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How Tax-Smart Rebalancing Benefits Both Advisors and Clients

September 12, 2023 Walt Butler By Walt Butler

Tax-smart rebalancing is a crucial strategy in portfolio management that aims to optimize tax efficiency while maintaining the desired asset location and asset allocation. This approach involves periodically adjusting the composition of a household’s investment portfolio to align with predetermined targets, taking into consideration factors such as market-related risk, risk tolerance, and tax implications.

The importance of tax-smart rebalancing lies in its ability to mitigate various risks associated with portfolio management. It helps investors maintain their desired asset allocation while continually making the portfolio more tax efficient, which is essential for increasing after-tax returns and generating more retirement income. 

For advisors,  tax-smart rebalancing helps increase their assets under management (AUM), generate higher returns for their clients, and produce more revenue from their book of business over time.

To successfully implement tax-smart rebalancing, advisors need to consider their asset allocation strategy, risk tolerance, capacity for bearing losses, and correction strategies for drift. Moreover, understanding the potential tax implications – including tax brackets and state and federal tax rates – is crucial for optimizing after-tax returns when rebalancing a household portfolio.

By implementing tax-smart rebalancing, investors can minimize their tax liabilities and maximize after-tax returns. LifeYield can provide advisors and their firms with the resources and guidance necessary to rebalance clients’ portfolios in the most tax-efficient way possible.

What is Tax-Smart Rebalancing?

Tax-smart rebalancing is a strategic investment technique that aims to minimize tax liabilities by adjusting the location and/or allocation of assets in a portfolio in a tax-efficient way. This approach involves periodically reviewing and adjusting the asset mix to maintain the desired risk level while leveraging the tax advantages of each type of account. By strategically rebalancing a portfolio through a tax lens, advisors can ensure client portfolios are optimized for tax efficiency.

Rebalancing is an essential aspect of this strategy as it ensures that the portfolio remains aligned with the investor’s objectives. It involves selling overweight asset classes and buying underweight ones to bring the portfolio back to its target allocation. 

Tax considerations should play a crucial role in this process, as certain transactions may trigger sizable taxable events. Tax-smart rebalancing seeks to find ways to make these adjustments while minimizing tax consequences and providing advisors and their clients with the tools to decide whether they should execute a full rebalance now or take an alternative route.

Overall, tax-smart rebalancing offers advisors a proactive approach to managing client portfolios by improving future projected returns with each rebalance. By following a disciplined strategy, advisors can enhance after-tax returns by using a lever they can control: tax exposure.

Benefits and Importance of Rebalancing

Optimizing a client’s asset location and allocation periodically helps maintain a balanced portfolio, ensuring that investments are aligned with the intended risk and return objectives. Rebalancing offers several benefits and is an extremely important piece of the investment management process:

Regular rebalancing optimizes risk management, enhances diversification, promotes investment discipline, and potentially generates additional returns for an investor’s portfolio.

Factors in Tax-Smart Rebalancing

When executing rebalancing on a household portfolio, there are many variables to consider

Different investors have different risk tolerances and objectives, so it is crucial to assess whether the current asset allocation aligns with these factors.

An analysis of the risk level can help determine if adjustments are needed to maintain an optimal balance between risk and return.

Risk level, asset allocation strategies, asset location, market-related risk, risk tolerance, concentration risk, and drift are all crucial to consider when executing a household-level rebalance. Here’s how.

Risk Level

The risk level of a portfolio is an important factor to consider when implementing tax-smart rebalancing strategies. Rebalancing involves adjusting the asset allocation within an investment portfolio to maintain desired risk levels and meet long-term goals.

By considering the risk level of each asset class in the portfolio, investors can determine how frequently they need to rebalance in order to minimize tax consequences while still achieving their investment objectives.

Different asset classes carry different levels of risk, with some being more volatile than others. Higher-risk assets may require more frequent rebalancing to keep them within desired risk thresholds. On the other hand, lower-risk assets may not need frequent adjustments.

By understanding the risk level associated with each asset class, investors can make informed decisions about when and how often to rebalance their portfolios in order to optimize tax efficiency without sacrificing long-term returns.

Asset Allocation and Asset Location Strategies

An asset allocation strategy involves determining the optimal mix of different asset classes in a portfolio to achieve specific investment goals like increasing retirement savings and managing risk. It is an essential component of investment management, as it helps investors balance their portfolios and maximize returns while minimizing risk. It also creates an opportunity to make a portfolio more tax-efficient, ultimately boosting returns.

We recommend taking a tax-smart approach to implementing an asset allocation across the household. This technique involves adjusting the weightings of various assets in the household’s portfolio to maintain the desired asset allocation while considering tax consequences and the tax advantages of each account type. It considers not only risk and return objectives but also tax implications. By strategically rebalancing the portfolio, investors can potentially minimize taxes on capital gains and dividends while still achieving their long-term investment goals.

An effective asset allocation strategy considers factors such as an investor’s risk tolerance, time horizon, and investment objectives. This ensures that the portfolio remains aligned with their retirement objectives and financial goals.

Market-Related Risk

Market-related risk plays a crucial role in determining the effectiveness of tax-smart rebalancing.

Market-related risk refers to the potential for losses due to fluctuations in financial markets. These risks can arise from various factors such as economic conditions, geopolitical events, and investor sentiment.

Capitalizing on market-related risk is essential for implementing an effective tax-smart rebalancing strategy because it allows investors to make informed decisions about when and how to adjust their portfolios.

By monitoring market trends and assessing potential risks, investors can strategically rebalance their portfolios to minimize tax implications while optimizing returns.

This approach requires a deep understanding of both taxes and the dynamics of financial markets, allowing advisors and investors to navigate these complexities with control and precision.

