Take taxes into account when rebalancing?

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tadamsmar
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Take taxes into account when rebalancing?

Post by tadamsmar » Fri Nov 09, 2018 10:08 am

I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.

I am not freely rebalancing like I used to anyway because my taxable is all in TSM and it costs to rebalance it.

I am wondering how others handle this issue.

KlangFool
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Re: Take taxes into account when rebalancing?

Post by KlangFool » Fri Nov 09, 2018 10:15 am

tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.

I am not freely rebalancing like I used to anyway because my taxable is all in TSM and it costs to rebalance it.

I am wondering how others handle this issue.
tadamsmar,

<<For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.>>

It is very simple. Do not take taxes into account when rebalancing. You are overcomplicating a simple issue.

<< I am not freely rebalancing like I used to anyway because my taxable is all in TSM and it costs to rebalance it.>>

Why? You could do "Tax Loss Harvesting" or "Tax Gain Harvesting" with TSM.

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Leesbro63
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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Fri Nov 09, 2018 10:16 am

Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.

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Re: Take taxes into account when rebalancing?

Post by KlangFool » Fri Nov 09, 2018 10:19 am

Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Leesbro63,

I disagree. With 5/25 band rebalancing or annual rebalancing, a person almost never has to rebalance except once every few years. And, if and when rebalancing is needed, tax cost is the least of a person's concern. Risk management is more important.

KlangFool

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Re: Take taxes into account when rebalancing?

Post by bertilak » Fri Nov 09, 2018 10:48 am

Two kinds of rebalancing:
  1. ACTIVE: Sell over-balanced assets and use the proceeds to buy under-balanced assets.
  2. PASSIVE: When you buy or sell for any reason do so in a way that tends to maintain the target AA.
One's target AA is pretty arbitrary, being an estimate (guess) at what is the right balance between risk and potential reward. No one can say if being off by a few percent is better or worse so there is no justification for high precision.

Bottom line, avoid ACTIVE re-balancing, at least in taxable accounts, and DON'T WORRY if PASSIVE re-balancing under achieves a return to the target AA. In time things will even out.
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tadamsmar
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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Fri Nov 09, 2018 11:28 am

bertilak wrote:
Fri Nov 09, 2018 10:48 am
Two kinds of rebalancing:
  1. ACTIVE: Sell over-balanced assets and use the proceeds to buy under-balanced assets.
  2. PASSIVE: When you buy or sell for any reason do so in a way that tends to maintain the target AA.
One's target AA is pretty arbitrary, being an estimate (guess) at what is the right balance between risk and potential reward. No one can say if being off by a few percent is better or worse so there is no justification for high precision.

Bottom line, avoid ACTIVE re-balancing, at least in taxable accounts, and DON'T WORRY if PASSIVE re-balancing under achieves a return to the target AA. In time things will even out.
Say your target was 40/60 stocks and bonds. Worst case, you have all your stocks in Roth and all bonds in tax-deferred. Using my numbers, you are 48/52 after taxes.

Some people use a 25% rebalancing band. You have a 20% pre-post-tax bias already.

But, as you say, it's fuzzy math anyway. And, 40% in Roth is perhaps uncommon, and the pure worst case Roth/tax deferred allocation will not hold up long-term anyway due to rebalancing.

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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Fri Nov 09, 2018 12:17 pm

KlangFool wrote:
Fri Nov 09, 2018 10:19 am
Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Leesbro63,

I disagree. With 5/25 band rebalancing or annual rebalancing, a person almost never has to rebalance except once every few years. And, if and when rebalancing is needed, tax cost is the least of a person's concern. Risk management is more important.

KlangFool
I'm not sure that "tax cost is the least of a person's concern" is correct. It guess it depends on the amount of tax involved, the person's overall wealth level and the investment time horizon. But I stand by my assertion that probably, for most upper middle class and above savers, paying tax to rebalance will do more long-term harm than good.

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Re: Take taxes into account when rebalancing?

Post by KlangFool » Fri Nov 09, 2018 12:30 pm

Leesbro63 wrote:
Fri Nov 09, 2018 12:17 pm
KlangFool wrote:
Fri Nov 09, 2018 10:19 am
Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Leesbro63,

I disagree. With 5/25 band rebalancing or annual rebalancing, a person almost never has to rebalance except once every few years. And, if and when rebalancing is needed, tax cost is the least of a person's concern. Risk management is more important.

KlangFool
I'm not sure that "tax cost is the least of a person's concern" is correct. It guess it depends on the amount of tax involved, the person's overall wealth level and the investment time horizon. But I stand by my assertion that probably, for most upper middle class and above savers, paying tax to rebalance will do more long-term harm than good.
Leesbro63,

<< But I stand by my assertion that probably, for most upper middle class and above savers, paying tax to rebalance will do more long-term harm than good.>>

I save 50K to 60K per year. My taxable account is 500K and it is 100% stock.

1) I only need to actively rebalance once in a few years.

2) The amount to be rebalanced is small and I pay 15% long-term capital gain tax.

In summary, I believe that I fit into the profile of your claim.

KlangFool

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tadamsmar
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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Fri Nov 09, 2018 1:40 pm

When one rebalances based on bands does one just rebalance to the band limit? Or does exceeding the band limit trigger full rebalance to the target AA? Seems like the former might be more appropriate when you having to pay taxes to rebalance.

