Capital Gains Taxes and Portfolio Rebalancing (2024)

FAQs

Do you pay capital gains when you rebalance your portfolio? ›

Selling assets to rebalance a portfolio will generate trading costs and perhaps also capital gains taxes. Instead, investors should buy more stock with cash if they're underweighted in equities.

The 5/25 rule for rebalancing indicates that you ought to adjust your portfolio if the proportion of any asset deviates from its intended initial allocation by an absolute margin of 5% or a relative one of 25%, opting for whichever threshold is lower.

Rebalance in tax-advantaged accounts

Because rebalancing can involve selling assets, it often results in a tax burden—but only if it's done within a taxable account. Selling these assets within a tax-advantaged account instead won't have any tax impact.

Rebalancing reliably reduces risk, but it doesn't necessarily improve returns.

Selling assets to rebalance a portfolio can trigger a taxable event and have tax implications. When an asset is sold at a profit, capital gains tax is triggered, which can eat into the overall returns of the portfolio. Additionally, frequent rebalancing can lead to more taxable events, which can further erode returns.

There is not a hard-and-fast rule on when to rebalance your portfolio. But many investors make it a habit to revisit their investment allocations annually, quarterly, or even monthly. Others decide to make changes when an asset allocation exceeds a certain threshold such as 5 percent.

Percentage-of-Portfolio Rebalancing

A preferred yet slightly more intensive approach to implement involves a rebalancing schedule focused on the allowable percentage composition of an asset in a portfolio. Every asset class, or individual security, is given a target weight and a corresponding tolerance range.

Smart rebalancing involves redistributing profits from assets with rapidly increasing value to other assets in the portfolio, ensuring a consistent increase in overall value.

A solid rule of thumb is the 5/25 rule from Larry Swedroe. When an asset class shifts from its original target by 5%, you should rebalance it. Let's imagine that your portfolio is originally 80% stocks. But then, the actual value shifts to 75% or 85% of your portfolio makeup.

Do I have to pay capital gains tax immediately? ›

This tax is applied to the profit, or capital gain, made from selling assets like stocks, bonds, property and precious metals. It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset.

An easy and impactful way to reduce your capital gains taxes is to use tax-advantaged accounts. Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment.

The major friction that investors face in rebalancing their portfolios is capital gains taxes, which are triggered by the sale of assets.

You should consider adopting a portfolio rebalancing strategy—even during down markets when it's tempting to let your “winners” keep growing while your “losers” are taking their lumps. That's because rebalancing helps you buy low and sell high—an investing adage that's easy to say and hard to do.

One of the simplest ways to rebalance without selling is to redirect your new contributions to the underweighted asset classes. For example, if your portfolio is too heavily weighted in stocks, you can direct new contributions to bonds or other asset classes until your portfolio reaches the desired balance.

Investing in retirement accounts eliminates capital gains taxes on your portfolio. You can buy and sell stocks, bonds and other assets without triggering capital gains taxes. Withdrawals from Traditional IRA, 401(k) and similar accounts may lead to ordinary income taxes.

Do I Pay Capital Gains if I Reinvest the Proceeds From the Sale? While you'll still be obligated to pay capital gains after reinvesting proceeds from a sale, you can defer them. Reinvesting in a similar real estate investment property defers your earnings as well as your tax liabilities.

Rebalancing is an important way to help minimize volatility in a portfolio and may improve long-term returns. Setting specific thresholds that trigger rebalancing can help eliminate emotion from the rebalancing process.