Your IPS should include an asset allocation and rebalancing table. The table should include both the target levels for each asset class and the minimum and maximum levels to which the allocations will be allowed to drift. Some drift should be allowed to occur: Rebalancing generally involves costs, including transactions fees and taxes in taxable accounts.

We suggest using a 5/25 percent rule in an asset class's allocation before considering rebalancing. In other words, consider rebalancing if the change in an asset class's allocation is greater than either an absolute 5 percent or 25 percent of the original percentage allocation. The actual percentages used are not as important as having a specific plan and the discipline to adhere to the plan. In your own situation, a 4/20 rule might be as appropriate as a 5/25 rule.

Application of 5/25 Rule: Assume that an asset class was given an allocation of 10 percent. Applying the 5 percent rule, one would rebalance only when that asset class's allocation had either risen to 15 percent (10 percent + 5 percent) or fallen to 5 percent (10 percent − 5 percent). Using the 25 percent rule, however, one would reallocate if the asset class had risen or fallen by just 2.5 percent (10 percent × 25 percent) to either 12.5 percent (10 percent + 2.5 percent) or 7.5 percent (10 percent − 2.5 percent). In this case, the 25 percent figure is the governing factor. If one had a 50 percent asset class allocation, the 5/25 percent rule would make the 5 percent figure the governing factor, since 5 percent is less than 25 percent of 50 percent (12.5 percent). So, one rebalances if either the 5 percent or 25 percent test indicates such a need.

The need for rebalancing should be checked at three levels.

A sample asset allocation and rebalancing table is shown in Chapter 2.

There are two ways to rebalance. The first is to sell one or more funds to raise sufficient cash to purchase the appropriate amount of one or more other funds. The other way is to use new cash to raise the allocations of the asset classes that are below targeted levels. A combination of the two strategies can be used. Using new cash is preferred, as it reduces transactions costs and for taxable accounts reduces/eliminates the generation of capital gains. Whenever new cash is available for investment purposes it should be used to rebalance the portfolio.

One strategy that can be employed is having distributions paid in cash rather than automatically reinvested, using that cash to rebalance. When making this decision, consider the size of the portfolio and size of the transactions costs. For small accounts, where transactions costs are present, this might not be a good strategy. Here are some other recommendations on the rebalancing process.

Rebalancing may generate capital-gains taxes. Whenever possible, rebalance with new investment dollars or using tax-advantaged accounts.

Tax management is a year-round job. Far too many investors wait until the end of the calendar year to check for opportunities to harvest losses. These should be checked for throughout the year.

A loss should be harvested whenever the value of tax deduction significantly exceeds the transactions cost of the trades required to harvest the loss, immediately reinvesting the proceeds in a manner avoiding the wash sale rule (see Glossary). Waiting until the end of the year is a mistake: Losses that might exist early in the year may no longer exist. In addition, it can be important to realize any short-term losses before they become long term. Short-term losses are first deducted against short-term gains that would otherwise be taxed at the higher ordinary income tax rates. Long-term losses are first deducted against long-term gains that would otherwise be taxed at the lower capital gains rate.

For example, before any loss harvesting, imagine a taxpayer has realized short- and long-term gains and unrealized short-term losses. These losses can be harvested, reducing the short-term gain that would have otherwise been taxed at higher ordinary tax rates. If not harvested until they became long-term losses, they would reduce long-term gains that would have been taxed at the lower long-term capital gains rate.

Investors who tax-loss harvest reset their cost basis to a new, lower level. The tax-rate differential then provides the opportunity to arbitrage the tax system. Here is how such arbitrage might work.

On January 1, 2009, you invest $10,000 in a fund. On March 1, 2009, the value of the fund has shrunk to $7,000. You sell the fund. Since the fund was held for less than one year, the loss is characterized as short term. Assuming a 35 percent ordinary federal income tax rate, you will have a $1,050 tax savings, leaving a net economic loss of $1,950.

Note that the deduction of capital losses in excess of capital gains is limited to a deduction against $3,000 of other income, though losses can be carried forward indefinitely during a taxpayer's lifetime. If there are net long-term gains in a given year, any net short-term losses not already used to offset short-term gains must be applied against those long-term gains, reducing the value of the deduction to that of the lower long-term capital gains rate.

Since you don't wish to be out of the market for thirty days, the time needed to avoid the "wash sale" rule, you use the $7,000 of sale proceeds to immediately purchase a similar fund. For example, if you had sold a Total Stock Market Fund, you might purchase a Russell 1000 Fund. Since they would be similar in their exposures to the three risk factors (market, size, and value) they have similar expected returns.

Continuing the example, jump forward to March 2, 2010 (one year and a day). Both the fund you sold and the one you purchased have each risen to $10,000. If you had simply held the first fund, you would have had neither gain nor loss, and no tax benefit in the prior year. If, however, you harvested the loss, replaced the original fund with the similar fund, and then sold it on March 2, 2010 (to repurchase the preferred holding), you would have a gain of $3,000 on which you would pay taxes at the long-term capital gains rate. Assume it is 15 percent. You owe taxes of $450, and you have a net gain of $2,550. You picked up a $600 arbitrage of the tax system (by receiving a $1,050 tax savings in March 2009 and paying only $450 in March 2010), and gained the time value of the tax savings for a full year. Note that you did not have to sell the fund in March 2010. If you'd continued to hold it, the tax on any unrealized gain would be deferred until the fund was sold. State taxes, if applicable, should also be considered.

