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Financial Advisors Must Take Tax Efficiency into Account When Rebalancing Portfolios

April 15, 2022 Steve Zuschin By Steve Zuschin

Time, swings in the markets, and inflation are some of the factors that can swing any portfolio outside of the asset allocation that aligns with a client’s risk tolerance. Financial advisors typically advise clients to rebalance, or reallocate assets, when the risk-return ratio of their portfolio veers too far outside the lines.

The trouble is that rebalancing brings risks – particularly in the tax liabilities it can bring on unwitting or poorly advised investors. Over time, paying taxes to realign a portfolio can deplete the gains on investments and the money available for retirement.

Financial advisors can help their clients avoid these road hazards by:

Aren’t Advisors Already Wise to the Risks Exposed in Rebalancing?

Yes, many are. But unfortunately, many advisors still lose sight of the risk of active rebalancing when advising their clients on their investment portfolio strategy. And they may not have adequately guided their asset location to begin with.

A 2017 Harris Poll revealed that only 43% of respondents’ total investments and retirement savings were in tax-efficient accounts or investments. The survey was conducted for the American Society of CPAs. Andrea Millar, director of the AICPA’s Personal Financial Planning Division, said, “Given the sharp bite taxes can take out of returns, the importance of structuring investments and income-generating savings in a tax-efficient manner cannot be overstated.”*

What is Tax Efficiency?

Tax efficiency describes the state when an investor has the lowest possible tax liability under state and federal laws governing the rates and regulations for income and investment taxes.

The degree to which a portfolio is tax-efficient is measured by how much tax an investor pays relative to the income generated by investments and income. Tax inefficiency describes the situation when an investor pays higher-than-needed taxes on income or investments when there are alternatives available to reduce the tax liability. And, the less an investor spends on taxes, the more money available for future investment and growth.

A simple example: An investor may want to invest in actively managed mutual funds. Such funds can generate high tax liabilities for investors through frequent trades to take advantage of market conditions and generate strong returns.

If an investor holds such mutual funds in a taxable brokerage account, that could mean some large tax bills. But if that investor has the option, holding the same mutual funds in a tax-advantaged account – like a 401(k) or an individual retirement account (IRA) – is a smarter tax strategy because:

Investment-related taxes tend to add up quickly. If an investor is paying taxes on investments in peak earning years, it can imperil the amount the same investor has available for future financial goals, most notably retirement income.

How Do I Maximize Tax Efficiency?

Tax-efficient investing is a must if you want to maximize returns. So how do you build a portfolio that is as tax efficient as possible?

Tax-efficient portfolios limit their investors’ exposure to capital gains, dividends, and income distributions. It takes knowing how tax laws work, what types of investments can help protect investors from taxes, and sound advice from a qualified tax expert.

There are many different things investors can do to achieve tax efficiency. Some of those include:

How Does Rebalancing Fit with Tax Efficiency?

Investors have become accustomed to seeing the U.S. stock market record all-time highs over the last few years. Undeniably, the bull trend has been beneficial to portfolio balances. However, investors who have allowed the market’s surge to push up their equity (stock) allocations may now be holding riskier portfolios than intended.

An investor, for example, who started with a traditional 60/40 portfolio – one considered “moderate” in its risk evaluation — a decade ago could now have a portfolio tilting heavier toward equities and now flirting with being more aggressive than the investor intended.

It’s possible that our investor’s risk tolerance has risen in tandem with the stock market. It’s probable that the current portfolio no longer resembles an appropriate mix of risky and safe assets to align with the individual’s risk tolerance.

Rebalancing, or regularly selling the top performers in a portfolio to buy the lowest performers, is one of the best strategies to hedge against market moves that alter a portfolio’s risk profile.

The benefits of rebalancing are undeniable in tax-advantaged accounts, such as 401(k)s or IRAs, when tax consequences are usually deferred (although not erased). In taxable accounts, rebalancing may also be reasonable. Still, the benefits aren’t as obvious, as rebalancing may trigger capital gains taxes depending on the investor’s exposure and income level.