I researched the band rebalance thing and did not see an answer to this question. Up till now, I just rebalanced annually, but I would now have to pay taxes to do that. Also, I am drawing from the taxable some for consumption and for Roth conversions, so that will draw it down somewhat anyway. I may just draw a bit out after the first of the year for 4th quarter taxes and delayed individual ira roth funding and next year's living expenses.

Roth conversions using taxable for the taxes tends to mitigate the rebalancing dilemma

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Re: Take taxes into account when rebalancing?

Post by KlangFool » Fri Nov 09, 2018 1:53 pm

tadamsmar wrote:
Fri Nov 09, 2018 1:40 pm
When one rebalances based on bands does one just rebalance to the band limit? Or does exceeding the band limit trigger full rebalance to the target AA? Seems like the former might be more appropriate when you having to pay taxes to rebalance.

I researched the band rebalance thing and did not see an answer to this question. Up till now, I just rebalanced annually, but I would now have to pay taxes to do that. Also, I am drawing from the taxable some for consumption and for Roth conversions, so that will draw it down somewhat anyway. I may just draw a bit out after the first of the year for 4th quarter taxes and delayed individual ira roth funding and next year's living expenses.

Roth conversions using taxable for the taxes tends to mitigate the rebalancing dilemma
tadamsmar,

<<Or does exceeding the band limit trigger full rebalance to the target AA? >>

I do this. It only triggers once over the last 5 years.

<<Up till now, I just rebalanced annually, but I would now have to pay taxes to do that.>>

I do both: band and annual rebalancing. The band only trigger once over the last 5 to 10 years. For most years, no action is required at the time of annual rebalancing. The deviation is too small for me to do anything.

KlangFool

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Re: Take taxes into account when rebalancing?

Post by inbox788 » Fri Nov 09, 2018 2:39 pm

tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.

I am not freely rebalancing like I used to anyway because my taxable is all in TSM and it costs to rebalance it.

I am wondering how others handle this issue.
I am looking at unadjusted AA as well as considering after tax-adjustment AA. I'm only looking at a model of tax adjustments, since it's not certain, has binary events, and will be impacted by future growth. They're not that far apart now, but it plays a minor role when time come to rebalancing.

I do a global AA and I don't pay taxes to rebalance, but fortunately, I've still got lots of room in tax-deferred to play with.

Tax location is a complex issue that I haven't figured out yet, but I've still got higher priorities to deal with first, so it's in the backburner.
https://www.bogleheads.org/wiki/Tax-eff ... _placement
viewtopic.php?t=250819

OP, do you know your current AA? desired AA? adjusted AA? what adjustments?

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Re: Take taxes into account when rebalancing?

Post by Random Walker » Fri Nov 09, 2018 3:18 pm

Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Disagree. I think it depends on stage of investing life. Early on, maybe yes. Later, near or in retirement, the potential pain of a big loss can be huge. When the happiness from a gain is not nearly as great as the unhappiness of an equal sized loss, rebalance, lock in gains, and pay the tax. Better to pay a tax than not have a tax to pay. Moreover the tax gets paid eventually anyways. Don’t have to rebalance all the way back to target; instead can rebalance just to the edge of a rebalancing band.

Dave

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Re: Take taxes into account when rebalancing?

Post by Random Walker » Fri Nov 09, 2018 3:23 pm

tadamsmar wrote:
Fri Nov 09, 2018 1:40 pm
When one rebalances based on bands does one just rebalance to the band limit? Or does exceeding the band limit trigger full rebalance to the target AA? Seems like the former might be more appropriate when you having to pay taxes to rebalance.

I researched the band rebalance thing and did not see an answer to this question. Up till now, I just rebalanced annually, but I would now have to pay taxes to do that. Also, I am drawing from the taxable some for consumption and for Roth conversions, so that will draw it down somewhat anyway. I may just draw a bit out after the first of the year for 4th quarter taxes and delayed individual ira roth funding and next year's living expenses.

Roth conversions using taxable for the taxes tends to mitigate the rebalancing dilemma
Band versus right on target I think is personal preference, and invites a little bit of recreational market timing. In taxable, I would take the sure thing. Minimize the tax by rebalancing back to the edge of the rebalancing band.

Dave

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Re: Take taxes into account when rebalancing?

Post by MotoTrojan » Fri Nov 09, 2018 3:29 pm

Do you expect to pay your marginal tax rate on your 401k/IRA pre-tax savings? Ideally you would not.

I've toyed with this but I ignore it, especially given that I am 100% equity so the expected growth of different assets isn't huge. I also keep a balance naturally in my various accounts, except I prefer small-value in my Roth.

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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Fri Nov 09, 2018 3:31 pm

inbox788 wrote:
Fri Nov 09, 2018 2:39 pm
tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.

I am not freely rebalancing like I used to anyway because my taxable is all in TSM and it costs to rebalance it.

I am wondering how others handle this issue.
I am looking at unadjusted AA as well as considering after tax-adjustment AA. I'm only looking at a model of tax adjustments, since it's not certain, has binary events, and will be impacted by future growth. They're not that far apart now, but it plays a minor role when time come to rebalancing.

