In our last blog, we talked about staying in the market as it hits new all-time highs. A related question on the topic of market advances has to do with rebalancing, one action that we DO recommend. Rebalancing is all about risk control and getting your portfolio back to your target allocation after large market movements. As an example, if your target allocation is 70% equity and a rise in stocks has raised that allocation to 80%, your portfolio is riskier than intended, and you would be harder hit by a stock market decline.
You might say, “that’s all well and good for my tax-deferred accounts like my IRA or 401(k), where I won’t be taxed on any gains if I sell stocks. But what about my taxable accounts? Why should I sell stocks funds that are doing well only to pay capital gains taxes?”
That is a legitimate question that really depends on an individual’s specific situation, but here are some of the things we think about:
- First, are there realized losses that would offset some or all of the gains? The tax loss harvesting we undertake throughout the year is geared to producing realized losses for situations like this. You may also have tax loss carryforwards from prior years.
- Are you making cash contributions to the account? Investing that in bonds would effectively reduce your equity percentage. Adding to an underweight asset class like this is a tax-efficient way to rebalance because you don’t have to sell anything. We employ this technique on a regular basis, especially for clients making systematic contributions.
- What trades would produce the lowest tax impact? There may be specific tax lots with smaller gains or even losses that can be sold to accomplish the rebalancing. If we must take gains, long-term gains (on securities held more than a year) are currently taxed at a lower rate, so we look to sell stocks that are past the one-year holding period.
- What is your individual tax situation in terms of factors like tax bracket, expected income and deductions? If you are near year-end, that could have an impact on when to take the gains—it could make sense to split the gains over two years. On the other hand, there is the potential for a capital gains tax increase next year, so this year might be better for taking gains. This will be something to consider as we wait to learn more about any tax legislation.
- Finally, what would the impact of taking the gains be on your overall long-term financial plan? While paying taxes may be irksome and provoke an emotional response (after all, who likes to pay taxes?), the amount of taxes you pay may be minor in the context of your overall financial life and goals. Your advisor can help you with this.
While we are tax-aware in our investment approach, we don’t want to let the tax tail wag the investment dog–meaning taxes shouldn’t have an undue influence on the basic investment decision. Team Hewins believes maintaining an asset allocation in line with your overall financial goals and risk profile is the primary concern.
Team Hewins, LLC (“Team Hewins”) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training, and no inference to the contrary should be made. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas.