Had Net Fixed Assets Of Last Year-End And This Year-End How To Use Deposits and Withdrawals To Rebalance Your Portfolio

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How To Use Deposits and Withdrawals To Rebalance Your Portfolio

The benefits of portfolio rebalancing are well documented. Constant rebalancing forces the investor to offload portfolio positions that have recently performed well and use the proceeds to buy more shares of portfolio assets 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 every six months). However, the tax status of an investment account can have a significant impact on the rebalancing strategy. While investments within a tax-advantaged account such as a traditional or Roth IRA can be sold without tax consequences, selling appreciated assets in taxable investment accounts will create a capital gains liability. Therefore, while rebalancing within a tax-advantaged account should be hassle-free, investors should carefully consider the tax consequences that may arise from rebalancing into a normal investment account.

For this reason, investors should view every deposit 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 where the wallet is undervalued. For example, suppose a $100,000 investment account has a target asset allocation of 50% stocks and 50% bonds ($50,000 invested in both). After a year in which stocks have made 10% and bonds have been flat, the portfolio will consist of $55,000 in stocks and $50,000 in bonds, for a total account balance of $105,000. If at this point the investor wishes 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 applied regardless of the size of the additional contribution. If the investor wanted to contribute $10,000 in the second year, the total account value would be $115,000 ($105k current balance + $10k new money). To return to our goals of 50% stocks and 50% bonds, we would like $57,500 for each position. With $55,000 already invested in stocks, we would like to invest only $2,500 of the new money in stocks and put the remaining $7,500 in bonds, bringing both parts of the portfolio to their goals.

Accepting withdrawals from a taxable investment account should also be viewed as a rebalancing opportunity. Rebalancing through withdrawals may not be free, as it is when rebalancing occurs when new funds are deposited, as appreciated assets are likely to be sold, creating a tax liability. However, when the withdrawal is taken from a taxable account, it is still prudent to sell overweight asset classes to produce the funds needed for the distribution.

Let’s go back to our previous example with a target portfolio of 50% stocks and 50% bonds that has grown to $55,000 stocks and $50,000 bonds. If the investor then wants to withdraw the $10,000, he can take the entire distribution out of bonds, which will allow him to release the required amount without creating a tax liability. However, the resulting portfolio would consist of $55,000 in stocks and $40,000 in bonds—a ratio of roughly 58% stocks and 42% bonds.

This is a significantly more volatile portfolio than the target portfolio of 50% stocks and 50% bonds. 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 would 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. While this could potentially create a small capital gains tax liability, it is a tax bill that will have to be paid at some point anyway, and the investor will maintain a portfolio with the target amount of volatility.

Also, remember that the long-term capital gains rate (which applies to all capital assets held for more than one year) is a favorable tax rate. For single filers with taxable income under $37,450 and joint filers with taxable income under $74,900, the capital gains tax rate is actually 0%! Additionally, for single filers with taxable income between $37,450 and $406,750 and joint filers with taxable income between $74,900 and $457,600, the capital gains tax rate is only 15%. Therefore, the investor can likely rebalance the portfolio back to the target allocation through withdrawals while incurring only a nominal tax bill.

Although rebalancing provides a significant increase in investment returns over long periods of time, tax implications must be considered when determining whether or not to rebalance a taxable investment account. However, depositing money into or withdrawing money from these accounts provides a favorable opportunity to receive the return premium that rebalancing creates while minimizing the tax consequences.

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