Six ways to rebalance your clients' portfolios tax-efficiently

Helping your clients weather market cycles and enjoy better risk-adjusted results takes a planned approach. It includes a thorough evaluation of how the timing and execution of rebalancing may affect their portfolios and generate tax consequences.

Part of a solid rebalancing plan is to decide whether to rebalance on a periodic basis, or as the result of passing certain thresholds in drift, keeping in mind some tax-efficient methods to rebalance.

Here are six tactics for rebalancing a portfolio in a more tax-efficient way:

1. Start with tax-advantaged accounts

One place to begin is rebalancing your clients' tax-advantaged accounts. The benefit of this approach is that any rebalancing trades are tax-exempt at the time they are made. This avoids immediate tax consequences that may be beneficial in periods of high income.

You will find this opportunity easiest to implement if your clients have a mix of asset classes in their accounts. Roth accounts can be particularly advantageous since portions of the Roth can be distributed tax-exempt at any time (up to principal) and enjoy tax-advantaged distribution rules.

2. Re-direct cash flows in taxable accounts

With taxable accounts, one way to rebalance is by directing new purchases and reinvested distributions into underweighted asset classes. For example, when a portfolio with a target allocation of 50% stocks and 50% bonds has drifted beyond the plan's target allocation threshold, it might make sense to add new contributions or reinvest dividends to the underweighted side until the portfolio is back at the target allocation. Conversely, when taking a withdrawal, it might make sense to draw down from an overweight asset class.

For your clients taking the required minimum distribution from their retirement account(s), but who don't need the distribution for daily living expenses, those assets can also be reinvested to increase the allocations to an underweighted asset class in nonretirement accounts.

3. Consider cost basis

When rebalancing, look for opportunities to harvest losses or manage cost basis across holdings in your clients' portfolios. Understanding their current and future expected income can help evaluate which shares to sell or which accounting method is most advantageous. In comparatively low-income years, you may want to sell lower-basis shares. In comparatively high-income years, it might make sense to sell higher-basis shares. If income is relatively stable year over year, an average accounting method may be the right answer. An average accounting method is easy to use but could limit some tax-planning strategies because clients are locked into this method for all shares they own until a new method is chosen. If a household's income generally has peaks and valleys, watching cost basis may help control taxes in the long run.

4. Explore charitable giving and annual gifting

You may want to consider rebalancing opportunities when your clients are deciding how and what to gift. It might make sense to gift shares of overweighted holdings with a low-cost basis in a taxable account directly to the desired charity or beneficiary. For example, when gifting to a beneficiary in a lower marginal tax bracket, consider evaluating options to gift shares in-kind rather than to gift cash. This strategy might also make sense when gifting to a charity. Additionally, charitably inclined clients may focus their rebalancing in an IRAs and use the proceeds to fund a qualified charitable distributions (QCDs).

5. Keep in mind the timing of fund distributions when rebalancing near year-end

It's all about timing. When rebalancing, it might make sense to sell before a distribution to avoid the taxes on that distribution. Conversely, buying right before a distribution may have its own tax and income implications.

6. Use rebalancing to improve the tax efficiency of the portfolio

Many portfolios were originally built based on priorities other than tax efficiency. Take advantage of rebalancing opportunities to shift the portfolio into more tax-efficient options, such as exchange-traded funds, passive investments, or other low-turnover options.

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Notes:

• Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).
• All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is not a guarantee of future returns. We recommend that you consult a tax or financial advisor about your individual situation.
• This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information.
• Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you carefully review the terms of the consent and consult a tax advisor before taking action.