I do a global AA and I don't pay taxes to rebalance, but fortunately, I've still got lots of room in tax-deferred to play with.

Tax location is a complex issue that I haven't figured out yet, but I've still got higher priorities to deal with first, so it's in the backburner.
https://www.bogleheads.org/wiki/Tax-eff ... _placement
viewtopic.php?t=250819

OP, do you know your current AA? desired AA? adjusted AA? what adjustments?
A couple of years ago, my target AA was 45 stock/12.5 reit/42.5 bond. This is based on the life-cycle model from the book Random Walk Down Wall Street. But I found that they tend to change the AA in each edition so I not too keen on keeping up with that.

I have followed the practice of keeping the bond allocation in tax-deferred. But I think Rick Ferri (an expert who posts here) tends to recommend not filling up your taxable with stock. I think that may be at odds with the boglehead tax efficient placement, but it does prevent or delay the issue I am having with needing to sell taxable to rebalance. So, if you are near retirement and anticipate needing to consume income from taxable anyway then it's not such a good idea to avoid bonds in taxable, I think. It's probably good to think ahead on this.

I listed the adjustments that I calculated in the OP, but they are mostly based on current tax rates. If you calculate adjustments, don't forget state taxes. The federal adjustments can be hard if you anticipate being on the edge of a bracket so the marginal rate is uncertain. And the cap gains taxes depend on the unrealized gains. These are never going to be more than ball-park estimates for actual tax rates. And there are other issues like minimizing taxes for a bequest as opposed to for consumption in your lifetime.

I am at the beginning of retirement. I did not look at tax adjustment earlier, but maybe it makes sense now, not sure.

There is a quote from Rick Ferri that goes something like "Investing is easy, taxes are hard". I find that this rings true. Tax avoidance tends to be complicated and time-consuming.
Last edited by tadamsmar on Fri Nov 09, 2018 3:34 pm, edited 2 times in total.

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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Fri Nov 09, 2018 3:32 pm

Random Walker wrote:
Fri Nov 09, 2018 3:18 pm
Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Disagree. I think it depends on stage of investing life. Early on, maybe yes. Later, near or in retirement, the potential pain of a big loss can be huge. When the happiness from a gain is not nearly as great as the unhappiness of an equal sized loss, rebalance, lock in gains, and pay the tax. Better to pay a tax than not have a tax to pay. Moreover the tax gets paid eventually anyways. Don’t have to rebalance all the way back to target; instead can rebalance just to the edge of a rebalancing band.

Dave
No, the tax doesn't get paid eventually anyways if, like many of us, the assets will be held until we die and our heirs get a "step up" in basis. And many can and do live off of the income from the portfolio (dividends, interest and forced capital gains from the mutual funds). So rebalancing and paying tax is real money that's gone forever. I get it that doing it my way isn't for everyone. This is especially true if you have a concentrated asset (large position in one company or sector), but if you have Vanguard Total Market or something similar, there is no single security risk. Again, I don't disagree that it might make sense for some to pay tax required to do a rebalance, but I disagree that the tax will be paid eventually anyway.

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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Fri Nov 09, 2018 3:48 pm

Random Walker wrote:
Fri Nov 09, 2018 3:18 pm
Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Disagree. I think it depends on stage of investing life. Early on, maybe yes. Later, near or in retirement, the potential pain of a big loss can be huge. When the happiness from a gain is not nearly as great as the unhappiness of an equal sized loss, rebalance, lock in gains, and pay the tax. Better to pay a tax than not have a tax to pay. Moreover the tax gets paid eventually anyways. Don’t have to rebalance all the way back to target; instead can rebalance just to the edge of a rebalancing band.

Dave
The taxes typically don't all get paid eventually even if you consume the investment in your lifetime. They remain as unrealized gains and the gains compound. You get 85% of the componding as money to consume. Of course, it does not amount to much unless you have a good bit of growth.
Last edited by tadamsmar on Fri Nov 09, 2018 6:07 pm, edited 1 time in total.

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Re: Take taxes into account when rebalancing?

Post by Random Walker » Fri Nov 09, 2018 4:01 pm

Leesbro63,
Certainly if timeframe is way beyond your own life expectancy, then I wouldn’t rebalance out of equities either.

Tadamsmar,
Agree, I was sort of making short cut approximation to make the point. By delaying payment of tax, you do get to potentially see growth of the money that wasn’t paid out as tax.

Dave

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Re: Take taxes into account when rebalancing?

Post by friar1610 » Fri Nov 09, 2018 4:04 pm

tadamsmar wrote:
Fri Nov 09, 2018 10:08 am


I have followed the practice of keeping the bond allocation in tax-deferred. But I think Rick Ferri (an expert who posts here) tends to recommend not filling up your taxable with stock. I think that may be at odds with the boglehead tax efficient placement, but it does prevent or delay the issue I am having with needing to sell taxable to rebalance. So, if you are near retirement and anticipate needing to consume income from taxable anyway then it's not such a good idea to avoid bonds in taxable, I think. It's probably good to think ahead on this.

