Tax-smart tips to rebalance your clients’ portfolios

If you haven’t rebalanced some of your clients’ portfolios recently, you may be overdue. After all, in the five years ended September 30, 2017, the CRSP US Total Market Index was up a cumulative 94.3% while the Bloomberg Barclays U.S. Aggregate Float Adjusted Index was up only a cumulative 10.8%, so it’s not hard to see how clients’ portfolios may no longer match their target allocations.

Still, you know that for clients who hold substantial taxable accounts, rebalancing can trigger capital gains taxes and, perhaps, additional net investment income taxes. Here are a few suggestions to help tax-sensitive clients maintain their risk profile through rebalancing:

Use your clients’ tax-advantaged accounts

Consider coordinating your rebalancing across all your clients’ portfolios, including assets held outside your management, such as 401(k) plans. If rebalancing is done through tax-advantaged accounts, there are no tax consequences.

Use required minimum distributions (RMDs) strategically

Clients over the age of 70½ will need to take mandatory distributions from their tax-deferred retirement accounts.1 While the amount to be taken is mandated, the funds from which it is withdrawn should be guided by you. Here are a few other things to consider:

If a client is taking RMDs for spending needs, then the distribution should come from the overweighted asset class. Since any withdrawals of earnings and pretax contributions will be taxed, it’s beneficial to pare back the part of the portfolio that is heavy relative to the target asset allocation.

If the client is fortunate enough to not need the RMD for spending needs and intends to reinvest the net proceeds in a nonretirement account, be mindful of the asset allocation mix while investing in tax-efficient investments, such as broad-market stock index funds, or municipal bond funds if the client is in a higher marginal income tax bracket.

For a charitably inclined client, a good option is to take advantage of a qualified charitable distribution (QCD).  For example, the client may have his or her 2017 RMD made payable to the charity of the client’s choice (provided it meets the IRS definition of a qualified charity), and then designate it as a QCD on his or her tax return. The client will have satisfied the RMD without the tax consequences, and the charity will get the full benefit—all while rebalancing!

Direct cash flows

It will soon be the season when many actively managed equity funds distribute capital gains and year-end dividends, and even index equity funds regularly kick off dividends.

You may have positioned many of your clients to automatically reinvest those distributions and dividends. But if they need to rebalance, then consider directing those to cash, and then using those funds to achieve rebalancing.

Similarly, if clients are investing new money in their portfolios, look at their asset allocations. This is a great time to direct cash flows to the underweighted asset class.

Clients should gift with their hearts and their wallets

Charitable giving can be an effective strategy outside your retirement accounts, too.

Gifting appreciated assets from taxable accounts to charity has three potential benefits—tax efficiency, rebalancing, and cost-effectiveness. With the equity markets’ strong performance so far in 2017, and in recent years, it makes a lot of sense to give appreciated securities in lieu of cash donations. Clients will get the full deduction value of the donation without paying capital gains taxes or transaction fees.

Your clients can also take advantage of annual gifting to friends or family, though this comes with some caveats. In 2017, a client can gift up to $14,000 to as many individuals as the client likes (up to $28,000 if he or she is married and files jointly) without gift-tax consequences. You can also advise your clients to consider gifting low-cost-basis shares instead of cash. Doing so can help with rebalancing and allow a client to transfer the gain to the client’s donee, since the taxable basis will carry over to the donee. However, keep in mind any estate planning considerations, especially for older clients. Because beneficiaries who inherit assets will receive a step-up in basis, you’ll want to consider any gifting in the context of the client’s broader estate plan.

I’m the first to admit that rebalancing for many clients can involve some behavioral coaching, because rebalancing is often counterintuitive and involves selling investments that have performed well. Our research on rebalancing shows there is no meaningful difference whether a portfolio is rebalanced monthly, quarterly, or annually, but the resulting costs increase significantly with the number of rebalancing events, so semiannually or annually appear to be fine solutions.

The real payoff of rebalancing, however, comes from maintaining the risk profile of your clients’ portfolios, which can help clients be less anxious during times of volatility.

For more, listen to our recent episode in Vanguard’s Investment Commentary series, How to handle RMDs and other year-end planning tips, featuring Maria Bruno.

Special thanks to my colleague Jenna McCleary for her contributions to this blog post.


1 If a client is still working, he or she can defer RMDs from employer-sponsored plans.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

We recommend that you consult a tax or financial advisor about your individual situation.

Brent Matthew

Author Brent Matthew

More posts by Brent Matthew

Leave a Reply