Portfolio Rebalancing in Taxable Accounts

This article explains how portfolio rebalancing works in taxable accounts. When we rebalance in ISAs and SIPPs, tax is not an issue.

But doing the rebalancing in taxable accounts means that we are left with less money after rebalancing. Is it worth it? What’s the cost?

First of all, let’s start by looking at what rebalancing is and why we should practice it.

We all choose an investment portfolio based on our goals, the risks we can tolerate and need to achieve those goals.

Sure maximizing the money our investing can make is always good, but we have to stay the course and make sure we sleep at night.

As a result, our portfolio includes various assets like stocks, property and bonds. It has a certain risk profile.

But the value of our assets changes over time. Therefore, our portfolio drifts from its original state and so does its risk profile.

That’s dangerous as we might sell out of panic, get worse returns or make the journey stressful.

Rebalancing is the act of bringing a portfolio back to its target state. This means selling winners and topping up losers when positions get out of balance.

As a result, we maintain our original asset mix and the risk profile we had chosen.

For example, say you own a 60% stocks 40% bonds portfolio. After a phenomenal 2021, your portfolio is now 75% equities 25% bonds.

To rebalance your portfolio you need to sell equities and buy bonds so that your new allocation goes back to 60-40.

The Benefits of Rebalancing

Why rebalance?

Rebalancing is very effective in a diversified portfolio, where not all positions move together. The result is a smoother journey and potentially a better total return than the sum of its parts.

The rebalancing benefits are:

• Constantly selling overweight assets, buying underweight ones (buy low sell high)
• Keeping the right risk profile for your age, risk tolerance and goals
• Potentially higher returns
• Higher risk-adjusted returns
• Prevent panic

For instance, let’s have a look at what happened during the Great Financial Crisis of 2008-09.

Here is the portfolio starting with $10,000 in Jan 2007 and running until the end of 2012.

I compare the 100% stocks (red) portfolio with the 60/40 stocks/bonds (blue).

It took 6 years for the 100% Stocks portfolio to break even. The 60/40 is 20% higher during the same period.

The 100% Stocks portfolio went down 50.80% during the doom and gloom of 2009.  The 60/40 though, only lost 28.71%.

After such a crash, you don’t see investing the same way anymore, particularly if you experience it for the first time. And let’s not forget, that GFC happened just 7 years after the dot-com bust. In 2000, equity investors experienced another 50% drop!

When starting in 2007, it wasn’t until 2017 that the 100% stocks portfolio reached the 60/40 bonds one. 10 years later!

Sure, I’m cherry-picking the ideal starting point to make a point here. But heavy crashes happen on average once a decade. If you think the last 12 years are the norm, they’re not….!

So mixing other assets with our stocks is prudent and can help with “dry powder” to rebalance into stocks when they’re cheap.

Rebalancing costs in TAXABLE accounts

If you have all your investments in ISAs and SIPPs, read no more. Lucky you, rebalancing is almost free (minus trading costs and bid-ask spreads).

But for those of us with investments in Limited company accounts and General Investment accounts the taxman wants his cut.

Psychologically it’s hard to rebalance because it means selling your winners and buying laggards. Imagine if you also had to pay tax on it!

Questions when rebalancing in taxable accounts

Every time you rebalance you might trigger a tax event.

Therefore, rebalancing in taxable accounts has these 2 disadvantages:

• You pay tax so you are left with less money to invest
• The tax money is not ‘working’ for your portfolio anymore

How serious are these two statements? And are the costs too expensive to make rebalancing worth it?

How big of an impact does TAX play when rebalancing? We need to consider if the tax costs outweigh the benefits we get from rebalancing.

Is it worth it?

And if so, is there a point where the tax rate is too high such that rebalancing doesn’t work in your favour? In other words, if tax was 50% should I still rebalance?

I’d like to thank my mate Dion with whom I debated this topic for days. He is a financial analyst and gave me some good inputs and helped with the process.

The company investing community offered some great insights as well and I’m grateful for that.

The inspiration I got for this post comes from 2 REITs I own with similar characteristics (NAV, dividend yield, etc). REIT A had outperformed REIT B by far, although nothing had changed in the fundamentals (that I know of). Investors have just decided to favour one versus the other.
I had split my money between the two. But REIT A has appreciated by 50% and REIT B only by 10%.

– Should I now sell REIT A and bring it back to a 50-50 split with REIT B? Also known as, rebalance.
– Yes, you should.
– But I will have to pay corporation tax. AND I will be left with less invested money in total. My previous pot minus the tax.