This sort of thing has emerged as a "first world problem" for me. Ever since I moved my workplace 401k's to a Rollover IRA, I have gone with bonds (and virtually no equities) in tax-deferred. As a result, when a rebalance calls for trimming back equities, I have no alternative but to sell equities from taxable and incur the tax hit. Of course, the equity market being what it is, it will eventually fall by some amount. When it does, my plan is to rebalance back into equities in my IRA. That way, when the market heats up again, I should be able to rebalance out of equities in tax-deferred. This will probably take a few years.
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Re: Take taxes into account when rebalancing?

Post by TimeRunner » Fri Nov 09, 2018 4:11 pm

I do something similar to the OP. At the very least, it's nice to have a column in your spreadsheet that shows the value "after tax" so you have a more realistic picture of your "millionaire" status. :wink:

:idea: There's a Wiki article on this subject: https://www.bogleheads.org/wiki/Tax-adj ... allocation
"What'd ya expect in an opera, a happy ending?" -Bugs Bunny. "You gotta fight for your right to party!" -Beastie Boys

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Re: Take taxes into account when rebalancing?

Post by Random Walker » Fri Nov 09, 2018 4:37 pm

TimeRunner wrote:
Fri Nov 09, 2018 4:11 pm
At the very least, it's nice to have a column in your spreadsheet that shows the value "after tax" so you have a more realistic picture of your "millionaire" status. :wink:

:idea: There's a Wiki article on this subject: https://www.bogleheads.org/wiki/Tax-adj ... allocation
I think that after tax column is pretty wise :-)

Dave

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Re: Take taxes into account when rebalancing?

Post by House Blend » Sat Nov 10, 2018 9:02 am

tadamsmar wrote:
Fri Nov 09, 2018 1:40 pm
When one rebalances based on bands does one just rebalance to the band limit? Or does exceeding the band limit trigger full rebalance to the target AA? Seems like the former might be more appropriate when you having to pay taxes to rebalance.
One does whatever one does.

There are infinitely many to maintain one's AA. None of them are wrong. (Despite what some people in this thread seem to think.)

Sounds like you need to refine your IPS, if you didn't anticipate being in this situation. (That is, having to pay taxes to rebalance.)

For my 85 year old mother with fixed income in IRAs, and stocks + fixed income in taxable, we've reached a point where rebalancing (a.k.a risk control) no longer matters. It is (now, for her) pointless to pay taxes just to stay in balance. So I've let her equity allocation drift above the rebalancing bands. If it were possible to rebalance inside her IRA, I would have done so.

For my own accounts--being at a life stage where risk control still matters--if the only way I could rebalance involved realizing cap gains, I would only move enough to get inside the rebalancing bands.

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Re: Take taxes into account when rebalancing?

Post by Doc » Sat Nov 10, 2018 7:48 pm

Not going to review this whole thread. Just ask yourself if a $50k fixed income position in a tIRA plus a $50k equity position in ROTH has the same risk as the reverse. The answer is obviously no.

David Grabiner has discussed this aspect at length years ago. There is a WIKI article addressing the idea.

Read it.

My take is not to adjust your different account type balances for the fact that part of that balance is not yours but belongs to the Guv but rather to adjust my target AA to reflect that part of your portfolio that is not yours but really is accrued taxes.

Same idea as David's but done in a different way. David is a scientist and I am an engineer. (See my signature block below.) :beer
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Take taxes into account when rebalancing?

Post by Pigeye Brewster » Sat Nov 10, 2018 8:37 pm

Earlier this year, I started calculating my tax-adjusted asset allocation to assist in my asset placement decision making. For me, the difference between nominal and tax-adjusted allocation is not very significant. Current equity is 61% nominal versus 63% tax-adjusted.

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Re: Take taxes into account when rebalancing?

Post by JustinR » Sat Nov 10, 2018 9:08 pm

No, this just sounds like a lot of busywork and over-optimization for nothing.

You don't know what taxes you're going to pay when you sell.

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Re: Take taxes into account when rebalancing?

Post by TimeRunner » Sat Nov 10, 2018 9:28 pm

JustinR wrote:
Sat Nov 10, 2018 9:08 pm
No, this just sounds like a lot of busywork and over-optimization for nothing.

You don't know what taxes you're going to pay when you sell.
I disagree, especially when you have what you would consider significant assets in retirement. You make your best guess as to taxes, and you revise those as new information (tax changes or whatever) comes to light. It's better to plan than to pretend there's no impact, especially when there might be quite a bit of money involved. Anyone who thinks they are a millionaire because they have a million in an TIRA, especially in a state like California or New Jersey for example, is deluding themselves. You don't KNOW but you can sure ESTIMATE. 8-)
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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Sun Nov 11, 2018 5:55 am

JustinR wrote:
Sat Nov 10, 2018 9:08 pm
No, this just sounds like a lot of busywork and over-optimization for nothing.

You don't know what taxes you're going to pay when you sell.
There are various issues with estimating taxes. The federal and state tax rates may change, but the changes are usually not that drastic. Federal brackets are now inflation adjusted. You could move to a state with a very different tax rate. The percentage of unrealized capital gains on taxable can change a lot over a decade or so, and that changes the tax bite.

Rebalancing can be busywork too and rebalancing in taxable can cost money. The exercise of looking at your after-tax allocation makes one realize that even your AA is fuzzy math and might discourage some precise rebalancing that can just be busywork. After-tax is an element in the rebalancing decision.

