When you first opened your 401(k) account, you probably gave some thought to your asset allocation, opting to put a certain percentage of your money into relatively aggressive investments like stock funds and some other percentage into less aggressive ones like bond funds in order to diversify.
Over time, however, those percentages may have gotten out of whack, as some investments may have outperformed others. To get those percentages back in line, you may need to rebalance your portfolio periodically. Here is how to go about it.
- When you first open a 401(k) account, you will probably want to allocate a certain percentage of your money to stocks and another percentage to bonds.
- For example, you might direct that 75% of your contributions go into stock mutual funds and the remaining 25% into bond funds.
- Over time, however, some of your investments will grow faster than others and your original asset allocation may get out of line.
- To return to your desired allocation, you can sell a portion of the investments that have outgrown their percentage and buy more of the ones that are lagging behind. This is known as rebalancing your portfolio.
Rebalancing: An Example
Kendra is in her early 30s and a relatively aggressive investor. Her asset allocation for her 401(k) plan is 75% in stocks and 25% in bonds. To keep things simple, suppose she chose one broad-based stock index fund for the stock portion of her portfolio and a similar bond index fund for the bond part.
Now let's say her account at the end of year 1 matches that exact allocation (an unlikely prospect but useful for this example). Her account would look like this:
- $7,500 stock fund
- $2,500 bond fund
Then, a year later, as a result of her new contributions and the gains on her investments, her account looks like this:
- $18,500 stock fund
- $5,250 bond fund
So now her 401(k) is worth a total of $23,750 and its allocation is as follows:
- 77.9% stock fund ($18,500)
- 22.1% bond fund ($5,250)
In keeping with her preferred asset allocation, her portfolio should instead look like this:
- 75% stock fund ($17,812.50)
- 25% bond fund ($5,937.50)
If Kendra wants to rebalance her portfolio at this point, she could sell $687.50 worth of shares in her stock fund and use that money to buy more shares of her bond fund. Note that she can move money from one fund to another within her 401(k) without any tax consequences. If she were to buy and sell funds outside of a retirement account, however, she'd be subject to taxes on any gains she made as well as eligible for a deduction on any losses.
An Alternative to Rebalancing
Rather than rebalance, Kendra could simply increase the amount she contributes to her bond fund until she's back to her original 75%/25% allocation.
How often you can make changes like this during the course of the year will depend on your employer. Some set limits, while others don't.
The total amount you can contribute to your 401(k) is set by law and can vary from year to year. In 2022, for example, the maximum is $20,500 for anyone under age 50. Those 50 and older can make an additional catch-up contribution of $6,500, for a total of $27,000.
Looking at the Big Picture
Of course, your 401(k) plan may be just one of the places you're investing your money. You might, for example, own some other mutual funds or have a brokerage account apart from your retirement savings. You might also have more than just a couple of funds in your 401(k) and even several different 401(k) plans if you've changed jobs and left a plan with a former employer. So it's important to consider the big picture. One way to look at it is as if all of your investments were just one big account and to rebalance them as necessary until your entire portfolio matches your desired asset allocation.
To save on taxes, bear in mind that it could make sense to rebalance through your retirement plans to the extent possible. If you're like many people, your 401(k) could be your largest single investment account anyway.
Changing Your Asset Allocation As You Age
Remember, too, that your asset allocation isn't forever. Many financial experts suggest adjusting it as you grow older, opting for a more conservative mix as you get closer to retirement age. For 30-something Kendra in our example above, 75%/25% may be about right. When she reaches age 60, however, an allocation closer to 50%/50% could make more sense.
What Is Rebalancing?
Rebalancing is the act of buying and selling different types of investments so that they align with the percentages in your desired asset allocation. You can rebalance retirement accounts or other kinds of accounts.
What Is Asset Allocation?
Your asset allocation is the percentage of your money that you want to invest in each particular asset category. For example, you might want to allocate 70% of your portfolio to stock investments, 20% to bond investments, and 10% to "cash" investments, such as a money-market fund.
How Often Should I Rebalance My 401(k)?
How often you should rebalance your 401(k) will depend on how quickly and how dramatically it has deviated from your desired asset allocation. You might, for example, want to check on your 401(k)'s actual asset allocation every year or so and rebalance it if necessary. In addition to rebalancing periodically based on how your investments have performed, you might choose to rebalance if your previous asset allocation is no longer appropriate. Many people adjust their asset allocations periodically so that their portfolios become less risky as they get closer to retirement age.
Will I Have to Pay Taxes If I Rebalance?
No, you can buy and sell investments within your 401(k) without incurring a tax liability. That is not true of investments held outside of retirement accounts, which are subject to capital gains tax on any profits. 401(k) accounts are tax-deferred, so you don't have to pay any taxes on them until you take money out.
The Bottom Line
Rebalancing is not an exact science. Since asset values move daily, even if you rebalance once a day, by the next, there will be a slight deviation in your asset allocation. Thus, a "good enough" asset allocation is appropriate. Since Kendra's portfolio wasn't too far off the mark, she might consider doing nothing and wait another year before revisiting the rebalancing decision.