Let’s look at the actual numbers to find out how bad rebalancing is in taxable accounts.

There are 2 separate cases here just because the tax system is different between LTD company accounts (corporate taxation) and General Investment Account (personal taxation).

Rebalancing in Limited Company Accounts

In limited company accounts, rebalancing means trimming our winners and paying corporation tax on the profits each year.

How much tax we pay depends on how much of our profit we sell to rebalance.

In the worst-case scenario, we will be taxed on the entire profit each year.

I will start the rebalancing analysis with the worst-case scenario, which is: Realise the entire profit and pay tax on it every year.

What’s the alternative? Well, not rebalancing 🙂

Not rebalancing doesn’t mean we will evade tax. It just means it will accumulate, until we sell our holdings at the end of our journey at which point we have to pay the tax.

OK, time for a simulation. How expensive is it to rebalance our portfolio vs running an unbalanced one for X years?

For comparison purposes, I will set the time horizon to 5 years. The rebalanced portfolio will pay tax every year, whereas the unbalanced one will only pay it at the end of the 5-year period.

Assumptions:

• Returns = 10%
• Corp tax = 19%
• Rebalance yearly for one portfolio

The results surprised me. I was expecting a more grim picture for the rebalanced portfolio. But instead, I find the rebalanced portfolio being very close to the unbalanced one after tax.

So in the worst-case scenario, where every year, our best-performing assets will sell all their profits to top up the least performing ones (hence maximum tax), rebalancing costs just 1.23% in total returns in 5 years. That’s £1,837 for our ending value of £149,451.

It’s worth noting I have not added the rebalancing benefit itself, just looked at the cost of rebalancing in tax terms, assuming the same returns in both portfolios.

I know, I know, not rebalancing means a different risk profile and probably different returns. But it can go both ways.

I run this experiment of only looking at the cost (tax) of rebalancing to get some perspective. I wanted to see to what extent upfront tax payments cost versus paying it all together at the end.

In theory, the rebalanced portfolio will perform better in risk-adjusted returns. This means that it may perform worse when you compare the two returns alone but when you consider the risk of big downswings, then rebalancing is better.

By practising this sell high buy low strategy between our assets, rebalancing makes sure we are on track.

I might look at different time periods and study the actual rebalancing cost (or benefit) in taxable accounts for historical events (market decline vs bull market). But that will be another post!

Why 5 years horizon? Well, I find it a bit reckless to remain unbalanced for longer just because of the tax situation. Don’t let the tax tail wag the investment dog!

Here is the rebalancing cost breakdown per year for the worst-case scenario. By cost, I mean lower returns due to paying tax upfront.

Ok, so the rebalancing will drag the portfolio by 1.23% after 5 years.

You might ask, why is that? Don’t we pay the tax anyway at the end in the “no rebalance” scenario?

Yes, but paying tax yearly means you interrupt the compounding which hurts the overall returns, all else being equal.

In short, if you are thinking of skipping rebalancing because of the tax, you now know the cost is not high at all.

In fact, I could argue the cost is negative. If you don’t rebalance, you risk running on an overvalued position and not buying your undervalued ones.

Or you risk deviating from your risk tolerance. As a result, you might panic sell during a crash or make other behavioural mistakes now that you’re not following your own rules.

It’s not just stocks and bonds. It all depends on your asset allocation. You can rebalance out of bitcoin when it’s very high and into property and vice versa.

Not rebalancing may damage your long-term returns.

Can Rebalancing be even better?

The reality is even better than that. When rebalancing you don’t realise the entire portfolio profit. So the tax is only triggered in parts of the profits.

For example, say you buy £10,000 in company A and £10,000 in company B. You aim to keep a 50-50 allocation between the two companies, they’re very much alike.

Company A goes up to £15,000. A 50% gain
Company B stays flat, £10,000. A no gain no loss.
Total = £25,000

To go back to our original 50-50 allocation we have to sell some shares of company A and buy company B.

We need £12,500 in both companies. As a result, we sell £2,500 in company A and buy £2,500 in company B.

End result:
Company A £12,500
Company B £12,500
Total = £25,000

Instead of realising the entire £5,000 profit, we only realised £2,500 of it. Therefore the 19% tax is only paid on the £2,500 of profit.

19% of £2,500 = £475 to pay (instead of £900 in the ‘worst-case scenario’)

In fact, sometimes we carry forward losses from previous years in limited company investments. Therefore, we might pay zero tax even if we rebalanced in taxable accounts. Check out the company investing academy for more on limited company investing.