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Re: Take taxes into account when rebalancing?

Post by JustinR » Sun Nov 11, 2018 6:05 am

tadamsmar wrote:
Sun Nov 11, 2018 5:55 am
JustinR wrote:
Sat Nov 10, 2018 9:08 pm
No, this just sounds like a lot of busywork and over-optimization for nothing.

You don't know what taxes you're going to pay when you sell.
There are various issues with estimating taxes. The federal and state tax rates may change, but the changes are usually not that drastic. Federal brackets are now inflation adjusted. You could move to a state with a very different tax rate. The percentage of unrealized capital gains on taxable can change a lot over a decade or so, and that changes the tax bite.

Rebalancing can be busywork too and rebalancing in taxable can cost money. The exercise of looking at your after-tax allocation makes one realize that even your AA is fuzzy math and might discourage some precise rebalancing that can just be busywork. After-tax is an element in the rebalancing decision.
There are ways to pay 0% tax on tax-deferred in retirement.

You're right, everything is fuzzy math when it comes to AA and precise rebalancing. That's exactly why it's a fruitless endeavor to try and over-optimize things. Just pick an AA, rebalance in your tax-protected accounts, put new money in your taxable accounts, and call it a day.

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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Sun Nov 11, 2018 6:43 am

JustinR wrote:
Sun Nov 11, 2018 6:05 am
You're right, everything is fuzzy math when it comes to AA and precise rebalancing. That's exactly why it's a fruitless endeavor to try and over-optimize things. Just pick an AA, rebalance in your tax-protected accounts, put new money in your taxable accounts, and call it a day.
One may get in a situation where there is a need to rebalance taxable to control risk.

What are the ways to pay 0% on tax-deferred? I think my wife and I are in a situation where we are going to pay ~27.5% on most RMDs, I think.

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Re: Take taxes into account when rebalancing?

Post by Dandy » Sun Nov 11, 2018 7:51 am

I have the same problem since my large TIRA is mostly fixed income and my Taxable mostly equities that have large cap gains. Taking RMDs means increasing taxable income and depleting mostly fixed income. I also have a very conservative allocation of about 43% equities.

I have done some rebalancing in our modest Roth accounts and last year did cash in some taxable Small Cap assets. I have all my taxable distributions sent to Fed Money Market instead of reinvesting. I guess the next moves are either taking cap gains or gifting shares.

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Re: Take taxes into account when rebalancing?

Post by JustinR » Sun Nov 11, 2018 8:03 am

tadamsmar wrote:
Sun Nov 11, 2018 6:43 am
JustinR wrote:
Sun Nov 11, 2018 6:05 am
You're right, everything is fuzzy math when it comes to AA and precise rebalancing. That's exactly why it's a fruitless endeavor to try and over-optimize things. Just pick an AA, rebalance in your tax-protected accounts, put new money in your taxable accounts, and call it a day.
One may get in a situation where there is a need to rebalance taxable to control risk.

What are the ways to pay 0% on tax-deferred? I think my wife and I are in a situation where we are going to pay ~27.5% on most RMDs, I think.
There's two ways:
  • Roth Conversion Ladder
  • 72(t) Substantially Equal Periodic Payments (SEPP)
https://www.madfientist.com/how-to-acce ... nds-early/

Most people prefer the Roth Conversion Ladder as it's more flexible.

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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Sun Nov 11, 2018 9:26 am

tadamsmar wrote:
Fri Nov 09, 2018 3:48 pm
Random Walker wrote:
Fri Nov 09, 2018 3:18 pm
Leesbro63 wrote:
Fri Nov 09, 2018 10:16 am
Your math is over my head, but I get the big concept. This discussion comes up every so often here. My own feeling, which has often been confirmed by others, is never (or perhaps ALMOST never) rebalance anything that requires paying tax to do so. The drag of the permanently lost tax paid is generally not offset by any gain or risk reduction in doing the rebalance.
Disagree. I think it depends on stage of investing life. Early on, maybe yes. Later, near or in retirement, the potential pain of a big loss can be huge. When the happiness from a gain is not nearly as great as the unhappiness of an equal sized loss, rebalance, lock in gains, and pay the tax. Better to pay a tax than not have a tax to pay. Moreover the tax gets paid eventually anyways. Don’t have to rebalance all the way back to target; instead can rebalance just to the edge of a rebalancing band.

Dave
The taxes typically don't all get paid eventually even if you consume the investment in your lifetime. They remain as unrealized gains and the gains compound. You get 85% of the componding as money to consume. Of course, it does not amount to much unless you have a good bit of growth.

This. For the long term investor who plans a 4% SWR or less, assuming all capital gains will be eventually realized and taxed is more folly than not.

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Re: Take taxes into account when rebalancing?

Post by Doc » Sun Nov 11, 2018 11:42 am

Our Wiki wrote:Tax-adjusted asset allocation

If you have accounts with different tax treatment (taxable, traditional IRA or 401(k), Roth IRA or 401(k)), equal dollar amounts in those accounts have different after-tax values. Therefore, if you want to optimize the after-tax value of your portfolio, you should base your asset allocation on the after-tax value of the accounts.
Why to adjust
The purpose of asset allocation is to design a portfolio with the desired level of expected return and risk. Returns and mathematical definitions of risk should be based on after-tax values, since the after-tax value is what you will be able to spend. Emotional definitions of risk should be based on how you perceive the risk.
https://www.bogleheads.org/wiki/Tax-adj ... allocation

Expected return and risk is what your AA rebalancing is all about.

