Rebalancing in an extremely high tax situation

[HuggieBear]

I've search around and cant seem to find good info on this topic.

I'm in the retirement stage and primarily living off income generated by the portfolio. Very little to no sales of assets to fund lifestyle. Almost the entire estate is in taxable investments and any incremental income is essentially in the marginal tax bracket of 44% (or thereabouts).

When thinking about rebalancing either the stock/bond allocation, or more importantly the intra-stock portfolio allocations, I'm really trying to wrap my head around the value of the rebalancing being enough to offset the 40%+ tax hit any gains would incur.

If there is any testing, literature or discussion on this that anyone is familiar with, would very much appreciate it!

Best
HB

[Stinky]

With income tax rates in the 44%(!) bracket and essentially drawing down no investments, it sounds like you have a very large portfolio.

What do you feel that you need to rebalance from and to? Maybe you’re just fine leaving well enough alone and not rebalancing at all.

By the way - the maximum tax rate on long term capital gains should be 20% plus 3.8% plus whatever state and local taxes you have. Not 44%.

[8000m]

Are you working through only short term gains? If so, why not wait until the clock strikes midnight to rebalance?

Once you've cleaned things up a bit, perhaps it's worth your considering auto-rebalancing options for your core holdings (e.g. all-in-ones, tax managed balanced funds, global equity funds). Not enough info in the original post to understand how you got stuck in a STCG vortex, but I would hope that is not a permanent problem for you due to your specific circumstances. Is it?

[Elbowman]

Remember there are (at least) two kinds of risk; volatility risk and "I might run out of money" risk. If your portfolio is large enough relative to you expenses that you are unlikely to ever run out of money then volatility (and therefore rebalancing) are less worrying.

[stan1]

It sounds like OP might live in California where long term gains are taxed as ordinary income.

I'd direct dividends and other income into bonds if that's what you are underweight in.

The details matter, but in general I would not sell equities just to rebalance. If you have an eight figure portfolio which might be the case if you are paying 40%+ marginal tax, I'd hire a spreadsheet whiz (likely $4-$8K) to help you figure out what to do taking the specifics of your holdings into account. That's assuming you don't want to spend dozens or even hundreds of hours figuring it out yourself as a hobby and "job".

[Outer Marker]

I'm in the retirement stage and primarily living off income generated by the portfolio. Very little to no sales of assets to fund lifestyle. Almost the entire estate is in taxable investments and any incremental income is essentially in the marginal tax bracket of 44% (or thereabouts).

When thinking about rebalancing either the stock/bond allocation, or more importantly the intra-stock portfolio allocations, I'm really trying to wrap my head around the value of the rebalancing being enough to offset the 40%+ tax hit any gains would incur.

What is it exactly that you're trying to rebalance to and from?

If you're in the decumulation phase, just spend from what you have too much of.

What "intra-stock" positions need rebalancing? If you're in index funds like most of us, there shouldn't be a lot of rebalancing required. On the other hand, if you're in highly concentrated single stock positions, such as a major holding in former employer stock, it is probably worth some level of transaction cost (tax) to de-risk that position.

[Jack FFR1846]

Do you have tax advantaged accounts? 401k, traditional IRA or the like? That's typically the place where rebalancing is done. No tax for trades in these accounts.

[trustquestioner]

Even in CA it’s impossible to imagine that tax rate is accurate.

[Katietsu]

Even in CA it’s impossible to imagine that tax rate is accurate.

I agree. A google search did not find any likely candidates for locations with a combined state and local income tax rate that exceeds 20%.

Additionally, if some of the positions are throwing off a lot of capital gains distributions, there might be shares that have no unrealized capital gains that could be sold for no tax cost.

OP, would you be willing to share any additional details concerning your marginal tax rate and your unrealized capital gains?

[HuggieBear]

Thanks for all the helpful replies. I overestimated the marginal tax rate -- in general it should be around 30%-ish. When i talk about rebalancing, im mostly talking about rebalancing amongst equity slices.

Given that I can live off of dividend income, it sounds like rebalancing and incurring the tax hit is probably not a great idea. Or perhaps, at least, should be more infrequent. At the same time, why have any slices to get the diversification benefit if one doesn't maintain some reasonable ratio.

Guess it's a question of diversification benefit versus tax cost...not easy to figure i think.

[snackdog]

The highest federal bracket is 37% (income over $350,000). How did you get to 44%?

