Six ways to rebalance your clients’ portfolios tax-efficiently
Helping your clients weather market cycles and enjoy better risk-adjusted results takes a planned approach. It includes a thorough evaluation of how the timing and execution of rebalancing may affect their portfolios and generate tax consequences.
Part of a solid rebalancing plan is to decide whether to rebalance on a periodic basis, or as the result of passing certain thresholds in drift, keeping in mind some tax-efficient methods to rebalance.
Here are six tactics for rebalancing a portfolio in a more tax-efficient way:
1. Start with tax-advantaged accounts
One place to begin is rebalancing your clients’ tax-advantaged accounts. The benefit of this approach is that any rebalancing trades are tax-exempt at the time they are made. This avoids immediate tax consequences that may be beneficial in periods of high income.
You will find this opportunity easiest to implement if your clients have a mix of asset classes in their accounts. Roth accounts can be particularly advantageous since portions of the Roth can be distributed tax-exempt at any time (up to principal) and enjoy tax-advantaged distribution rules.
2. Re-direct cash flows in taxable accounts
With taxable accounts, one way to rebalance is by directing new purchases and reinvested distributions into underweighted asset classes. For example, when a portfolio with a target allocation of 50% stocks and 50% bonds has drifted beyond the plan’s target allocation threshold, it might make sense to add new contributions or reinvest dividends to the underweighted side until the portfolio is back at the target allocation. Conversely, when taking a withdrawal, it might make sense to draw down from an overweight asset class.
For your clients taking the required minimum distribution from their retirement account(s), but who don’t need the distribution for daily living expenses, those assets can also be reinvested to increase the allocations to an underweighted asset class in nonretirement accounts.
3. Consider cost basis
When rebalancing, look for opportunities to harvest losses or manage cost basis across holdings in your clients’ portfolios. Understanding their current and future expected income can help evaluate which shares to sell or which accounting method is most advantageous. In comparatively low-income years, you may want to sell lower-basis shares. In comparatively high-income years, it might make sense to sell higher-basis shares. If income is relatively stable year over year, an average accounting method may be the right answer. An average accounting method is easy to use but could limit some tax-planning strategies because clients are locked into this method for all shares they own until a new method is chosen. If a household’s income generally has peaks and valleys, watching cost basis may help control taxes in the long run.
4. Explore charitable giving and annual gifting
You may want to consider rebalancing opportunities when your clients are deciding how and what to gift. It might make sense to gift shares of overweighted holdings with a low-cost basis in a taxable account directly to the desired charity or beneficiary. For example, when gifting to a beneficiary in a lower marginal tax bracket, consider evaluating options to gift shares in-kind rather than to gift cash. This strategy might also make sense when gifting to a charity. Additionally, charitably inclined clients may focus their rebalancing in an IRAs and use the proceeds to fund a qualified charitable distributions (QCDs).
5. Keep in mind the timing of fund distributions when rebalancing near year-end
It’s all about timing. When rebalancing, it might make sense to sell before a distribution to avoid the taxes on that distribution. Conversely, buying right before a distribution may have its own tax and income implications.
6. Use rebalancing to improve the tax efficiency of the portfolio
Many portfolios were originally built based on priorities other than tax efficiency. Take advantage of rebalancing opportunities to shift the portfolio into more tax-efficient options, such as exchange-traded funds, passive investments, or other low-turnover options.