24,400 for married couples filing jointly.) Given that exceeding the standard deduction is the name of the game, if you’re charitably inclined you may benefit from bunching your charitable contributions together into a single year in which you itemize rather than making smaller charitable contributions over several years.
To take advantage of this strategy, you would donate the appreciated shares directly to charity or, alternatively, use a donor-advised fund. This can be a sensible way to lighten up on highly appreciated positions that are adding risk to your portfolio.
Strategy 7: Harvest tax gains in the 0% capital gains bracket. Tax-gain harvesting is another strategy to consider if you find yourself in a year when your taxable income is at a low ebb, either in 2019 or beyond. That's because there's currently a 0% tax rate in place for single filers with taxable incomes below $39,375 or married couples filing jointly with taxable incomes of less than $78,750. That provides such investors with the opportunity to reduce highly appreciated or otherwise problematic positions with no tax costs, provided their total taxable incomes, including the capital gains on the sale of the security, don't exceed the above thresholds.
In addition to not increasing their tax burdens in a given year, so-called tax-gain harvesting may prove especially advantageous for such investors if their tax brackets increase down the line. That’s because they’ve effectively washed out the taxes due on the appreciated securities by selling at a time when doing so didn’t entail tax costs. If they deploy the funds into another position in their portfolios (or even reinvest in the same holdings they sold), they’ve reset their cost basis to today’s higher levels. If they eventually bust out of the 0% bracket and owe capital gains taxes, their tax burden will be calculated off of the new, higher cost basis.