TJ PorterBy T.J. Porter, WCI Contributor

Investing is a complicated thing. Sure, you can build a great portfolio with just a few low-cost index funds that you can hold for the long term, but even that takes time and effort when it comes to keeping things tax-efficient and deciding on the right asset allocation.

If you’re like many people, you may have a more complicated portfolio that includes a wide variety of assets. Because investing is such a long game, you might find after years or decades that some of your investments haven’t panned out like you thought they would or that they no longer match your investment goals or strategy. What you do with these now suboptimal assets in your portfolio depends on a few factors.

 

Consider Your Investment Goals and Strategy

The first thing you should do before making any major changes to your investment is sit down and think about your goals. Your investing goals may change over time. When you’re young, you might be focusing on saving for short- and medium-term goals, like buying a house. As you get older, things like helping your kids pay for college and setting yourself up for retirement become more important.

Once you’ve made sure you have a clear understanding of your goals, you can start to rethink your strategy. Think about why you originally bought your underperforming asset. Does that reasoning still hold up, and if so, does it align with your current goals? For example, you might have taken a gamble on some small cap stocks that you believe had a lot of upside. If your goal is still to make high-risk, high-reward investments, a period of underperformance might not be enough of a reason to sell if they still have a chance to do well.

On the other hand, if you’re looking to build a more conservative portfolio, selling off those riskier investments makes sense. Similarly, if your portfolio is full of high-cost mutual funds or other investments and there are cheaper options that fit your needs, changing things up is a good idea.

Once you’ve confirmed that the assets in your portfolio truly don’t fit your current needs and aren’t just temporarily underperforming, you can take steps to fix your portfolio.

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Suboptimal Assets in Tax-Advantaged Accounts

If your suboptimal assets are in a tax-advantaged account like a 401(k), IRA, or 529, handling the issue is usually quite easy. Because these accounts are tax-advantaged, you don’t have to worry about capital gains taxes or other tax implications related to selling investments. All you have to do is sell the investments that no longer meet your needs and buy the ones that do.

In some cases, it can be a bit trickier. For example, investment options in your 401(k) or 403(b) are set by your employer. Depending on where you work, the options could be underwhelming, expensive mutual funds. You can look to see if your retirement account has cheaper options, but you might be out of luck. It’s worth speaking to your employer to see if the options can be improved. If not, you might have to do a bit more work.

 

Optimizing Your IRA and 401(k)

401(k)s and IRAs are both retirement accounts that offer tax benefits, but they function very differently. 401(k)s (and 403(b)s) are tied to your employer. You can contribute far more each year to these accounts, but you’re usually stuck investing in the funds your employer has selected.

IRAs offer the same tax benefits but have a far lower contribution limit. You might also not be eligible to contribute if your income is too high (that's where the Backdoor Roth comes into play). However, you have far more control over your IRA than a 401(k), and you can choose almost any investment that you’d like.

Now, picture this scenario. Your employer’s 401(k) doesn’t have the best fund options. There’s a selection of target date funds, but the expense ratios are high, sitting at 0.7%. There’s also an S&P 500 fund available with a lower expense ratio of 0.25% but no good bond fund. You also own a low-cost target date fund in your IRA. To save on costs, you could consider moving your 401(k) investments into the S&P 500 fund, reducing your costs. Then, you could move your IRA funds into a low-cost bond fund to achieve your desired asset allocation. 

This takes more effort, but in a scenario where good employer-sponsored retirement plan investment options are limited, doing something like this can help you save on fees, improving your overall returns.

More information here:

What to Do with a Crummy 401(k)

 

Suboptimal Assets in a Taxable Account

Unlike retirement accounts, adjusting the makeup of a taxable brokerage account can be trickier.

Of course, there’s nothing stopping you from simply selling the investments that you don’t want to own any longer and allocating those funds to other things. In fact, that’s probably the way to go if you’re selling at a loss. However, selling anything for a profit will incur capital gains taxes.

If you’ve held those investments for at least a year, you could pay 0%, 15%, or 20% in tax based on your taxable income. If you held them for less than a year, you’ll pay your regular income tax rate on the gains. For 2024, the 15% tax rate kicks in at $47,026 in taxable income and $94,051 when Married Filing Jointly, which most physicians easily clear. The 20% tax rate kicks in at $518,900 ($583,750 when MFJ).