Counting the money in your account that represents money that is not yours but is basically accrued taxes that belong to someone else (the Guv) makes no sense. Ignoring the concept just because you don't know future tax rates is nonsense. We probably know future tax rates a lot better than what the S&P 500 is going to return next year.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Take taxes into account when rebalancing?

Post by tadamsmar » Sun Nov 11, 2018 1:21 pm

JustinR wrote:
Sun Nov 11, 2018 8:03 am
tadamsmar wrote:
Sun Nov 11, 2018 6:43 am

What are the ways to pay 0% on tax-deferred? I think my wife and I are in a situation where we are going to pay ~27.5% on most RMDs, I think.
There's two ways:
  • Roth Conversion Ladder
  • 72(t) Substantially Equal Periodic Payments (SEPP)
https://www.madfientist.com/how-to-acce ... nds-early/

Most people prefer the Roth Conversion Ladder as it's more flexible.
I looked up Roth Conversion Ladder. Looks like you would have a low income to get 0% taxes, and be in a state with a 0% income tax bracket. But could be done in principle. Anyway too late for me to retire early. Some 0% income tax states have high sales taxes, but I can see possible workarounds for that.

Did not know about SEPP, interesting.

I see your point that a young investor has planning options that make estimating the after-tax value dicey.

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Re: Take taxes into account when rebalancing?

Post by grabiner » Sun Nov 11, 2018 5:32 pm

tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.
I view rebalancing as controlling risk, so I look at the marginal tax on gains, and thus devalue US stock more than this.

If I gain $1000 in my Roth IRA, I have the growth of $1000 tax-free.

If I gain $1000 in my employer plan, I have the growth of $690 tax-free because I expect to retire at a 31% marginal tax rate (25% federal plus 8% state deducted from federal, assuming tax rates return to the old levels in 2026; it would be 30% if the current rates remain permanent).

If I gain $1000 in my taxable account, I will lose 21% of all dividends to taxes, and then 21% of the capital gains when I sell. With 25 years to the middle of retirement, I estimate a 27% loss, so I value the $1000 at $730.

All of these calculations are done in my spreadsheet. If I make a contribution of $1000 to a foreign stock fund in my taxable account, this adds $730 to the "foreign" total. If I move $1000 from a bond fund to a US stock fund in my employer plan, the "US" and "bonds" totals both change by $690.
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Re: Take taxes into account when rebalancing?

Post by grabiner » Sun Nov 11, 2018 5:35 pm

Leesbro63 wrote:
Fri Nov 09, 2018 12:17 pm
I'm not sure that "tax cost is the least of a person's concern" is correct. It guess it depends on the amount of tax involved, the person's overall wealth level and the investment time horizon. But I stand by my assertion that probably, for most upper middle class and above savers, paying tax to rebalance will do more long-term harm than good.
I agree with this. My IPS says that I will not sell for a capital gain in a taxable account to rebalance unless I am over a rebalancing band limit and don't expect to fix this with upcoming contributions. And if I ever did this (which has never happened), I would only rebalance to the band limit. In contrast, when I rebalance in a tax-deferred account (which I do annually, and also needed to do in October 2008 and September 2009), I will go all the way to the target allocation, since that is free.
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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Sun Nov 11, 2018 5:53 pm

grabiner wrote:
Sun Nov 11, 2018 5:32 pm
tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.
I view rebalancing as controlling risk, so I look at the marginal tax on gains, and thus devalue US stock more than this.

If I gain $1000 in my Roth IRA, I have the growth of $1000 tax-free.

If I gain $1000 in my employer plan, I have the growth of $690 tax-free because I expect to retire at a 31% marginal tax rate (25% federal plus 8% state deducted from federal, assuming tax rates return to the old levels in 2026; it would be 30% if the current rates remain permanent).

If I gain $1000 in my taxable account, I will lose 21% of all dividends to taxes, and then 21% of the capital gains when I sell. With 25 years to the middle of retirement, I estimate a 27% loss, so I value the $1000 at $730.

All of these calculations are done in my spreadsheet. If I make a contribution of $1000 to a foreign stock fund in my taxable account, this adds $730 to the "foreign" total. If I move $1000 from a bond fund to a US stock fund in my employer plan, the "US" and "bonds" totals both change by $690.
But if you have enough, selling down your taxable account will probably not ever happen.

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Re: Take taxes into account when rebalancing?

Post by grabiner » Sun Nov 11, 2018 6:06 pm

Leesbro63 wrote:
Sun Nov 11, 2018 5:53 pm
grabiner wrote:
Sun Nov 11, 2018 5:32 pm
tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.
I view rebalancing as controlling risk, so I look at the marginal tax on gains, and thus devalue US stock more than this.

If I gain $1000 in my Roth IRA, I have the growth of $1000 tax-free.

