Rebalancing with the tax bill in mind: the order we trade in
Bringing a portfolio back to its targets should not create a tax bill you did not need. The sequence we follow before selling anything in a taxable account.
By Jabari Ellsworth
5 min read
Every portfolio drifts. When stocks rise faster than bonds, the mix becomes riskier than the plan intended. Rebalancing brings it back, but selling winners in a taxable account can create capital gains tax. The order of steps matters.
1. Use new money first
Contributions, dividends and interest go to whatever is underweight. For many clients that alone keeps the portfolio inside its ranges for months at a time.
2. Rebalance inside retirement accounts
Trades inside an IRA or 401(k) have no immediate tax effect. If the same fund exists in both kinds of account, we make the adjustment where it costs nothing.
3. Take withdrawals from what is overweight
For retirees drawing income, each withdrawal is a chance to trim what has grown past its target instead of selling across the board.
4. Harvest losses when they appear
When a holding in a taxable account is below what you paid, we can sell it, bank the loss and buy a similar but not identical fund. Buying the same or a substantially identical security within 30 days before or after the sale would disallow the loss under the wash-sale rule.
5. Only then, sell gains
If a portfolio is still outside its written range, we sell the shares with the highest cost basis first and prefer long-term gains to short-term ones. Investing involves risk and no strategy can guarantee a result, but the tax cost of staying on plan can usually be kept small.
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