[snowday2022]

The highest federal bracket is 37% (income over $350,000). How did you get to 44%?

It’s easier to get there on earned income (or higher), though this doesn’t apply to LTCG as confirmed by OP above. My marginal tax rate on earned income is 44% because of 35% federal, 6% state, and then Medicare plus supplemental Medicare tax.

[Stinky]

I overestimated the marginal tax rate -- in general it should be around 30%-ish. When i talk about rebalancing, im mostly talking about rebalancing amongst equity slices.

What kind of "equity slices" are you talking about? Is it general mutual funds (like US vs international)? Or is it too-large exposures to specific individual stocks?

If it is "general mutual funds", I'd probably forgo the form of rebalancing which is to sell one asset group and buy another. Rather, I'd "rebalance" with marginal cash flows, and sell assets (when I need to generate cash) from the asset group that I am most overweighted in.

If it's individual stocks, I'd be concerned if I was grossly overweight in one or more individual names. I'd probably sell and take the capital gains tax hit if I got way too heavy in an individual stock.

[tj]

It sounds like OP might live in California where long term gains are taxed as ordinary income.

I'd direct dividends and other income into bonds if that's what you are underweight in.

The details matter, but in general I would not sell equities just to rebalance. If you have an eight figure portfolio which might be the case if you are paying 40%+ marginal tax, I'd hire a spreadsheet whiz (likely $4-$8K) to help you figure out what to do taking the specifics of your holdings into account. That's assuming you don't want to spend dozens or even hundreds of hours figuring it out yourself as a hobby and "job".

Don't most states tax capital gains as ordinary income?

[retiredjg]

Thanks for all the helpful replies. I overestimated the marginal tax rate -- in general it should be around 30%-ish. When i talk about rebalancing, im mostly talking about rebalancing amongst equity slices.

Given that I can live off of dividend income, it sounds like rebalancing and incurring the tax hit is probably not a great idea. Or perhaps, at least, should be more infrequent. At the same time, why have any slices to get the diversification benefit if one doesn't maintain some reasonable ratio.

Guess it's a question of diversification benefit versus tax cost...not easy to figure i think.

I'm not sure the question can be answered with only the information offered.

You apparently are living off mostly dividend income. If that means stock dividends, some or even most of those dividends may be "qualified" and therefore taxed at a lower tax rate than ordinary income. You may not have a 30%ish marginal tax rate at all.

Whatever the tax rate is, it is your stock to bond ratio that is important. Rebalancing amongst equity slices would be of little concern to me if I were in your shoes.

If your portfolio is large enough to live off the dividends, your asset allocation probably doesn't matter much anyway.

[TomatoTomahto]

Some of us never rebalance, except possibly with new money coming in, which doesn’t apply to you. Whatever the LTCG tax rate is for you, I would not bother.

[JazzTime]

Some of us never rebalance, except possibly with new money coming in, which doesn’t apply to you. Whatever the LTCG tax rate is for you, I would not bother.

I'm with TT on this. I have a wildly disproportionate portfolio with a large stake in two stocks. This wasn't intentional. It just grew that way. I have no intention of changing anything. I am tax averse and refuse to take a 30% hit on any sale.

I look at it this way. If I sell investment X and take a 30% hit, that means I must reinvest those reduced proceeds into investment Y that will get back that 30% and grow from there. Do I know an investment Y that will outperform investment X. Hell no! So leave well enough alone.

[TomatoTomahto]

I look at it this way. If I sell investment X and take a 30% hit, that means I must reinvest those reduced proceeds into investment Y that will get back that 30% and grow from there. Do I know an investment Y that will outperform investment X. Hell no! So leave well enough alone.

I hadn’t thought of it that way, but it makes perfect sense; thanks for the rationale supporting my “no rebalancing” choice.

[Hacksawdave]

OP, not enough information provided. Is there a working spouse? Are there components generating large OI distributions such as REITs and corporate bonds in taxable? Reaching just over 30% in a high tax state like CA is pretty easy on a MFJ AGI of just over $90K.

[goingup]

Guess it's a question of diversification benefit versus tax cost...not easy to figure i think.

Diversification benefits are not a sure thing. Taxes are a sure thing!

We are retired, living primarily off dividends and bond/cash interest. No plans to incur taxes to rebalance. The portfolio drifts and I'm OK with that.