Rebalancing in General Investment Accounts

The tax rules for individuals are a bit different to limited company accounts.

Instead of corporation tax, individuals pay capital gains tax on the realised profits. Here’s a big bonus: The first £12,300 capital gains are tax-free in every tax year! (as it stands in 2021/2022)

Then the Capital gains tax is 10% for basic rate taxpayers and 20% for higher rate taxpayers.

As a result, my intuition says that without even looking at the numbers, rebalancing every year should actually be encouraged. On top of the rebalancing benefits, you can now also capitalise on the £12,300 tax-free gift.

If you don’t use your capital gains allowance you lose it. It’s not transferred to the next year.

Running the same assumptions as before, but now using the personal taxation rules, here’s how much rebalancing costs benefits:

So your portfolio not only is closer to your risk tolerance but also has better absolute returns as well! This is thanks to the tax savings that we ‘harvest’ every year – hence the technical term, tax-gain harvesting.

It is, therefore, important is to rebalance at least yearly in taxable accounts.

As a reminder, those investing in ISA or a pension account should not worry at all about the cost of rebalancing. They should just do it.

How to Rebalance in Taxable Accounts

We saw that rebalancing costs little in limited company accounts and it’s actually beneficial in general investment accounts.

Here are some really useful tips when rebalancing in taxable accounts:

1. Use your contributions to rebalance the portfolio

Typically, we invest our money over time thanks to regular income such as a salary or an invoice.

For example, your limited company generates profits and invests the money over time.

In this case, you can use your new contributions to top up the part of the portfolio that is left behind, instead of selling. So every time you make a contribution, you can rebalance by topping up the underweight holdings first.

As a result, you will not trigger any tax event while also rebalancing your portfolio in a smooth way.

2. Rebalance using your withdrawals

Similarly, if you need to make withdrawals from your portfolio, you can use them to rebalance.

When choosing what to sell, you should focus on selling first what brings you to your desired asset allocation.

3. Use dividends, interest and rental income to rebalance

As you receive dividends, interest or rental income from properties, you can use this regular income to rebalance.

This is quite useful and it’s one of my favourite ways to rebalance because it involves no selling and no tax payments.

4. Use ISA and SIPP first

Most people with a general investments account or a limited company account have an ISA and a SIPP or some other pension.

Instead of looking at our portfolio in silos, we should be looking at our portfolio as a whole.

When selling winners, we can rebalance by using our ISA or SIPP holdings first where selling is tax-free.

It’s important not to overdo this. Otherwise, assuming risky assets will have higher returns, our company account will be left with all risky assets and our ISA mostly in risk-free ones!

5. Practice capital gains tax-gain harvesting

In a General Investing Account tax-gain harvesting is really free money.

As we saw above, UK taxpayers have a £12,300 capital gains tax allowance every tax year.

So, if your total capital gains this tax year are under that amount, you’ll pay no tax.

Even if you don’t need to rebalance, selling your gains to ‘harvest’ the £12,300 capital gains allowance every tax year is a no brainer.

Even better if it helps you rebalance along the way. Your future capital gains tax will be £12,300 lower.

We need to be mindful of the UK tax rules that say you have to wait 30 days before you can buy the same holding back. You can buy a similar ETF after selling, not the same. Or just stay in cash for 30 days.

6. Use auto-rebalancing funds

Say you want to stay within a certain split between stocks and bonds. You can find a fund that includes a mix of Stocks/Bonds at your desired allocation. For example, the Vanguard Lifestrategy funds.

The fund manager will automatically rebalance at a pre-defined frequency so you don’t even have to worry about doing it manually.

There are not many funds like that. For example, this does not apply if you have a custom portfolio of say 20 stocks. Rebalancing has to happen manually.

But if you rebalance between asset classes (say 80/20 stocks/bonds) then it’s possible to use a fund. They will automatically rebalance the holdings and keep it tax-efficient too.

Should you rebalance in taxable accounts?

We saw how rebalancing can be beneficial even if it comes with slightly higher costs because of upfront taxes.

Overall, yes, UK taxpayers and limited companies should rebalance their UK taxable accounts. They can improve the process by rebalancing their ISAs and SIPPs first, they can benefit from the yearly capital gains tax allowances and also use their new contributions to bring the portfolio back to the target state over time.

After such a period of strong returns, I’m sure some portfolios need some TLC 🙂

Use the recommendations above to rebalance your portfolio in a tax-efficient way and do not postpone it. Do not let the tax tail wag the investment dog!

Hope you enjoyed this post. Happy rebalancing!