It’s important to note that any rebalancing trading should also take advantage of tax harvesting – using losses to offset gains to reduce an investor’s tax liability.

How often should investors rebalance? There are no hard-and-fast rules. The frequency with which you rebalance a portfolio should be a personal decision influenced by many characteristics such as age and particularly risk tolerance. However, it is advisable to rebalance a portfolio at least once a year.

Considerations When Rebalancing Portfolios

When investors rebalance, they sell a portion of their outperforming securities to acquire more of the underperforming ones to revert their investment mix to its desired composition. However, before rebalancing your portfolio, there are a few things to consider:

#1 Make Rebalancing Portfolios a Habit

Financial advisors should keep a close eye on the makeup of their clients’ portfolios and rebalance only when their asset mix drifts away considerably from their tolerance range. Even if it’s only been six months since the last rebalancing, if an original stock-to-bond ratio was 60/40 and rising share valuations have pushed it to 65/35, it may be time to rebalance.

What if advisors don’t do anything to rebalance client portfolios? Depending on market performance and other economic factors, those advisors leave their clients exposed to risks they don’t want to take. It’s possible that failing to rebalance robs their clients of potential gains if their portfolios drift too far into the conservative territory.

Managing risk is especially critical for persons less than ten years away from retirement. In that case, too-heavy equity allocations can leave their plans exposed if an equity shock happens shortly before or early in their retirements.

#2 Help Clients Decide What to Sell

This is where financial advisors can demonstrate the value of advice. Using the research and recommendations of the staff at their disposal, advisors can evaluate which securities appear to be the best to sell and which warrant holding longer.

#3 Use a Measured Approach

Mistakes happen when people rush. Small fluctuations in a client’s stock-to-bond ratio changes don’t invoke an immediate need to rebalance. When the shift is around 5%, it’s a good rule of thumb to perform the rebalancing operation. Others put that point at about a 10% shift.

Whatever a firm’s or an advisor’s opinion on rebalancing is, it’s always good to explain it to clients. Some clients may receive rebalancing notices from their 401(k) plans, for example, and wonder why their advisors are not encouraging them to rebalance accounts under their management.

#4 Keep an Eye on the Market Data

It’s critical to distinguish between short-term stock market volatility and a more long-term shift in the market’s direction. However, this can be challenging.

Is rebalancing the right move when it’s unclear if prices are rising because of the start of a new bull market? Rebalancing in stages is a solid strategy for dealing with this scenario. So is spreading activity across two or three months, allowing more time to understand the market’s trajectory.

#5 Remember that Risk Profiles Can Flex with Time

Experts have long suggested that moving people’s investments to safer fixed-income investments is wise as people age. But this doesn’t apply to everyone.

Individual circumstances could mean investors who were timid when they first filled out a risk evaluation become more comfortable with experience and have the assets, income, or time horizon to ride out market corrections. And many investors now fear that with rising longevity, being too safe with investing means they won’t have the money they need in old age.

In short, reviewing risk tolerance is something advisors should do with clients regularly. Based on those reviews, advisors will need to evaluate if clients’ current stock-to-bond ratios suit their needs the next time they rebalance their portfolios.

#6 Use a Broad Lens in Rebalancing to Capture All Accounts in a Portfolio

Financial advisors often manage only a portion of any client’s total portfolio. It’s pretty standard for an investor to have a financial advisor managing a taxable (brokerage) account and one or more tax-advantaged accounts, like an IRA created from 401(k) portfolios. Those same clients may have one more 401(k) accounts not under the advisor’s management and invest in and stocks themselves in an online account.

Advisors ask how they can do their best when they aren’t managing a client’s entire portfolio. Or – another frequent scenario – there are spouses with separate accounts and separate advisors.

Many firms have recognized that they need to adapt their practices and technology to the rising complexity of client portfolios. And they have worked with LifeYield to update their asset management platforms for performing multi-account rebalancing.