[TomatoTomahto]

It sounds like OP might live in California where long term gains are taxed as ordinary income.

I'd direct dividends and other income into bonds if that's what you are underweight in.

The details matter, but in general I would not sell equities just to rebalance. If you have an eight figure portfolio which might be the case if you are paying 40%+ marginal tax, I'd hire a spreadsheet whiz (likely $4-$8K) to help you figure out what to do taking the specifics of your holdings into account. That's assuming you don't want to spend dozens or even hundreds of hours figuring it out yourself as a hobby and "job".

Don't most states tax capital gains as ordinary income?

Of states that do levy an income tax, nine of them tax long-term capital gains less than ordinary income. These states include Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont and Wisconsin.

Via Google, but probably true.

[tj]

It sounds like OP might live in California where long term gains are taxed as ordinary income.

I'd direct dividends and other income into bonds if that's what you are underweight in.

The details matter, but in general I would not sell equities just to rebalance. If you have an eight figure portfolio which might be the case if you are paying 40%+ marginal tax, I'd hire a spreadsheet whiz (likely $4-$8K) to help you figure out what to do taking the specifics of your holdings into account. That's assuming you don't want to spend dozens or even hundreds of hours figuring it out yourself as a hobby and "job".

Don't most states tax capital gains as ordinary income?

Of states that do levy an income tax, nine of them tax long-term capital gains less than ordinary income. These states include Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont and Wisconsin.

Via Google, but probably true.

I think that would still qualify as most. Arizona has a wonky calculation. In some cases it does not apply.

From the Form 140 instructions, they do have: "You may subtract 25% (.25) of any net long-term capital gain included in your federal adjusted gross income that is derived from an investment in an asset acquired after December 31, 2011"

[HuggieBear]

Thank you to everyone for the replies. This was extremely helpful.

I have no new cash coming in and live almost exclusively off of dividends (so never selling assets for income). The equity side of my portfolio is made up of 5 ETFs/Funds with target allocations - I was wrestling with how it could possibly make sense to rebalance amongst those slices given the tax implications. Several of the replies here have convinced my that its simply not worth it. So i guess my investing life just got a little simpler...truly set it and forget it (mostly).

In the future, if I do need to spend assets down, I'll do so directionally toward my allocation targets. Also, if the overall equity/bond mix gets far beyond my allocation targets, I'll likely do the same.

[Stinky]

Reaching just over 30% in a high tax state like CA is pretty easy on a MFJ AGI of just over $90K.

Reason #497 for not living in California.

[Hacksawdave]

Reaching just over 30% in a high tax state like CA is pretty easy on a MFJ AGI of just over $90K.

Reason #497 for not living in California.

Yes, but municipal funds and 0% QD/LTCGs do come in handy. My effective combined fed/CA tax rate counting MAGI is below 2% on $68,659.

[asset_chaos]

Rebalancing is a trade off between a certain cost now (which can be zero) and a risk reduction benefit of an unknown size that will realize at an unknown time; there can be immediate "sleep well" benefits too. As such, I think rebalancing bands should be proportional to the cost of rebalancing. As your cost to rebalance is high, you should learn to tolerate large deviations from your nominal policy allocations.

[Eagle33]

You may want to expand your thinking to include a Donor Advised Fund (DAF).

[typical.investor]

Thanks for all the helpful replies. I overestimated the marginal tax rate -- in general it should be around 30%-ish. When i talk about rebalancing, im mostly talking about rebalancing amongst equity slices.

Given that I can live off of dividend income, it sounds like rebalancing and incurring the tax hit is probably not a great idea. Or perhaps, at least, should be more infrequent. At the same time, why have any slices to get the diversification benefit if one doesn't maintain some reasonable ratio.

Guess it's a question of diversification benefit versus tax cost...not easy to figure i think.

Have you looked at your actual cost basis lots?

I'd be surprised if you didn't have lots (especially if you have fixed income of any duration in taxable) you could use.

I see things like -$18.40 which isn't much of a loss, but still it's $1053 to rebalance with if sold. And then I can sell something for $18.40 in gains which will generate more to rebalance.

I actually have quite a bit of losses in bonds and will be able to take $3k off ordinary income for a few years.

I would not pay taxes to rebalance. I'd look to tax loss harvest. And then if you do need to sell assets to fund lifestyle, obviously take it from the appreciated asset.