When you first open your 401(k) account, one of the first tasks is to set your asset allocation. You may opt 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 addition, many 401(k) plans may offer alternative investment options such as real estate or precious metals.
Over time, however, your desired portfolio allocation may become skewed as certain investments outperform 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.
- Alternatively, you may have access to target date funds, which automatically rebalance based on how near you are to retirement.
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.
Let's say her account at the end of year 1 matches that exact allocation. Although this is unlikely, due to gains and losses in each of these fund accounts, it's a greater starter point for this example.
- End of Year 1 Stock Fund: $7,500 (75% of portfolio assets)
- End of Year 1 Bond Fund: $2,500 (25% of portfolio assets)
During the second year, Kendra contributes another $10,000 to her 401(k) in this exact 75%/25% proportion. However, equities perform exceptionally well, increasing in value $2,000. On the other hand, bonds struggle and decrease by $1,000.
- End of Year 2 Stock Fund (Before Rebalance): $7,500 + $7,500 contribution + $2,000 gain = $17,000 (81% of portfolio assets)
- End of Year 2 Bond Fund (Before Rebalance): $2,500 + $2,500 contribution - $1,000 loss = $4,000 (19% of portfolio assets)
Because of the fluctuations in value of the two funds, Kendra's portfolio is now overweight equities and underweight bonds, based on her preferred 75%/25% portfolio allocation. Kendra now has several options when trying to rebalance her portfolio to her desired allocation.
Rebalancing gets more complicated as the number of different types of holdings increases.
Methods of Rebalancing
Sell the Overweight, Buy the Underweight
In the example above, Kendra is technically holding too much value in equities because of their strong performance. Kendra is also not holding enough in bonds since they decreased in value.
The most common method of rebalancing a 401(k) is to sell assets of the heavier weight to the desired portfolio amount. Then, sale proceeds can be used to buy assets of the lower weight fund. This sale and purchase is allowed within a 401(k) without tax implications as long as 401(k) funds are not withdrawn from the account. Be mindful that this sell-and-buy strategy does not apply to non-tax-sheltered accounts that will incur capital gains and/or losses.
In the example above, Kendra's total portfolio is worth $21,000. In a perfect world, her portfolio would be divided 75% into equities ($15,750) and 25% into bonds ($5,250). Therefore, Kendra can rebalance by:
- Selling the overweight security. In this case, Kendra is overweight $1,250 ($17,000 actuals - $15,750 desired allocation), so Kendra should sell this amount of the stock fund.
- Buy the underweight security. Since Kendra only holds two assets, she is underweight by $1,250 on bonds ($4,000 actuals - $5,250 desired balance). She can take the proceeds from the sale above and buy additional shares of the bond fund.
Change Future Allocations
Investors willing to rebalance their portfolio slower (and maybe a little lazier) can do so by changing future allocations instead. This is a much less precise method of rebalancing a 401(k), as it will be very difficult to land on the exact allocation desired. In addition, there may be delays in when your allocation request is processed by your broker; once your allocation is corrected, you'll need to change it back to the actual desired allocation.
Imagine Kendra and her $21,000 portfolio want to get back to 75% equities/25% bonds. Since she is overweight in equities, she can also rebalance by changing her allocation for her next pay period. In this case, she can perhaps select to invest 70% of her contribution to equities and 30% into bonds. This can often be done via your broker's online investment portfolio. By overcontributing to bonds, Kendra will theoretically get closer to her desired allocation. Alternatively, by under contributing to equity, Kendra's overweight proportion will decrease.
To restate the major risk here, Kendra will need to remember to change her future allocation once her portfolio is set. For example, let's say Kendra's portfolio returns to the 75%/25% allocation. However, her default allocation based on the above situation is now 70%/30%. Kendra needs to convert her future allocation back to target.
Perform a One-Time Overcontribution
Investors looking to add funds to their existing 401(k) may be able to rebalance by performing a one-time overcontribution into the underweight security. There's several steps to this process.
- First, Kendra identifies what her target portfolio balance is based on the balance of her overcontributed asset. In this case, Kendra wants 75% of her portfolio to be equities (valued at $17,000). This means Kendra can get to her desired allocation by leaving equities as-is but increasing her portfolio to roughly $22,666 ($17,000 / 75%).
- Kendra needs to then determine how much she needs to contribute to get to this new portfolio balance. Since her current 401(k) is worth $21,000, Kendra needs to contribute $1,666 ($22,666 - $21,000) to get to this new target 401(k) amount.
- Kendra needs to then buy the underweight security. By buying $1,666 of bonds, the total amount of bonds is now $5,666 ($4,000 + $1,666).
Kendra can double-check the value of her portfolio by comparing her previous equity value ($17,000), new bond value ($5,666), and their proportions to her new 401(k) balance ($22,666).
The main consideration for this method is 401(k) contribution limits set forth by the IRS. In 2023, the maximum you can contribute to your 401(k) is $22,500, and this contribution limit is $23,000 in 2024. Individuals 50 years or older are eligible to make a catch-up contribution of $7,500 in 2023 and the same in 2024.
Convert to Target Date Fund
An even more convenient (and even more lazy) approach to rebalancing one's portfolio is to not rebalance it on your own at all. Instead, there are investment funds that automatically target specific asset allocations. In addition, these target date funds will change their portfolio allocation over time, shifting more to bonds as an investor approaches retirement.
In this example, Kendra would need to sell both her stock fund and bond fund holdings. Then, Kendra should identify the target date fund that best aligns with her retirement expectations. For example, should Kendra expect to retire in about 20 years, she may consider the Target Date 2045 plan. This plan will automatically rebalance the portfolio to maintain a strict equity-to-debt target.
Rebalancing doesn't necessarily need to be limited to broad categories. For example, an investor may want the equity portion of their portfolio to be 50% large cap, 30% mid cap, and 20% small cap. The same principles above hold, though this may make for a more complicated rebalance.
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), have several different 401(k) plans if you've changed jobs and left a plan with a former employer, or hold personal IRAs.
Therefore, when rebalancing, it's important to consider the big picture. Consider investing in specific products with the lowest fees across your holdings. For example, your 401(k) may consist of strictly bond funds if your 401(k) plan has the lowest cost or most attractive offering across all of your retirement accounts.
In addition to considering accounts, be mindful of the types of accounts. There are significant tax considerations for Roth 401(k) contributions compared to traditional 401(k) contributions. Very broadly speaking, it's best to keep more aggressive holdings in Roth accounts as large capital appreciations will be non-taxable when you retire. Safer, less risky investments with less upside potential are usually better suited for traditional 401(k)s or traditional IRAs.
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. As mentioned above, target date funds will automatically decide this appropriate allocation for you and change as you age. For investors wanting more control., you can simply buy or sell specific equities to realign your portfolio any time you change your allocation preference.
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.