Sam Swenson, CFA, CPA| The Motley Fool
Thanks to the the red-hot stock market we've enjoyed over the past several months, there's a good chance your portfolio is up from a year ago. This also means you'll probably owe some amount of capital gains tax this coming tax season if you were to sell any or all of your investments before the year is out.
Below, we'll discuss rebalancing and how to avoid any pesky tax charges in the process.
What is rebalancing?
Rebalancing means bringing your investments back to your original asset allocation. For example, if you started the year with a portfolio comprising 60% stocks and 40% bonds, you might now be staring at a portfolio made up of 70% stocks and 30% bonds. This is mostly due to the stock market's outperformance this year – as of this writing, the S&P 500 is about 25% higher than a year ago.
To adjust for the increased risk in your portfolio, you might want to rebalance to bring your portfolio back in line with your original risk exposure. In this example, you'd sell a portion of the stock position and add the proceeds to the bond position, thereby bringing the risk of your portfolio back to where it was at the beginning of the year.
This is a fancy way of saying that you should consider taking some chips off the table.
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1. Do all your rebalancing in tax-advantaged accounts
When you trade in a taxable brokerage account, you'll be on the hook for capital gains tax if you sell an investment that's gone up in value since you purchased it. Gains on investments held longer than a year will enjoy favorable long-term capital-gains tax treatment, while gains on investments held less than a year will be taxed at higher, ordinary-income rates. If you were to rebalance your portfolio in a taxable account, you'd be leaving yourself open to a higher-than-expected tax bill come next April.
If you do your rebalancing in a tax-deferred account, like a pre-tax 401(k)or even a tax-exempt account like a Roth IRA, you'd steer clear of any tax whatsoever. This is because these retirement accounts are subject to special rules that allow you to avoid taxation once money is in the account. In the case of a traditional, pre-tax 401(k), you won't pay tax until money is withdrawn in retirement, so you can trade to your heart's content without the threat of any extra tax charges.
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2. Use capital losses to offset capital gains
This is also known as tax-loss harvesting. If you sell a winning investment and lock in a capital gain of $2,000, you can realize a $2,000 capital loss in another investment, and the two transactions will net to zero on your tax return. This only works for assets in a taxable account, but it might be one way for you to avoid paying any tax if you choose to rebalance before the new year.
While this may be more difficult to do in a year when the market has gone up 25%, you can rebalance quite effectively by simply making the most of your capital losses. What's more, you can actuallyreduce your adjusted gross income by up to $3,000 if your capital losses exceed your capital gains. Depending on the size of your losses, it might be a good time to clean them up before the tax year is over.
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3. Use new contributions to get your portfolio in line
Assuming you're continuously adding money to your portfolio, you can simply force new contributions into the asset class that's currently underweight. Continuing the above example, imagine again that your portfolio has drifted from 60% stocks and 40% bonds to a 70/30 portfolio following a year of market outperformance.
One strategy is simply to add any new contributions to the bond side of the portfolio until it falls back into balance with your original asset allocation. This may mean using the next few pay periods to manually buy bonds or other conservative investments. But critically, it's a tax-advantageous way to get your portfolio back in line while simultaneously avoiding any tax or other transaction costs.
Plan before you rebalance
If you've done well in the stock market this year, you have a lot to be proud of – especially if you've been able to stomach the unpredictable highs and lows. Try to make the most of your capital gains by keeping them and not handing them straight to the IRS. Know the tax consequences of your trading behavior, create a rebalancing plan, and be willing to stick to it.
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