When investing, it's important to adjust your asset allocation so it continues to align with your goals and risk tolerance, and rebalancing can help you stay on track.
Rebalancing refers to buying and selling assets in your portfolio to maintain the right allocation. For example, if you're targeting a portfolio of 60% stocks and 40% bonds but the stock market surges and 70% of your portfolio is now in stocks, it’s time to sell some stocks.
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The way you rebalance your portfolio will determine how much you pay in taxes. Doing it incorrectly can result in unnecessary expenses, but there are a few rebalancing rules that can maximize your savings.
1. Don’t base it on emotions
Rebalancing should be methodical. Investors who buy and sell due to scary market headlines and sharp corrections risk losing out on long-term growth opportunities and exiting quality positions too early. Having a fixed schedule, such as quarterly or annual portfolio reviews, keeps emotions out of the decision-making process.
You can check in with your current financial situation and assess if your portfolio construction serves your long-term goals. Some retirees can cut back on growth-oriented assets and focus on fixed-income investments to minimize volatility and risk. However, the decision shouldn’t be based on how the stock market has performed over the past month. Long-term financial goals and your risk tolerance are the key variables that should influence how you rebalance your portfolio.
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2. Prioritize tax-advantaged accounts
When rebalancing, make sure you understand what will trigger a taxable event. Rebalancing in tax-advantaged accounts such as 401(k)s and individual retirement accounts (IRA) isn’t taxable, but doing so in a taxable brokerage account can be. If you can — and it aligns with your overall plan — prioritize selling assets in tax-advantaged accounts instead of your brokerage account.
When investors live off their portfolios, it often makes sense for them to strategically withdraw from their traditional 401(k) and IRA plans to spread the tax impact over several years. You can avoid higher tax rates by tapping into your brokerage and Roth accounts when appropriate. Withdrawing some money from your traditional retirement plans in between retirement and collecting your first Social Security payout can also help.
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3. Use dividends
You don’t have to sell the winners in a taxable brokerage account to diversify your holdings. Investors can opt to receive dividends as cash instead of reinvesting dividends into additional shares. People who follow this strategy can then put the dividend income toward underperforming assets in their portfolio.
This strategy lets you rebalance your portfolio without selling your holdings, which may reduce your tax bill.
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4. Use tax-loss harvesting
Tax-loss harvesting is a strategy that entails selling investments at a loss to offset gains elsewhere in your portfolio to potentially lower your tax bill. Tax-loss harvesting is especially popular near the end of the year, when investors will sell losing stocks and buy elsewhere.
Just be careful of the wash-sale rule from the IRS which prohibits you from selling an asset for tax-loss harvesting and then immediately buying the same or a substantially identical security within 30 days before or after that sale. Tax-loss harvesting can be complicated, so consider reaching out to a financial advisor or tax expert to help you with your plan.
