4 Tax Questions To Ask Before You Rebalance Your Portfolio

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Portfolio rebalancing is a long-held approach to investing.

Done wisely, it can ensure holdings align with your investment strategy. However, thoughtless actions can have inadvertent consequences come tax time. Ask yourself these four questions before rebalancing to avoid a nasty tax surprise.

Which Type of Account Am I Rebalancing In?

IRAs have various benefits for Americans. One key perk is that transactions within an IRA are tax-sheltered. Gains or dividends don’t create taxable consequences. That’s not the case for taxable brokerage accounts.

Rebalancing in a taxable account can generate short-term capital gains if you held the investment for less than a year; that gain is taxed as ordinary income. What if the sale created a loss? You might be able to use the loss to offset gains on other transactions, according to Fidelity.

Will I Trigger a Wash-Sale?

Gains are inevitable if you trade actively in a taxable account. Selling a losing investment can help mitigate gains and reduce taxable liability via tax-loss harvesting. The IRS allows Americans to utilize up to $3,000 in net losses to reduce ordinary income.

Unfortunately, erroneous actions can limit this ability if you trigger the wash-sale rule. Here’s how the wash-sale rule works. If you sell an investment at a loss and buy the same or nearly identical investment too soon, then the loss is disallowed. Per Charles Schwab, the time frame is within 30 days before or after the sale. If you’re unsure about the timing, consult a tax advisor for guidance.

Am I Selling the Correct Shares?

Americans may not realize they can select which shares (known as a tax lot) of an investment they can sell, if they purchased it on multiple occasions. Each purchase has its unique cost basis and holding period.

Brokerages allow investors to specify which tax lot they can sell. Selling a lot with a smaller gain or loss, or one held over a year, can minimize the tax hit while still allowing you to rebalance. It’s best to specify which lot to sell during the transaction. Per Wells Fargo Advisors, this must be done before the settlement date.

Can I Rebalance Without Selling?

Rebalancing doesn’t always require selling an investment at a potential gain. Adding funds to your account can be more tax-friendly, and you don’t need to be an expert to figure it out.

If you have sufficient funds, depositing them into your account to purchase the underweight investment(s) can avoid a tax hit. You can do similar even if you don’t have the cash to add to your account. If you have dividends or capital gain distributions, you could consider redirecting them to underweight holdings, as those payouts may be taxable either way.

Rebalancing your portfolio is an effective way to keep your investments on course. Performing due diligence before rebalancing is an important step to avoid any undesirable tax hits.

Editor’s note: This article is for informational purposes only and does not constitute financial advice. Investing involves risk, including the possible loss of principal. Always consider your individual circumstances and consult with a qualified financial advisor before making investment decisions.

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