One Simple Trick to Get the Best Tax Benefit From Your Retirement Portfolio


The most basic strategy for long-term investing is asset allocation. But keeping to an allocation means rebalancing your portfolio, and rebalancing is fraught with complications — one big one being the tax implications of the sales you need to make. A simple trick can help you deal with that issue, but first let's take a closer look at asset allocation and rebalancing. (See also: The Best Asset Allocation for Your Portfolio)

What Is Asset Allocation?

The idea of asset allocation is to spread your investments among various categories (stocks, bonds, cash, gold, real estate, etc.), with the percentages in each category chosen to balance your desire for return and willingness to take risk.

There are a lot of rules of thumb for asset allocation.

Spreading Your Wealth Around

One simple one is to set the stock fraction of your portfolio equal to 100 minus your age — so a 24-year-old would go with a portfolio of 76% stocks with the rest in bonds. Each year the portfolio gets a little more conservative, gradually shifting to only 35% stocks by age 65.

An asset allocation championed by financial writer Harry Browne was a simple 25% each divided among stocks, bonds, gold, and cash.

Many financial writers and advisors have model asset allocations. There is, of course, no way to know what asset allocation will turn out to be the best (until the future arrives, and it turns out that an asset allocation of 100% in whatever went up the most would have been best).

My own sense is that any reasonably well-diversified portfolio will be okay: Just pick one. Sticking to an asset allocation means that you automatically avoid the error of putting all your money into whatever last year's hot investment was. (See also: How to Know if a Company Is Worth Your Investment)

What Is Rebalancing?

Because investment prices are constantly changing, your portfolio will almost immediately be out of balance. If stocks have gone up, the percentage of your portfolio invested in stocks will be above the target level. Rebalancing is the process of getting each category of your portfolio back to its target percentage. (See also: 7 Online Investing Tools and Apps)

In theory, rebalancing is easy:

  1. Calculate your total assets.
  2. Apply your target percentages to figure out how much money you should have in each category.
  3. In any category that's over its allocation, sell enough to bring the category down to the target.
  4. Use the money from those sales to buy the appropriate amount in each category that was under it's percentage.

In practice, rebalancing is trickier than that, for several reasons.

Rebalancing Complications

The first issue with rebalancing is deciding how often to do it. You could do it every day — or even every second — selling a little of anything that had gone up a penny and buying whatever had gone down a penny, but that much churning would just add complexity and expense to no particular benefit. The general consensus is that annual rebalancing is about right, but you could make the case that doing it monthly or quarterly would be better.

The second issue with rebalancing is procrastination. There's just natural inertia — it's one more thing to do, but one that doesn't have a real deadline, so it gets put off until later. (See also: 10 Ways to Stop Procrastinating)

There's another factor, though, which is that after a year, your portfolio is probably pretty far off from its target percentages — but in what seems like a good way. You'll have more of your winners and less of your losers, and who doesn't want that? Selling your winners is always tough, and buying the laggards even tougher.

Those are both real issues, but this post is about the third issue with rebalancing, which is taxes.

Tax-Efficiency in Rebalancing

Besides the issue of it just being tough to let your winners go, rebalancing also raises the issue of capital gains taxes. All those sales of winners incur tax liabilities. (Worse, since you're not selling the losers, you don't even have any losses to offset your gains.)

Rebalance Via Contributions Rather Than Sales

There's one basic trick to ameliorate this issue, which works pretty well: Use your contributions to rebalance your portfolio. Instead of dividing your contributions up the same as your target percentages, divide them up so as to move your portfolio closer toward balance.

The calculations can get complicated if you let them — but you don't need to let them.

If you make contributions frequently, and especially if a single contribution isn't big enough to bring your portfolio entirely back into balance, you can do it the easiest possible way: Figure out which category is the most dollars below its target, and put your whole contribution into that one category. Do the calculation afresh for the each contribution, and your portfolio will stay reasonably close to your desired asset allocation.

The same thing can work when you leave the contribution phase of your life and move into the draw-down phase: Use your withdrawals to move your portfolio back into balance by selling from whatever category is the most dollars over its target.

Rebalancing by targeting your contributions works very well, especially in the early phases of building your portfolio, when each month's contribution is large compared to the size of your total portfolio.

After ten or twenty years, your portfolio (we very much hope) will be large compared to each month's contribution, and it will drift from your target asset allocation faster than targeting your contributions can bring it back in line. This is somewhat eased by the fact that you'll probably be able to make larger contributions as you progress along in your career, but eventually market volatility will almost certainly force you to going back to plan A: Sell things that have gone up and buy things that have gone down. But a careful application of rebalancing with your contributions will minimize the amount you have to sell — and thereby minimize the amount of capital gains taxes you incur. (Clever use of tax-advantaged accounts, like IRAs and 401(k)s, will also help.)

Do you look after your retirement funds via asset allocation? What tricks do you use to keep everything in balance?

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