Rebalancing and Tax Efficient Investing

Written By: Brian Ellenbecker, CFP^®, EA, CPWA^®, CIMA^®, CLTC^®

As tax time approaches, thoughts often shift to what can be done to reduce this coming year’s tax liability. One of the best ways to improve your tax picture is to make sure you are taking advantage of the opportunities right in front of you. For some, this means taking a closer look at their investment portfolio to ensure it is being managed as tax efficiently as possible.

Let’s take a look at some of the strategies available to improve the tax-efficiency in your portfolio. Rest assured, if you are working with a Shakespeare advisor, these techniques are already being implemented.

Asset Location

One of the most effective techniques you can implement to reduce your portfolio’s tax liability is asset location. Asset location, sometimes referred to as householding of accounts, is the strategic placement of investments in different account types to maximize the tax efficiency of the overall portfolio.

It’s easy to simply allocate all your accounts identically so they each reflect your target asset mix, but that may not lead to the best after-tax result. Asset location achieves an overall asset allocation for all accounts in your household by allocating each account differently based on the tax attributes of the account type and each investment. Different investments are subject to different tax rules, and different account types have different tax treatment. Sorting your investments by the right account type has the potential to help lower your overall tax bill.

Here’s a simple example to illustrate how asset location works:

• An investor has a $1 million portfolio with $500,000 in a taxable brokerage account and $500,000 in their 401(k).
• Their target asset allocation is 60% in equities and 40% in fixed income.
• They currently have each account invested the same way—60% in equities and 40% in fixed income.
• Following the asset location methodology, they would put all fixed income investments ($400,000) in their 401(k). They would have $100,000 of equities in their 401(k) and their $500,000 brokerage account would be invested in equities.
• By placing tax inefficient investments, like bonds, in their 401(k) and tax efficient investments in their brokerage account, the expected tax liability from their portfolio should decrease while their after-tax return increases.

Where you put your investments—meaning the type of account you choose to put them in—can make a major difference in how much you can earn, on an after-tax basis, over time.

Three Main Investment Account Categories

1. Taxable accounts, such as traditional brokerage accounts, hold securities that are taxed when you earn dividends or interest; or you realize capital gains by selling investments that went up in value.
2. Tax-deferred accounts like traditional 401(k)s, 403(b)s and IRAs allow payment of taxes to be delayed until money is withdrawn, when it is taxed as ordinary income.
3. Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s require income taxes to be paid on all contributions up front, but then allow the investor to avoid further taxation (as long as the rules are followed). Fully tax-exempt accounts such as health savings accounts (HSAs), allow you to make pre-tax or deductible contributions, earnings or withdrawals if used for qualified health expenses.

Within these account categories, you will place different investments based on its tax efficiency. Typically, fixed income securities and equity investments that are very tax inefficient will be placed in tax-deferred accounts. High growth, tax-inefficient investments are typically best placed in Roth accounts. Taxable accounts should hold either inherently tax-efficient investments or those that offer other tax benefits (foreign tax credit, depreciation deduction, etc.).

Rebalancing

Rebalancing is a key component of a comprehensive investment management strategy. It entails adjusting the weights of your portfolio investments to return to your target asset allocation over time. It’s ok to let your portfolio allocations drift a little bit, but eventually it gets far enough away from your target that your risk level is dramatically different. Moving back to your target allocation restores you to your original risk level.

It’s important to develop and then follow a disciplined process to avoid the temptation to time the market. Setting targets for when you rebalance and then monitoring your asset allocation is the easiest way to do this. Once your allocation reaches the target drift tolerance, you rebalance back to your original allocation. Doing this essentially forces you to sell securities that have been doing well and buying those that have been lagging. In other words, you are selling high and buying low—at least at relative points. For those drawing down on their portfolio, it can also be an opportunity to replenish their cash reserve bucket if the rebalance is occurring after stocks have done well.

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For optimal results, consider rebalancing based on changes in your portfolio’s asset allocation, not at regular intervals (annually, quarterly, etc.).

Rebalancing will help you keep emotions out of your investing decisions. Rebalancing around volatility is often the best time, but fear and uncertainty can run high during these periods. Having a disciplined approach in place helps alleviate these emotions and allows you to stick to your investment plan.

The key to remember with rebalancing is that it is primarily a risk mitigation tool. While there are times it will enhance your returns, there are also times where your returns could lag. However, it keeps your portfolio at a specified risk level to ensure you’re not taking more risk than you are comfortable with.

Your Shakespeare advisor builds a relationship with you to learn your risk tolerance and create goals for different stages of your life. We manage your portfolio with tax efficiencies in mind and we rebalance accordingly. If you have any questions, we are here to provide you with peace of mind.