The average investor will face higher tax bills in the years ahead. This is true even if President Biden’s tax plan—including higher marginal tax rates, higher capital gain rates and numerous other wealth-reducing provisions—never makes its way into law. Why? Because the average investor owns a portfolio that contains significant unrealized capital gains.
This is certainly the case with clients of Bragg Financial. The stock market has done well over the last decade. Over ten years ending June 30, 2021, the S&P 500 is up 225.4% cumulatively (12.5% annualized), and most of that return has come in the form of price appreciation. As a result, owners of diversified portfolios have large unrealized gains that are widespread throughout the portfolio.
Rebalancing the portfolio—trimming stocks and adding to bonds to return to the target allocation—after the run-up in stock prices has become more challenging without realizing capital gains. Investors who regularly draw from their accounts—whether monthly withdrawals or periodic lump sums—likewise find that trimming equities to fund these withdrawals face the same challenge.
Yes, it is a good problem to have. Few of us would trade our widespread gains for the alternative. But paying taxes is painful nonetheless.
Is there an alternative? Our answer in most cases is that there is not a good alternative to simply taking the hit and paying the tax. Perhaps this Q&A will be helpful.
Q: What if I don’t rebalance and simply let my stocks run? In other words, what if I let stocks become an increasing percentage of my overall portfolio balance relative to bonds.
A: This works well until it doesn’t. When the market takes a significant hit—and it will at some point—it is critical that your allocation is appropriate. You’ll need to have an adequate sum in bonds/cash to get through the decline and subsequent recovery. If you are drawing on your portfolio, our preference is for you to have a multiple of your annual draw, preferably 8–10 times the amount of your draw, in bonds/cash.
Q: What if I simply fund my withdrawals by trimming bonds and let the stocks continue to run?
A: Our answer is similar to the the first answer. Again, you’ll need to rebalance to trim your winners (trim stocks) and replenish your bond/cash position to maintain your target allocation and to have adequate liquidity.
Q: I don’t make withdrawals from my portfolio. Do I still need to rebalance?
A: Yes. We think it makes sense to recognize that yesterday’s winner, whether an asset class like US Large Cap or Emerging Markets or a sector like Technology or Healthcare, might be tomorrow’s laggard. Rebalancing within asset classes, sectors and even specific positions reduces the risk that we end up with too much concentration in the portfolio. Rebalancing means trimming overweight asset classes, sectors and positions at the margins in order to add to underweight positions in order to maintain diversification.
Q: Should I take on debt to fund my withdrawals to avoid drawing from the portfolio?
A: Only if your withdrawal is a temporary phenomenon. For example, you might use debt in the form of a bridge loan if you are moving from one house to another or if you have a different temporary need for a lump sum that has a time-certain end date.
In summary, the market has been good to us over the last decade. Most long-term investors have widespread gains embedded in their portfolios and normal portfolio activity—rebalancing the account or trimming holdings to fund withdrawals—will result in higher capital gains as we go forward.
Please note that this article does not address the changes to tax rates, including capital gain rates, being considered by Congress. These changes being considered by Congress, if passed as proposed, would add additional planning challenges. Please look for our articles about this subject in the months ahead.
If you would like to discuss your portfolio or the issues raised here, please contact us.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.