ETF Investing Guide: Combining Tax-Loss Selling & Rebalancing

by: David Jackson

Yes, you guessed it: you can combine tax-loss selling and portfolio rebalancing. I mentioned that if you rebalance your portfolio in a taxable account, you trigger capital gains (because you sell asset classes that have appreciated and buy asset classes that have depreciated). To some degree, you can minimize those gains by selling the lots that you purchased at the highest prices. But now you can further minimize the tax impact by selling all the assets that have depreciated, and moving them sideways into equivalent-but-not-identical ETFs.

If this sounds like a lot of expensive trading (even in an online brokerage account), it could be. But if you combine the portfolio rebalancing and tax-loss selling, you’ll also reduce the number of trades. Here’s how. Imagine you have a simple portfolio: IVV (lowest-fee S&P 500 stock index ETF) and SHY (short-term bond index ETF). You start off with a 50/50 split, but stocks prices fall, bonds prices rise and you find yourself with a 40/60 split. Here’s what you could do:

  • Sell 1/6th of your bond position.
  • Sell all of your stock position.
  • Invest all the resulting cash in IWB, the Russell 1000 stock ETF.

You’ve rebalanced your portfolio back to 50% stocks, 50% bonds. You’ve realized a tax gain on the bond ETF you sold, and a more than offsetting tax loss on the stock ETF you sold. And you’ve accomplished both the rebalancing and the tax-loss selling in 3 trades rather than 4. Neat, eh?

Note also that tax-loss selling is now more valuable than it originally seemed. While the limit for deductions from current ordinary income for net capital losses is $3,000, tax-loss selling delivers far larger benefits if used to offset profits from portfolio rebalancing in large portfolios.

If you’re thinking “This is all sounding too complicated and too much work”, don’t panic. The low-maintenance investor can chose a simple portfolio with only a few ETFs, rebalance once a year, in December, and execute tax-loss selling at the same time. Even then, you should reap considerable benefits: lower risk, and greater after-tax returns.

Even using a simple rebalancing rule with only two asset classes (50% in a stock index and 50% in a bond index) would have given you an average return between 1996 and 2002 of 9.2%, versus 6.8% in only stocks and 7.9% in only bonds, according to Vanguard.

And if you’re a high-maintenance investor who doesn’t mind more work, you can chose a more granular ETF portfolio, and rebalance and tax-loss sell whenever the market moves enough to hit your preset percentage triggers.

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