Rebalancing Your Portfolio in a Tax-Smart Way

Don’t treat your portfolio like a casino.

Riding a winning streak is tempting but hazardous. Now’s the time to reduce risk and bring your portfolio in line with your long-term asset allocation.

Since March 2009, the U.S. stock market has shot up roughly 150%. A conservative investor with an appropriate 50-50 split between equities and fixed income in 2009 might have a 75-25 split now without any rebalancing in the interim

Eventually we are going to have a bear market. But, when, I have no idea — and don’t believe anyone who claims to know. The only way to be prepared for the inevitable downturn, whenever it happens, is maintaining an asset allocation that you can live with in a bear market.

First, calculate your current allocation. Next, define your ideal asset allocation. If you can’t figure that out or need help with sticking to it, consult a certified financial planner.

Tax-smart rebalancing

If it turns out you are too heavy in equities, sell the right amount and invest the proceeds in high-quality, short-term bond funds. But selling without a tax strategy could result in higher taxes than necessary.

Some people can rebalance without any tax impact. Look for opportunities to sell overweight positions in your IRAs and 401(k) before realizing gains in taxable accounts. If you can't make all your trades in retirement accounts, you'll need a good strategy to minimize taxes.

First, sell losing investments, if any, to offset your gains. Don’t limit yourself to equities.

If you bought long- or intermediate-term bond funds recently, you may be surprised at the unrealized losses in your account. You can harvest tax losses by selling these funds before year-end.

Consider selling some winners now and some in January. That way, you’ll defer paying the tax for a year on some of your gains.

Spreading out gains over two years also reduces the chance that your marginal tax rate will increase. Given the new Medicare and investment income taxes for high earners, tax planning is even more important.

Look carefully at your bond investments. Despite recent increases, rates are still near historic lows. Long- and intermediate-term bond funds are vulnerable should rates go back up.

Sell such funds and low-quality funds (like junk funds and convertible bond funds) and buy short-term funds that invest in high-quality taxable or tax-free bonds that mature in less than a year.

These funds produced a slight positive return this year to date despite rate increases and are well positioned to withstand rising rates in the future.

Paul Jacobs, CFP, is chief investment officer of Palisades Hudson Financial Group, a fee-only financial planning firm and investment advisor with more than $1.2 billion under management. He can be reached at paul@palisadeshudson.com He is based in Palisades Hudson’s Atlanta office; the firm is headquartered in Scarsdale, N.Y.

Palisades Hudson offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, Fla., and Portland, Ore.