Rebalance your portfolio for your benefit, not the tax man’s

Whatever strategy you employ when you rebalance your portfolio, you need to think about tax.

For instance, it might not make sense to sell your shares to reduce a theoretical risk if it triggers an all-too-real capital gains tax bill.

By only using tax-exempt or tax-deferred accounts, you can avoid paying tax on investment income and capital gains completely – which means investing via ISAs and pensions in the UK.

Congratulations if that’s you – school’s over, and it’s the weekend!

Many of us have at least some investments outside of tax-exempt wrappers, which makes rebalancing more challenging.

In this article I’ll outline a few tax factors to consider when rebalancing.

Every circumstance is different, so these are only pointers. You’ll need to crunch the numbers yourself, and possibly get some help.

Incidentally, the standard wisdom is you shouldn’t let tax determine how you invest, but I think some pragmatism is called for.

There’s little more miserable than risking a big slug of your money, only to find the Government wanting a cut of the gains, despite taking none of the risks!

Invest via tax-exempt accounts

“Too late for that!” I hear you cry. Well, it’s never too late to start.

In the UK you can direct new money – or money freed up when you rebalance – into tax-free ISAs, pensions, National Savings Certificates, and even Premium Bonds (though I wouldn’t).

Like this you’ll hopefully reduce tax headaches as the years go by, unless you’re lucky enough to get very rich.

Do think about what assets to hold where. Income from cash, bonds and PIDs from REITs are taxed more heavily than share dividends in the UK, but the potential for large capital gains is usually much higher with shares.

Exploit your annual Capital Gains Tax (CGT) allowance

Most countries allow you to make some capital gains every year before tax is due – and in some countries there’s no CGT at all!

Here in the UK, we can make £10,100 in gains in the 2009/10 year before paying CGT.

That is £10,100 a year across all your taxable investments that you sell in the 12 months, NOT £10,100 on each investment!

It’s a good idea to use up your CGT allowance every year by realising capital gains to ‘defuse’ long-term tax liabilities.

Rebalance using new money, rather than selling

If your portfolio is still small relative to the amount you’re saving and investing every year, you can use new money to rebalance your allocations rather than selling and triggering CGT and other costs.

For instance, say you have a simple ETF and cash portfolio of £100,000 consisting of:

• 25% in cash (£25,000)
• 25% in a bond ETF (£25,000)
• 25% in FTSE 100 ETF (£25,000)
• 25% in a REIT ETF (£25,000)

In one year the stock market doubles (hey – it’s a conveniently stellar year!) while your other investments perform more sedately or fall to leave you with £126,000 roughly as:

• 20% in cash (£26,000)
• 16% in bonds (£20,000)
• 40% in the FTSE 100 (£50,000)
• 24% in REITs (£30,000)

You want to rebalance back towards your original allocations. You also plan to invest another £10,000 from your earnings over the next 12 months.

In this circumstance you could sell say £15,000 worth of the FTSE ETF, which would realize gains well below the CGT threshold, and distribute the proceeds between your bond and cash holdings.

Then you could direct your new savings towards topping up the remaining shortfall in bonds and REITs over the next year.

Remember, rebalancing isn’t a precise art – it’s keep overall allocations roughly in line that matters.

Carry forward capital losses to use later

When you’ve lost money in the market, the last thing you may want to do is work out how much.

However if you’ve sold assets such as shares at an overall loss in the tax year, you should fill in the appropriate pages of your tax return to carry the loss forward.

Who knows? That £3,000 you lost might save you £500 in tax someday – but it’s down to you to make sure the record of the loss is lodged with the authorities.

Allow allocations to drift

If you’ve got a very big portfolio outside of tax-exempt accounts, you may sniff at the puny £10,100 allowance that makes CGT ‘the rich man’s tax’ for the rest of us.

Ironically, the rich are notorious for finding ways to avoid CGT, too, which is one reason why some people say CGT should be abolished as pointless.

But back to you, Rockefeller Jr.

I’m not in the position of having a six-figure portfolio outside of tax-exempt accounts, so I can’t speak from personal experience.

However, I know a man who can.

David Swensen, the famous Ivy League portfolio manager who runs Yale University’s multi-billion dollar fund, suggests you may be best leaving your allocations to drift, if the alternative is paying a big tax bill.

In Unconventional Success, he writes:

“In cases where adverse tax consequences accompany rebalancing trades, investors must weigh the certain tax costs against the uncertain portfolio benefits. Often, investors will choose to allow allocations to drift modestly from the target to avoid paying taxes on appreciated positions”.

One investor who does this is Warren Buffett, who has held on to some of his massive equity positions for decades to avoid crystalising a capital gains bill.

Risky: Consider shorting or options to protect your gains

Some sophisticated investors protect their portfolios by using spreadbets or other shorts to effectively reduce their exposure to a particular asset, in a similar way to a hedge fund.

For instance, you might have a £500,000 equity portfolio but a £100,000 short position against the market, so your overall equity exposure is £400,000.

You might take the short position via a spreadbet or an option such as a Contract for Difference, or else you could have a specialist create a structured option tailored to your portfolio.

This technique may be worth doing if you’re trying to carry your gains into a new tax year, or in some other specific circumstance.

However it is expensive, risky, and requires expert advice before you go any further as you could easily lose far more money than you stand to pay in tax if you get it wrong.

For 99% of us, it’s over-complicating things.

Don’t let tax dominate your rebalancing

It’s important not to get too obsessed about avoiding tax, to the extent that you start to put money into dubious schemes you’d otherwise shun.

If you don’t want to invest in structured products, Venture Capital Trusts or offshore bonds (and you probably don’t) then don’t do so for tax reasons – unless you’ve so much money that you may as well take the punt.

Indeed if that’s your attitude, you could very carefully try spreadbetting on shares to increase your allocations – capital gains aren’t taxed at all, but neither can you carry forward losses, and it’s easy to lose more than you think through leverage. You have been warned!

Further reading

• The latest UK tax rates for interest, dividends, CGT and more
  

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