Multi-account rebalancing enables advisors to do their best to guide their clients toward their financial goals. It can also help firms and their advisors demonstrate the value of moving management of held-away accounts to them, increasing the firms’ ability coordinate household

assets and grow their assets under management.

Tax-Efficient Rebalancing Techniques

Implementing a rebalancing strategy may be difficult because it includes selling appreciated securities, resulting in tax charges if investors are not careful. This is where software for multi-account rebalancing holds the key to maximizing tax efficiency and optimizing returns.

Multi-account rebalancing software will recognize the opportunities for such techniques as tax harvesting and trades, down to the tax lot level, that will set a portfolio back on its target risk allocation. It takes advantage of these time-honored rebalancing techniques:

Beginning With Tax-Advantaged Accounts

Unlike taxable accounts, where selling appreciated stocks often results in a tax bill, any repositioning within your tax-sheltered accounts will not result in tax bills today as long as all of the money remains in the accounts.

Fortunately, the IRS doesn’t keep track of sales of appreciated winnings in tax-advantaged accounts. Tax bills happen when clients withdraw money from tax-favored accounts. And in the case of Roth accounts, qualifying withdrawals in retirement will be tax-free.

Scaling back on appreciated investments and redirecting those gains to positions that haven’t fared as well won’t result in any tax charges for investors with most of their money in IRAs, 401(k)s, and other tax-advantaged accounts. So, this is the obvious place to start for trimming appreciated positions in a portfolio.

Making Charitable Distributions

Clients with accounts subject to mandatory minimum distributions (RMDs) can benefit from making qualified charitable donations.

This strategy involves directing RMDs, up to a limit of $100,000, to charities of a client’s choice. Clients can claim the charitable contribution and don’t pay income taxes on the RMD.

Clients whose portfolios have higher-than-desired concentrations of appreciated stock can also take advantage of tax laws by gifting stock to charity or selling it and depositing proceeds into a charitable gift account from which they can make donations.

Making Withdrawals Has an Impact on Asset Allocation

Another strategy for rebalancing portfolios of retired clients is removing assets from their tax-advantaged accounts. Retirement is, after all, what they saved for!

Making withdrawals does require careful evaluation of the tax consequences and whether there are other income sources available to retirees. And financial advisors must also keep in mind that withdrawals affect the size of the portfolio left to grow for future income and possibly for legacies to family members, friends, or charity.

Using Contributions to Rebalance Asset Allocations

Taxable accounts that have drifted from the desired asset allocation leave financial advisors and clients with fewer options than for resolving the problem with tax-advantaged accounts.

One option for clients who are dollar-cost averaging is to cease contributions to their highly valued positions and only add fresh dollars to underweight positions to rebalance in the most tax-efficient method possible.

Of course, suppose clients have been investing in a taxable account for a long time and have significant balances. It may take some time for new contributions to the underweighted positions to affect a portfolio’s asset allocation.


Rebalancing is a respected strategy for keeping clients’ financial plans on track. It can seemingly conflict with their desires to minimize tax liabilities.

But when advisors are using comprehensive advice platforms, they can evaluate different options that will keep client portfolios aligned to their risk tolerance while being as tax efficient in trades and withdrawals as possible.

LifeYield is a leading developer of tax-efficiency APIs that leading firms and advisors use to get the best outcomes for their clients through tax-efficient investing, withdrawals, and decumulation.

Contact us today for a demonstration of our capabilities and a discussion of how you can harness the engine of tax efficiency to improve client outcomes and increase assets under management.

*Americans say New Tax Law will Trigger Changes in their Financial Plan. (2018, February 18). AICPA.Org. Retrieved April 4, 2022, from

Steve is the EVP of Advisor Success at LifeYield. He's responsible for leading our Direct-to-Advisor channel and always keeps up on the latest advisor technology. Steve writes about how advisors can grow their business by building stronger relationships with clients and adopting new technology.