How to Properly Rebalance an Investment Portfolio with Asset Location in Mind
How to Properly Rebalance an Investment Portfolio with Asset Location in Mind
Rebalancing an investment portfolio is a crucial aspect of long-term wealth management. It ensures that your portfolio aligns with your financial goals, risk tolerance, and time horizon. However, effective rebalancing doesn’t only involve adjusting the proportions of different asset classes like stocks, bonds, and cash. A smart rebalance also takes into account asset location—how and where each asset is held, such as in taxable or tax-advantaged accounts. Understanding and utilizing asset location can minimize taxes, maximize after-tax returns, and improve overall investment efficiency.
Here’s a step-by-step guide to rebalancing an investment portfolio with asset location in mind:
1. Understand Asset Allocation and Asset Location
Asset Allocation refers to the distribution of your investments across different asset classes, like equities, fixed income, and cash. A typical strategy might involve 60% stocks and 40% bonds.
Asset Location refers to where those assets are held, such as taxable brokerage accounts, tax-deferred accounts (like IRAs), or tax-free accounts (like Roth IRAs). The goal of asset location is to place investments that generate the highest taxes in tax-advantaged accounts, and those that generate minimal taxes in taxable accounts.
Tax-Advantaged Accounts: These include accounts like 401(k)s, IRAs, and Roth IRAs. The goal is to house investments in these accounts that generate a lot of taxable income (like bonds and dividend-paying stocks) or those with high capital gains.
Taxable Accounts: These are standard brokerage accounts, where you pay taxes on dividends, interest, and capital gains in the year they’re realized. This is where investments with lower tax consequences, such as index funds or tax-efficient stocks, should be placed.
2. Assess Your Current Portfolio
Before diving into rebalancing, take a look at your current portfolio’s allocation and location. Review where each investment is held and categorize them according to the type of account:
In tax-advantaged accounts (e.g., IRA, 401(k)): What kind of assets are held? Are these investments tax-inefficient (like high dividend-paying stocks or bonds)?
In taxable accounts (e.g., brokerage account): Are these investments low tax burden (e.g., broad market index funds, tax-efficient ETFs)?
Also, review the overall asset allocation to ensure it still reflects your desired risk tolerance, financial goals, and investment horizon.
3. Identify Areas of Overweighting or Underweighting
Once you’ve categorized your assets, check if you’re overweighting or underweighting certain asset classes. For example, you might have 70% stocks but need only 60%, or you might have too much exposure to bonds, which may lead to unnecessary tax inefficiencies.
Make sure that the overweight or underweight is adjusted based on your risk tolerance and goals. The goal of rebalancing is to bring your portfolio back in line with the target allocation, while considering the location of the assets.
4. Prioritize Tax-Efficient Rebalancing
Tax-efficient rebalancing means making adjustments that minimize taxes. The key is to consider which assets should be sold or shifted, and where these transactions occur:
Selling in Taxable Accounts: If you’re selling investments in taxable accounts, aim to sell assets that have appreciated the most or have the least tax burden, such as tax-efficient index funds or ETFs. You’ll pay capital gains taxes when you sell, so try to minimize this impact by choosing investments with favorable long-term capital gains tax treatment.
Rebalancing in Tax-Advantaged Accounts: If possible, make adjustments within tax-advantaged accounts first. You don’t need to worry about taxes in an IRA or Roth IRA, which can allow for easier rebalancing. Shift around your assets within these accounts without triggering tax consequences.
Harvesting Tax Losses: Consider tax loss harvesting, especially if you hold investments in taxable accounts. This strategy allows you to sell underperforming assets and use the losses to offset any taxable gains you’ve realized elsewhere in the portfolio. Keep in mind the “wash-sale” rule, which prohibits claiming a tax loss if you buy the same or substantially identical investment within 30 days.
5. Review Contributions and Withdrawals
As part of rebalancing, review any new contributions (such as regular retirement contributions) or withdrawals (such as for income or expenses). Contributions can be a powerful tool for rebalancing, as you can direct new money toward asset classes or accounts that are underrepresented.
Contributions: Direct new contributions into underweighted asset classes, especially those that are tax-efficient.
Withdrawals: When withdrawing funds, it may be wise to take from accounts or asset classes that have grown too large or are too tax-inefficient.
6. Consider Tax-Deferred Growth and Tax-Free Withdrawals
Asset location should also factor in how investments will grow over time and how you’ll withdraw funds in the future.
Tax-Deferred Accounts (401(k), IRAs): These accounts are great for investments that generate interest or dividends (like bonds or REITs) because the income isn’t taxed as it grows. You’ll pay taxes on distributions when you withdraw the funds, but that could be years down the road, and possibly at a lower tax rate.
Roth Accounts (Roth IRA, Roth 401(k)): These accounts are ideal for investments with high growth potential, such as stocks. Since withdrawals from Roth accounts are tax-free, placing high-growth investments there means you can avoid paying taxes on future capital gains.
7. Execute the Rebalance
Once you’ve developed a strategy based on your asset allocation and asset location, it’s time to execute the rebalance:
Rebalance Within Accounts: Shift assets within each account type. If you need more stocks in a tax-advantaged account, exchange some of the bonds there for stocks. If you need more bonds in taxable accounts, sell stocks and buy bonds.
Use Contributions to Rebalance: For new contributions, you can directly allocate new money to asset classes that need more exposure. This is often the simplest way to make adjustments without incurring any transaction costs.
Avoid Frequent Trading: While rebalancing is important, frequent trading can incur unnecessary fees and taxes. Stick to a schedule (quarterly, semi-annually, or annually) for rebalancing and only make adjustments as needed.
8. Monitor and Adjust Over Time
Rebalancing is not a one-time event. Over time, market fluctuations and changes in your financial situation may cause your portfolio to drift. Regularly review your portfolio to ensure it aligns with your investment goals and risk tolerance, and make adjustments as needed. Every year or two, review the asset allocation and asset location to ensure they are still optimal.
Conclusion
Rebalancing your investment portfolio with asset location in mind is a powerful strategy to improve after-tax returns and minimize tax liabilities over time. By strategically placing different assets in taxable, tax-deferred, and tax-free accounts, you can enhance the overall efficiency of your portfolio, reduce unnecessary tax drag, and position yourself for long-term growth. Remember, this process requires regular monitoring and adjustment to ensure that your portfolio remains aligned with your goals, especially as tax laws and market conditions change. Happy investing!
Author:
James Hargrave, MBA, CFRⓇ, CLUⓇ