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Kevin P. Brosious, CPA/PFS, principal, Wealth Management Inc. 

You tune up your car, you tune up your guitar and piano, but a lot of investors routinely ignore their portfolios until they have to start taking distributions or the stock market plummets. In these cases they often find an unpleasant surprise. However, studies show that a periodic portfolio tune-up can improve portfolio returns and reduce portfolio risk.

So how critical is it to pay attention to your portfolio and do some periodic tuning up? A Vanguard study found that rebalancing portfolios can add an additional .35 percent annually to portfolio return. The study also found that tax-efficient asset location can add up to .75 percent, and managing the order of fund withdrawals (i.e., when to withdrawal taxable vs. tax-deferred funds) could add another .70 percent. That’s a potential for an extra 1.8 percent annual portfolio return. For example, improving your portfolio return from 6 percent to 7.8 percent over 20 years, will earn you an additional $130,000 for every $100,000 invested.  

The Tune-Up
Portfolio rebalancing should be considered at least annually, as this has proven to improve long-term portfolio returns and reduce portfolio risk. Rebalancing helps you maintain your appropriate risk tolerance and forces you to sell high and buy low, the basic tenet of sound investing. An Ibbotson study found that a portfolio that consisted of 100 percent government bonds that was never rebalanced was more volatile than a portfolio that contained 70 percent government bonds and 30 percent stocks. In addition, the 30 percent stock portfolio returned 1.5 percentage points more over the period of 1926-2009.

When tuning up your portfolio also consider where your investments are held. Asset location is critical for avoiding unnecessary taxation of portfolio returns. Income produced by stocks (dividends and long-term capital gains) is taxed at a maximum 15 percent (except for those in the highest tax brackets). So keeping stock investments in ordinary taxable accounts is more advantageous than having these investments in tax-deferred accounts where they will be taxed at ordinary income tax rates when withdrawn. Conversely, bonds produce interest that is taxed at ordinary income tax rates. So whenever possible, bonds should be held in tax deferred accounts, such as a 401(k), 403(b), IRA, etc. There are exceptions:

• Municipal bond income is usually exempt from federal and state income taxes, so these investments are appropriate for taxable investment accounts for investors in higher tax brackets.
• Dividends from real estate investment trusts (REITs) are nonqualifying and taxed at ordinary income tax rates. So, these investments should be held in tax-deferred accounts.

Withdrawal Strategies
An often overlooked key to investment management is setting your portfolio up to minimize taxes when withdrawing funds.

For taxable account withdrawals, investors can avoid paying any tax by liquidating investments that have incurred losses.  However, selling positions with long-term capital gains and paying the current 15 percent tax should also be considered as a way to avoid taxes at a future rate that could be higher. Furthermore, taxpayers in the 15 percent or lower bracket currently pay zero tax on capital gains. An investor in these tax brackets should consider selling and realizing long-term capital gains at zero tax if only to reset their cost basis and reduce the impact of higher tax rates in the future.

Withdrawals from Roth IRAs are tax free if held for five years. In addition, Roth IRA contributions can be withdrawn at any time -- both tax and penalty free -- which can provide quick, tax-free funds for the investor.  

Most other tax-deferred vehicles -- traditional IRAs, 401(k)s, etc. -- are fully taxable when withdrawn. Any withdrawals from traditional IRA accounts prior to age 59 ½ may incur an additional 10 percent penalty. However, the 10 percent penalty for 401(k) and 403(b) starts prior to age 55, so an investor requiring funds prior to age 59 ½ would be wise not to roll these accounts into traditional IRAs.

Give your portfolio the financial attention it deserves. Just doing some basic tuning up will help you reduce risk, minimize taxes, and improve your return. So tune up, don’t tune out.   

Kevin Brosious is the founder and president of Wealth Management Inc. in Allentown, an independent fee-only financial planning and Registered Investment Advisory firm. Kevin is an active member of both the PICPA and the American Institute of CPAs.