Thursday, June 18, 2015

How To Use Deposits and Withdrawals To Rebalance Your Portfolio

The benefits of rebalancing a portfolio are well documented. Constant rebalancing forces an investor to lighten the portfolio positions that have recently performed well and use the resulting funds to buy more shares of the assets in the portfolio that have remained flat or even declined in value. In other words, rebalancing causes the investor to sell high and buy low.

Most financial professionals recommend rebalancing your portfolio at least once a year (I rebalance my clients’ portfolios on a semi-annual basis). However, the tax status of an investment account can have a significant impact on a rebalancing strategy. While investments within a tax-advantaged account like a traditional or Roth IRA can be sold without tax implications, selling appreciated assets in a taxable investment accounts will create a capital gains liability. Consequently, while rebalancing within a tax-advantaged account should be a no-brainer, investors should carefully consider the tax implications that may result from rebalancing a normal investment account.

For this reason, investors should view every deposit to or withdrawal from a taxable investment account as a chance to rebalance. Depositing new money is a free opportunity to buy more of the positions in which the portfolio is underweight. For example, suppose an investment account of $100,000 has a target asset allocation of 50% stocks and 50% bonds ($50,000 invested in both). After a year in which stocks made 10% and bonds were flat, the portfolio would consist of $55,000 of stocks and $50,000 of bonds, for a total account balance of $105,000. If at this point the investor would like to invest an additional $5,000, the entire contribution should be placed in bonds, bringing the actual portfolio allocation back to 50% stocks and 50% bonds ($55,000 invested in each).

Of course, this same strategy can be implemented regardless of the size of the additional contribution. If the investor wanted to contribute $10,000 in year two, the total account value would be $115,000 ($105k current balance + $10k new money). In order to get back to our 50% stock and 50% bond targets, we would want $57,500 in each position. With $55,000 already invested in stocks, we would only want to invest $2,500 of the new money into stocks and place the remaining $7,500 into bonds, bringing both portions of the portfolio up to their targets.

Taking withdrawals from a taxable investment account should also be viewed as an opportunity to rebalance. Rebalancing via withdrawals may not be free as it is when rebalancing is done when new funds are deposited because appreciated assets are likely sold, creating a tax liability. However, when a withdrawal is taken from a taxable account, it is still wise to sell overweight asset categories to produce the funds needed for the distribution.

Let’s return to our previous example of a 50% stock and 50% bond target portfolio that had grown to $55,000 of stock and $50,000 of bonds. If the investor then wanted to withdraw $10,000, he could take the entire distribution out of bonds which would allow him to free up the amount needed without creating a tax liability. However, the resulting portfolio would consist of $55,000 of stocks and $40,000 of bonds – a ratio of approximately 58% stocks and 42% bonds.

This is a significantly more volatile portfolio than the target 50% stock and 50% bond portfolio. For example, in 2008 a portfolio that consisted of 50% large cap stocks and 50% long term government bonds lost -7.16%. Meanwhile, a portfolio of 58% stocks and 42% bonds lost -11.93% over the same time period – a 66.6% increase in volatility.

Alternatively, I’d suggest using the $10,000 withdrawal to rebalance the portfolio, bringing the resulting $95,000 portfolio back to 50% stocks and 50% bonds ($47,500 in each). Of course, to do this, the investor would liquidate $7,500 of stocks and $2,500 of bonds. Although this could potentially create a small capital gains tax liability, this is a tax bill that will need to be paid at some point anyhow, and the investor will maintain a portfolio with the target amount of volatility.

Further, remember that the long-term capital gains rate (which applies to any capital assets held for over a year) is a favorable tax rate. For single filers with a taxable income of less than $37,450 and joint filers with a taxable income of less than $74,900, the capital gains tax rate is actually 0%! Additionally, for single filers with a taxable income of between $37,450 and $406,750 and joint filers with a taxable income of between $74,900 and $457,600, the capital gains tax rate is only 15%. Consequently, the investor can likely rebalance the portfolio back to the target allocation via the withdrawal while incurring only a nominal tax bill.

While rebalancing provides a significant increase in investment return over long time periods, tax implications should be considered when determining whether or not to rebalance a taxable investment account. However, depositing money to or withdrawing money from these accounts provides a favorable opportunity to obtain the return premium rebalancing creates while minimizing tax implications.

2 comments:

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Jennifer Davies said...

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