That can be a big percentage to pay. That makes figuring out the best way to offload assets that no longer fit your portfolio while limiting taxes the name of the game. 

 

Compare Costs

The first thing to do is compare the cost of holding the investment to the cost of capital gains taxes. In some cases, paying the tax might be cheaper than continuing to hold the investment.

Imagine you have $200,000 invested in a bafflingly expensive mutual fund that charges a 1.25% expense ratio. That means that you’re paying $2,500 in expenses each year you stay invested in the fund. If you sell your investment and book a $30,000 profit, you’d pay $4,500 in taxes at the 15% capital gains rate and $6,000 at the 20% capital gains rate. If the alternative is holding the mutual fund for two or three years, you’d save money by just selling now and taking the tax hit.

 

Consider Tax-Loss Harvesting

Tax-loss harvesting is one way to reduce the amount of taxes you pay when selling investments.

When you sell investments, you only have to pay tax on your net profits from investments. If you’re only selling for a profit, that means paying taxes on the full profit. However, if you have some assets that you’re selling at a loss, you can deduct the losses from the gains, reducing the amount of income on which you pay tax.

If you have underperforming investments, consider selling them at a loss so you can use that loss to offset gains from investments you sell for a profit. However, be careful to avoid a wash sale. When selling for a loss, you can’t take a deduction for the loss if you buy a substantially similar investment within 30 days.

 

Take the Gains Across Multiple Years

The capital gains tax rate depends on your overall taxable income. In all likelihood, you’ll be paying some capital gains taxes when you sell suboptimal assets, but you may not have to pay the highest rate.

Imagine this scenario. You have investments that you’d like to sell that have appreciated in value by $100,000. Your normal taxable income for the year is $450,000. This puts you in the 15% capital gains bracket. That means you can earn an additional $68,900 before you move into the 20% capital gains bracket. One option is to sell all of the investments and book the $100,000 capital gain. That pushes you into the 20% capital gains bracket, so you pay the highest tax rate. A second option is to sell half of the investment now, booking $50,000 in capital gains and staying in the 15% bracket. The next year, you sell the remaining half of the investment, booking another $50,000 profit and still remaining in the 15% capital gains bracket. That plan reduces the overall tax burden.

Keep in mind that there is some risk to this strategy. Waiting to sell an investment means it could fall in value, so if the asset truly doesn’t match your current investing strategy or you fear it could lose significant value, it may be better to take the tax hit and offload it sooner rather than later.

 

Donate or Gift Appreciated Assets

If you regularly donate money to charity, you could consider donating your investments rather than making a cash donation. When you donate stocks, bonds, or other investments, you can avoid the capital gains taxes associated with selling the investments and receive a charitable contribution tax deduction for their market value. That effectively lets you double dip on tax benefits. You can then use the cash you would have donated anyway to purchase investments that match your new investing strategy.

For example, if you want to make a $10,000 donation to a charity, you could instead donate $10,000 worth of appreciated but now suboptimal investments. Then, use the $10,000 in cash to buy the investments you want to own.

If you want to make a financial gift to someone, you could also consider giving the appreciated investment instead of cash. The recipient will be on the hook for capital gains taxes, but they may be in a lower tax bracket than you, reducing the overall tax paid.

 

Hold Growth Assets in Tax-Advantaged Accounts

This strategy probably won’t help you in the moment, but it’s one to consider now because it can help you in the future.

Most people build a portfolio that contains a mix of higher-risk, higher-rewards assets and less volatile ones that offer a lower return. To limit the impact of capital gains taxes, you could try to hold assets that you expect to produce the greatest return in your tax-advantaged accounts while putting the less volatile ones that produce lower returns into taxable accounts.

More information here:

The Nuts and Bolts of Investing

 

The Bottom Line

Building the optimal investment portfolio is difficult, and odds are that you’ll want to change things up at some point in your life. Planning ahead by trying to put the investments you expect to appreciate the most in tax-advantaged accounts, as well as taking advantage of things like tax-loss harvesting and donating investments can help you limit the tax impact of trying to offload suboptimal investments.

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