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Plan Well, Retire Well

Saving and investing your money

How's your asset allocation? Time to rebalance?


Most investors have their money divided between stocks, bonds, and cash. If you have a plan for how you invest, that plan probably gives a target asset allocation - the percent of your investments you want in each of those asset classes. Your target asset allocation may use more specific categories, providing percentages for stock in large US companies (large cap), small US companies (small cap), foreign stocks, and others.

The current market turmoil may have thrown your asset allocation out of whack. Many people rebalance on a schedule, say, once a year. Another rule of thumb used by some financial experts is to rebalance when your allocation varies by 5% or more from your target. It's very likely that the recent drop in stock prices has thrown your asset allocation off by at least 5%.

How should you go about rebalancing? You can do it all at once, or eat away at it over a period of time. You could sell investments in the asset class you now own too much of (probably bonds or cash right now), and use the proceeds to purchase more of what's lost value (stocks). Or, you could direct new money, such as contributions to your employer retirement plan, into underweighted asset classes. If you need to generate income for current expenses, you could sell investments in an overweighted asset class.

You could use interest, dividends, or capital gains to make new investments in the asset class you need to build up. This is the slowest approach, but it may be especially appealing if your investments are in a taxable account and selling would leave you with a taxable gain. However, check whether you will pay a fee for each purchase.

Income taxes are one of several things to consider before taking action.

  • Income taxes: You can buy and sell investments within a retirement account without tax consequences. But if you sell an investment at a profit that's in a taxable account, you will have either a taxable gain to report on your income taxes, or a loss that you can use to offset other gains or, with certain limitations, regular income. For more information, see IRS Publication 550, Investment Income and Expenses (http://www.irs.gov/pub/irs-pdf/p550.pdf).
  • Transaction costs: For certain types of investments, there are fees for purchases or sales, penalties for taking money out or closing accounts. Examples include:
    • Commissions or broker fees for buying or selling stocks and bonds.
    • Loads for purchasing certain mutual funds (A shares), or back-end loads for selling them before a certain number of years have passed (B shares).
    • Surrender charges for taking money out of annuities before a certain number of years have passed.
    • Early withdrawal penalty taxes for taking money out of retirement accounts before age 59 ½. For rules and exceptions, see Rules for Taking Distributions from Tax-Deferred Retirement Plans at http://www.ace.uiuc.edu/cfe/retirement/takingdistributions2007.PDF.)
    • Frequent-trading fees: Some retirement plans impose fees on investors who exceed the allowed number of transfers. Certain mutual funds assess a charge if you transfer money out too quickly. Check your plan documents or mutual fund prospectus.
  • A single transaction versus a series of smaller ones: If you decide to buy or sell substantial amounts of any one investment, the costs, if any, may be lower if you do it all in a single transaction.

Rebalancing may well improve your investment returns over time, since it forces you to sell investments that have risen in value and purchase more in asset classes that have dropped in value.

Let me know your thoughts about rebalancing, and how you decide when to do it.



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