If I gain $1000 in my employer plan, I have the growth of $690 tax-free because I expect to retire at a 31% marginal tax rate (25% federal plus 8% state deducted from federal, assuming tax rates return to the old levels in 2026; it would be 30% if the current rates remain permanent).

If I gain $1000 in my taxable account, I will lose 21% of all dividends to taxes, and then 21% of the capital gains when I sell. With 25 years to the middle of retirement, I estimate a 27% loss, so I value the $1000 at $730.

All of these calculations are done in my spreadsheet. If I make a contribution of $1000 to a foreign stock fund in my taxable account, this adds $730 to the "foreign" total. If I move $1000 from a bond fund to a US stock fund in my employer plan, the "US" and "bonds" totals both change by $690.
But if you have enough, selling down your taxable account will probably not ever happen.
I assume it will because I have no heirs, and because my donations to charity come from my oldest shares which I am going to keep regardless of rebalancing decisions. If I buy a new stock now, I intend to eventually sell it.

But if you are investing for your heirs, the proper adjustment for your taxable account would be the dividend tax only, compounded over your life expectancy. In my situation, assuming that I live 35 years, the 21% tax on a 2% dividend yield would be 0.42% annually, a 14% loss.
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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Sun Nov 11, 2018 6:39 pm

grabiner wrote:
Sun Nov 11, 2018 6:06 pm
Leesbro63 wrote:
Sun Nov 11, 2018 5:53 pm
grabiner wrote:
Sun Nov 11, 2018 5:32 pm
tadamsmar wrote:
Fri Nov 09, 2018 10:08 am
I have been playing around with using after-tax values for rebalancing.

Roth funds need no reduction so the after-tax multiplier factor is 1

For tax-deferred, the factor is about 0.7325 for me. That's assuming a 22% federal marginal tax plus my state tax rate.

For taxable, the factor is about 0.9 with my current 50% unrealized long-term capital gains.

But, in the future, the unrealized gains go up and there is also the taxes on dividends.
I view rebalancing as controlling risk, so I look at the marginal tax on gains, and thus devalue US stock more than this.

If I gain $1000 in my Roth IRA, I have the growth of $1000 tax-free.

If I gain $1000 in my employer plan, I have the growth of $690 tax-free because I expect to retire at a 31% marginal tax rate (25% federal plus 8% state deducted from federal, assuming tax rates return to the old levels in 2026; it would be 30% if the current rates remain permanent).

If I gain $1000 in my taxable account, I will lose 21% of all dividends to taxes, and then 21% of the capital gains when I sell. With 25 years to the middle of retirement, I estimate a 27% loss, so I value the $1000 at $730.

All of these calculations are done in my spreadsheet. If I make a contribution of $1000 to a foreign stock fund in my taxable account, this adds $730 to the "foreign" total. If I move $1000 from a bond fund to a US stock fund in my employer plan, the "US" and "bonds" totals both change by $690.
But if you have enough, selling down your taxable account will probably not ever happen.
I assume it will because I have no heirs, and because my donations to charity come from my oldest shares which I am going to keep regardless of rebalancing decisions. If I buy a new stock now, I intend to eventually sell it.

But if you are investing for your heirs, the proper adjustment for your taxable account would be the dividend tax only, compounded over your life expectancy. In my situation, assuming that I live 35 years, the 21% tax on a 2% dividend yield would be 0.42% annually, a 14% loss.
I understand what you are saying, but I never heard of reducing an asset’s value due to the taxation of the income it produces. To me the asset is the asset and the income is net of taxes.

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Re: Take taxes into account when rebalancing?

Post by grabiner » Sun Nov 11, 2018 7:18 pm

Leesbro63 wrote:
Sun Nov 11, 2018 6:39 pm
I understand what you are saying, but I never heard of reducing an asset’s value due to the taxation of the income it produces. To me the asset is the asset and the income is net of taxes.
For investment asset allocation, what matters is not what the asset is worth now, but what it will produce in spendable income. The purpose of the adjustment is to optimize risk.

It's easiest to see this with a traditional and a Roth account, because the percentages are easier to compute. If you have $400K in a traditional account, $300K in a Roth account, and are in a 25% tax bracket, you currently have the ability to spend $600K in retirement. If the traditional account is all in bonds and the Roth is all in stocks, and the stock market loses half its value, your retirement spending drops to $450K. If the traditional account is all in stocks and the Roth is all in bonds, and the stock market loses half its value, your retirement spending also drops to $450K. Thus, either way, you lose 25% of your retirement spending. The two strategies have an equivalent allocation, as they will have the same value regardless of what happens to the market.

But it is also necessary to adjust a taxable account. If you will lose 25% of the gains on your taxable account to taxes before you can spend them, then $400K in stock in a taxable account and $300K in stock a Roth account also give you the same exposure to the stock market. (The current value of the stock may be different; if you sold your stock now, you would get the value less capital-gains tax.)
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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Sun Nov 11, 2018 8:23 pm

grabiner wrote:
Sun Nov 11, 2018 7:18 pm


For investment asset allocation, what matters is not what the asset is worth now, but what it will produce in spendable income.
I thought that you buy an asset for an expected total return...income AND capital appreciation? And that stocks, especially since the 1950s, have most of their return from capital appreciation. And that whether you ever realize that appreciation or not is voluntary. Is Warren Buffett worth only $40B instead of $60B because he has imbedded capital gains that he COULD recognize (but never will)?

