Take the tax bite out of stock sales

If it's time to sell some stocks to rebalance your portfolio, Money Magazine's Walter Updegrave has some advice on how to keep the tax man at bay.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I need to rebalance my portfolio and move some money out of stocks. I don't want to touch the total stock market index fund in my 401(k), so I'm thinking of selling individual stocks I own in tax accounts that aren't doing as well as I would like. But I don't want to take a huge tax hit. What should I do? -Linda, Dover, N.J.

Answer: I think it makes the most sense for you to deal with this issue holistically. In other words, rather than considering your 401(k) money and taxable accounts as separate pieces that you deal with independently of each other, you should consider all of your holdings as one big portfolio that you need to get into shape.

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And while your desire to avoid a big tax hit is understandable - and there may be ways for you to minimize it - tax considerations alone shouldn't be driving your decisions. Your main goal is to maintain a coherent and consistent investment strategy.

So before you start selling anything, your first step should be to settle on an overall target mix of stocks and bonds that's right for you. This target mix should be based on how long you'll have your money invested and your overall tolerance for risk - that is, how comfortable you are seeing the value of your portfolio bounce around during periods of market turmoil.

If you're investing for retirement that's still 20 or more years away, then you probably want to have 80 percent or more of your portfolio in stocks. But if you've got a shorter investing time horizon, you'll want to keep more money in bonds to buffer your portfolio a bit from swings in the stock market. For guidance on how to set an asset allocation that works for you, you can check out our Asset Allocator tool.

How many stocks should you own?

Whatever target mix you choose, you don't want to change it willy-nilly just because of what may be going on in the stock market. So if stocks are getting hammered, you shouldn't just start moving money into bonds or, conversely, begin shifting more dough into stocks when they're romping to big gains. This sort of behavior turns investing into a guessing game and defeats the whole purpose of setting an asset allocation strategy in the first place.

Sometimes, however, your portfolio mix will naturally fall out of whack. If stocks post big gains during the big year, for example, then stocks will make up a larger percentage of your portfolio. In years when bonds outperform, then bonds will become a larger portion of your holdings. Which is why you should rebalance your portfolio every year or so to bring it back to your target mix.

So the question you're really facing now is how do you do that? And, more specifically, how do you combine rebalancing with other aims, like culling inferior or mediocre investments from your portfolio or assuring that no single holding looms too large.

As a rule, you're better off limiting your moves as much as possible to tax-advantaged accounts. The reason: You can buy and sell shares in 401(k)s, IRAs and the like without triggering taxes. That's a plus because more of your money will remain invested and working for you.

As a practical matter, though, that's not always possible, or advisable. Sometimes you might have to make adjustments in taxable accounts. Notice that I said "might." The mere fact that stocks in your taxable accounts aren't doing as well as you would like isn't an automatic reason to sell them.

Maybe those stocks have declined in value simply because the market has fallen. Perhaps they're down, but have actually held up better than stocks overall. Maybe these stocks are now undervalued and represent real bargains.

All of which is to say that the real question you need to ask yourself is, What are the future prospects for these stocks? If you decide that the outlook for the company has worsened since you bought the shares and that, given their current price, they aren't likely to generate a competitive return, then fine, sell.

20 timeless money rules

But you shouldn't unload the shares until you've done this sort of analysis, otherwise you may be dumping them at precisely the wrong time. (And if you don't feel you're up to this sort of evaluation, then you probably shouldn't own individual share in the first place.)

So let's say that, after examining these shares' prospects, you decide you do need to unload them. Well, if you sell these shares for more than you paid for them, you're going to have a realized gain, which is taxable. There's not much you can do about that, although you may be able to reduce the bite.

How? Well, one thing to consider is your holding period for these stocks. If you sell shares you've held a year or less, you pay tax on the gain at ordinary income rates, which can go as high as 35 percent. If you've held them longer than a year, you pay the long-term capital gains rate, which maxes out at 15 percent.

I don't want to suggest that you should hold onto these stocks a long time just to pay a lower tax rate, especially if we're talking about a relatively small gain. But if we're talking about a matter of a couple of weeks or maybe even a couple of months until you're into long-term capital gains territory and you've got a large gain in these positions, then you might at least want to consider holding on until you qualify for the lower rate.

And while your focus right now is on the stocks you want to sell, you should also be looking at other holdings in your taxable accounts. Do you own shares of other stocks or funds that are currently trading for less than you paid for them and that have subpar future prospects?

If so, you might consider selling some or all of those shares to generate a loss that you can use to offset all or part of the gain in the stocks you've already decided to sell. (Indeed, if you have shares in taxable accounts that are trading below your purchase price but you're still confident about their future, you could even sell, book the loss and buy them back later. Just be sure you don't run afoul of the "wash sale" rules.

If such losses exceed the gain in your stock sale, you can even deduct up to $3,000 in investment losses against ordinary income. (For more on offsetting investment gains and losses, click here. And for the IRS Publication that goes into all the nitty gritty details about how to do this, click here.

Again, I don't want to suggest that you start ripping apart your portfolio simply for tax reasons. But as part of the process of rebalancing and evaluating your portfolio, you want to be sure to assess all your holdings.

But there's still one aspect of this issue that we haven't addressed - namely, if you do sell shares of stocks or funds in your taxable accounts, what do you do with the proceeds?

Well, if you're doing this as part of a process of rebalancing your portfolio, then ideally you want to plow the proceeds into whatever asset class you've got to bulk up in order to bring your portfolio's mix back into balance. In your case, since you say you need to move out of stocks, that would mean putting the proceeds into bonds (or, more likely, bond funds).

But before you buy bonds in your taxable accounts, you might want to consider whether you're better off keeping your bond holdings in tax-advantaged accounts. The reason: The bulk of bond returns come in the form of interest payments, which are taxed annually at ordinary income rates if you hold the bonds in taxable accounts. If you hold your bonds in tax-advantaged accounts like a 401(k), on the other hand, you can defer paying that tax for many years.

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I don't want to make too big a deal of this. It's not as if having some of your bond allocation in taxable accounts will completely undermine your portfolio, especially considering that you can always invest in tax-free munis. But as my colleague Jason Zweig pointed out in an earlier column, you're generally better off holding whatever bond allocation you decide is appropriate for you in tax-deferred accounts like your 401(k).

Which means that, if you do decide to unload those stocks in your taxable accounts, you may want to re-invest the proceeds into other stocks or stock funds in your taxable accounts, and then transfer some of your stock holdings in your 401(k) to bond funds to get the right stocks-bonds mix.

Yes, this could mean shifting some of your money out of that total stock market index fund in your 401(k) that you say you don't want to touch. But I don't see that as a big problem. After all, there's nothing to prevent you from taking the proceeds from stock sales in your taxable accounts and investing that money in a total stock market fund held in a taxable account.

Clearly, the process of rebalancing a portfolio and re-evaluating specific holdings while considering the tax effects can be like putting together a jigsaw puzzle with moving parts. But if you approach this task by realizing that your moves should always be part of an your larger investment strategy, and then proceed slowly and methodically taking care to make only changes that really need to be made, you should do just fine. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.