Risk Tolerance and Capacity

Risk tolerance and capacity are important factors to consider when implementing an effective asset allocation strategy, as they determine an investor’s ability to withstand potential losses and fluctuations in the market. Risk tolerance refers to an investor’s comfort level with taking on risk in their investments, while risk capacity relates to their financial ability to bear losses. Understanding these factors is crucial for a tax-smart rebalancing approach.

By assessing risk tolerance and capacity, investors can determine the appropriate asset mix that aligns with their goals and constraints. A financial advisor can assist in this process by conducting a thorough analysis of the investor’s circumstances, including their time horizon, income, expenses, and investment objectives. This ensures that the investor’s portfolio is tailored to meet their specific needs while minimizing unnecessary risk.

Incorporating a tax-smart rebalancing strategy further enhances the effectiveness of investing by optimizing tax efficiency while maintaining the desired asset allocation. This strategy considers an investor’s ability to realize gains or losses in a current year and optimizes a rebalancing strategy to meet the investor’s needs.

Concentration Risk

Concentration risk is crucial to consider when implementing an effective asset allocation strategy. When rebalancing a portfolio, it is important to assess this periodically in order to determine the right time for a rebalance.

Concentration risk relates to having an excessive allocation to a particular asset class or investments’. By diversifying across different asset classes, such as stocks and bonds, as well as industry sectors, investors can reduce concentration risk and potentially enhance returns while managing overall portfolio risk.

Fixed-income assets can provide stability during market downturns due to their lower volatility compared to stocks. Knowing where to hold bonds vs. stocks across account types is essential for creating the most tax-efficient portfolio. 

Drift and Correction

Drift and correction are important aspects to consider in maintaining the stability and alignment of an investment portfolio. When implementing tax-smart rebalancing strategies, it is crucial to understand the implications of drift and how to correct it effectively. Here are four key considerations:

  1. Drift: Over time, market fluctuations can cause a portfolio’s allocation to deviate from its target. This poses a risk as it may lead to excessive exposure or underweighting of certain asset classes.
  2. Monitoring: Regularly monitoring the portfolio’s performance is essential for identifying any deviations from the target allocation. Intelligent portfolios utilize advanced algorithms that continuously analyze data to detect drift.
  3. Correction techniques: Once drift is identified, corrective measures need to be taken. These may include selling overweight asset classes or buying underweight ones, with a focus on tax lot selection that minimizes tax consequences.
  4. Equities: Given their higher volatility compared to other asset classes, equities often contribute significantly to drift. Careful consideration should be given when determining the optimal location for each asset class during rebalancing.

By proactively addressing drift and applying appropriate correction techniques, advisors can ensure their clients’ portfolio remains aligned with their desired asset location and asset allocation while optimizing tax efficiency.

Tax Risk and Mitigation

One crucial aspect to consider in maintaining the stability and alignment of an investment portfolio is the potential for tax implications, which can be effectively mitigated through careful planning and strategic decision-making – and of course, the right software.

Tax risk refers to the possibility of adverse tax consequences arising from investment activities. It is essential for investors to understand the potential impact of taxes on their portfolio returns and take appropriate measures to minimize this risk.

One effective way to mitigate tax risk is through tax-smart rebalancing, which involves strategically adjusting the asset location and asset allocation of a portfolio while taking into consideration the tax consequences of such adjustments. By carefully evaluating capital gains, losses, early withdrawal penalties, and dividend distributions, investors can make informed decisions that optimize their after-tax returns.

Minimizing tax risk requires a proactive approach that includes regular monitoring of investment portfolios, strategic rebalancing tactics, and adherence to applicable tax regulations. By considering these factors alongside traditional investment considerations like asset allocation and diversification, advisors and investors can work towards achieving optimal after-tax returns while maintaining control over their financial outcomes.

Frequently Asked Questions

How does tax-smart rebalancing differ from regular rebalancing?

Tax-smart rebalancing differs from regular rebalancing by considering the tax implications of portfolio adjustments and the tax treatment of each account type with each transaction. It aims to minimize the long-term tax impact on a portfolio during each rebalance by locating tax-inefficient assets in qualified accounts and tax-efficient assets in non-qualified accounts.

What are some tax-efficient strategies for rebalancing a portfolio?

Some tax-efficient strategies for portfolio rebalancing include tax harvesting, asset location, and using tax-efficient investment vehicles. These techniques aim to minimize capital gains taxes and maximize after-tax returns for investors.

Can tax-smart rebalancing help minimize capital gains taxes?

Tax-smart rebalancing can help minimize capital gains taxes by strategically selling investments with lower tax implications, ensuring that the portfolio remains aligned with desired asset allocation while minimizing tax liabilities.

How often should tax-smart rebalancing be done?

Tax-smart rebalancing should be done periodically to ensure an ongoing optimal portfolio allocation. The frequency depends on factors such as market conditions, tax implications, and an individual’s investment goals. Consistent monitoring and adjustment can help achieve long-term investment objectives while minimizing investment taxes.

Are there any potential downsides or risks associated with tax-smart rebalancing?

Potential downsides and risks associated with tax-smart rebalancing include increased complexity, reliance on accurate tax information, and the need for ongoing monitoring and adjustments. All this can be eliminated by using the right technology.


Tax-smart rebalancing is a crucial strategy that investors should consider to optimize their portfolios.

By periodically adjusting asset location and asset allocation based on market conditions and risk factors, investors can minimize drift and greatly reduce potential tax liabilities.

This approach requires a thorough analysis of factors such as capital market assumptions, asset allocation strategy, market-related risks, risk tolerance, contingency and concentration risks, as well as tax implications.

By implementing a comprehensive, tax-smart rebalancing strategy, investors can effectively mitigate risks and enhance their overall investment returns in an intentional way.

Walt is the VP of Product Development at LifeYield.