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Re: Take taxes into account when rebalancing?

Post by grabiner » Sun Nov 11, 2018 8:39 pm

Leesbro63 wrote:
Sun Nov 11, 2018 8:23 pm
grabiner wrote:
Sun Nov 11, 2018 7:18 pm


For investment asset allocation, what matters is not what the asset is worth now, but what it will produce in spendable income.
I thought that you buy an asset for an expected total return...income AND capital appreciation? And that stocks, especially since the 1950s, have most of their return from capital appreciation. And that whether you ever realize that appreciation or not is voluntary.
(By "spendable income", I mean the total amount spent, including the value of the asset, not the financial definition of "income".)

This is all correct, but there is that "most". I have a large holding in Total Stock Market in my taxable account, but I will never get as much out of that as if I held it in a Roth IRA. If I sold it now, I would owe taxes on a large capital gain. If I never sell it, I will pay taxes on the dividends every year for the rest of my life, so it won't grow as fast as the IRA. The only way I could get the full value would be to donate it to a charity now. (I do donate stock with large capital gains to charity, but this fund is more than I would want to donate.)
Is Warren Buffett worth only $40B instead of $60B because he has imbedded capital gains that he COULD recognize (but never will)?
And that is the exception, as he owns a stock which does not pay dividends. When he dies, his heirs will lose only the estate tax, which they would lose regardless of what type of account they inherited.
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Re: Take taxes into account when rebalancing?

Post by Leesbro63 » Sun Nov 11, 2018 9:56 pm

grabiner wrote:
Sun Nov 11, 2018 8:39 pm
Leesbro63 wrote:
Sun Nov 11, 2018 8:23 pm
grabiner wrote:
Sun Nov 11, 2018 7:18 pm


For investment asset allocation, what matters is not what the asset is worth now, but what it will produce in spendable income.
I thought that you buy an asset for an expected total return...income AND capital appreciation? And that stocks, especially since the 1950s, have most of their return from capital appreciation. And that whether you ever realize that appreciation or not is voluntary.
(By "spendable income", I mean the total amount spent, including the value of the asset, not the financial definition of "income".)

This is all correct, but there is that "most". I have a large holding in Total Stock Market in my taxable account, but I will never get as much out of that as if I held it in a Roth IRA. If I sold it now, I would owe taxes on a large capital gain. If I never sell it, I will pay taxes on the dividends every year for the rest of my life, so it won't grow as fast as the IRA. The only way I could get the full value would be to donate it to a charity now. (I do donate stock with large capital gains to charity, but this fund is more than I would want to donate.)
Is Warren Buffett worth only $40B instead of $60B because he has imbedded capital gains that he COULD recognize (but never will)?
And that is the exception, as he owns a stock which does not pay dividends. When he dies, his heirs will lose only the estate tax, which they would lose regardless of what type of account they inherited.
Ok, I get where you are coming from. I guess I prefer to look at the value of my taxable account as the current market value, because I don’t plan to ever sell any of it. And the value of all of my income as it’s net value to me, after taxes. This seems more accurate that an adjustment to the asset value based on capital gains taxes that I plan to never recognize.

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Re: Take taxes into account when rebalancing?

Post by Chip » Mon Nov 12, 2018 5:02 am

Leesbro63 wrote:
Sun Nov 11, 2018 9:56 pm
I guess I prefer to look at the value of my taxable account as the current market value, because I don’t plan to ever sell any of it. And the value of all of my income as it’s net value to me, after taxes. This seems more accurate that an adjustment to the asset value based on capital gains taxes that I plan to never recognize.
I agree with this point of view. If one is going to tax adjust it requires looking at the tax rates specific to one's particular situation, over the life of the account. The life of the account usually extends beyond the life of the current account holder.

In addition to the example of your taxable account, consider my tIRA. I expect to only take RMDs from that account, which make it extremely unlikely that I will personally deplete the account during my lifetime. The beneficiaries are my wife and then a charity. So withdrawals from that account will face three tax rates: our joint filing rate while both of us are alive, a single filing rate while one of us is alive, and ultimately the 0% rate of charity.

Probabilities can be applied to amount of withdrawals that will occur at each of those rates by using life expectancy tables. I have used this Excel table from the Kitces web site. Needless to say, it gets complicated pretty quickly and there isn't going to be a single "correct" rate to use. Unless of course I knew exactly when we were both going to die. :P

So, like you, I don't bother to tax adjust. The numbers are too squishy.

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Re: Take taxes into account when rebalancing?

Post by Doc » Mon Nov 12, 2018 8:18 am

Chip wrote:
Mon Nov 12, 2018 5:02 am
So, like you, I don't bother to tax adjust. The numbers are too squishy.
We're going to get our first snow covered roads in a few hours. I'm going to slow down when I drive despite the effect that the roads might just be a little squishy. :)

Do the math based on your best estimates while adding some what ifs. Only then decide if tax adjusting your AA is warranted for your situation.

Don't lose a lot of sleep over it. You can always make adjustments to your tax adjusted AA as time goes by and your portfolio grows and your future tax liability rate becomes better defined.
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