After the wash sale time period has expired, you will likely want to swap back into the original holding. That can create further tax problems. If there is a further loss, there is no problem, as you simply harvest it. However, if there is a gain, it will be short term and taxed at ordinary income-tax rates. Generally, you much prefer to pay taxes at the long-term capital gains rate. Harvesting the prior losses has mitigated part of the problem. You can use the loss to offset gains. By selling only when a reasonably large loss is being harvested (see below), you can maximize the likelihood the harvest ends up being an overall benefit. If the gain during the thirty-one day period required to avoid the wash sale rule in the replacement investment is smaller than the harvested loss, and the replacement fund is not as tax-efficient an investment, then it is generally best to swap back, even if this uses up some of the harvested losses.

Even if the gain is slightly higher than the harvested loss, you may still want to swap back in thirty-one days. For example, if you have swapped a tax-managed fund with a non-tax-managed one, in December you may face even larger capital gain distributions from the replacement investment. A swap back might be warranted.

On the other hand, if the gain from the replacement property is large (for example, 5 percent greater than the harvested loss), you should hold on to the replacement property until the gain becomes long term or prices drop again and swapping back to the original position can be done at low or even no short-term capital gains. In this case, it is recommended you watch the distribution estimates for the replacement investment to make sure distributions won't be greater than the short-term gain you are trying to avoid. In that instance, you should swap back to the more tax-efficient investment before the distribution.

By waiting until the gain becomes long term, the gain could become substantially larger. You don't want to pay taxes, even at longer-term rates. You want a swap holding that is both a suitable replacement in terms of asset class exposure and tax efficient (if such an alternative exists), so you are comfortable holding for the long term, if necessary.

In short, to reduce risks, we suggest taking only significant losses. You should establish a minimum percentage loss of the invested assets and a minimum absolute dollar. A loss is large enough to consider harvesting when it exceeds a predetermined hurdle. For example, you might set a hurdle of $5,000 for bonds and 2 percent of the value. For equities, hurdles of $5,000 and 5 percent might be set. However, for highly volatile asset classes like emerging markets or commodities (remembering that in most cases commodities should be held in tax-deferred accounts), the hurdles might be $5,000 and 7.5 percent. The better the fit in terms of asset class exposure and greater the tax efficiency of the fund you are swapping into (while avoiding investments "substantially identical" to the original holding), the lower the hurdles.

Because of their tax efficiency and absence of redemption fees imposed by some mutual funds, exchange-traded funds make good candidates for tax loss harvesting purposes. However, because of their high trading volume, a significant amount of their dividend distributions are not considered qualified dividends, and so are taxed at ordinary income tax rates.

There are several mutual funds and ETFs that make good substitutes for one another. To avoid the wash sale rule, the investor cannot sell and buy two investments considered "substantially identical" in nature; the IRS would likely disallow the deduction. For example, selling one S&P 500 Index fund and using the proceeds to buy another S&P 500 Index Fund is not recommended. Instead, an investor might purchase a Russell 1000 Fund. Its risk and expected return is substantially similar, but not substantially identical, thereby avoiding the wash rule. The sale of a tax managed fund and purchase of a non-tax-managed fund in the same asset class would not constitute a wash sale. Always consult with a qualified tax adviser.

For individual bonds, the replacement bond must be "materially different" from the one sold. Although this term appears in the tax code and numerous IRS rulings, no specific rules define what makes one bond materially different from another. Also note that when swapping individual bonds for loss harvesting purposes, there is no need to reverse the swap after thirty-one days.

An increase in tax rates, including capital gains tax rates, may have a substantial impact on a portfolio, and so should be considered when harvesting losses. For investors who may need to take withdrawals from their taxable accounts in the near future (to buy a house or support children in college), harvesting tax losses will reset the cost basis lower and may hurt more than help. A tax loss harvest may save an investor 15 percent in capital gains taxes (the rate at the time of this writing), but could cause the investor to pay an increased rate (20 percent or 28 percent) in the future on an even lower cost basis. This issue will have less effect on investors who do not expect to need withdrawals from their taxable accounts for many years.

There is one other point to consider: If you (1) have gains; (2) will need the money within a few years; and (3) believe tax rates will rise or your own tax bracket will be higher, you may want to harvest gains now to minimize total taxes.

The IRS prohibits claiming a loss on the sale of an investment if that same or substantially similar investment was purchased within thirty days before or after the sale date. The investor has a choice: Stay out of the market for thirty days after a tax loss harvesting transaction, or immediately purchase a similar but not substantially identical investment. Since a large percentage of the return over any long period typically comes in short bursts, we recommend immediately reinvesting the proceeds. If you are out of the market, you can miss out on those returns. From 1926 through 2008, 169 out of 996 months (17.0 percent) produced returns to the total market in excess of 5 percent. Twenty-nine months had returns in excess of 10 percent, four in excess of 20 percent, and three in excess of 30 percent. Being out of the market for a month also meant you had a 10.1 percent chance (101 months out of 996) of avoiding a loss of at least 5 percent. So, historically, there has been a 70 percent greater likelihood you would "miss" a large gain instead of a large loss.

Given this evidence, the strategy should be to immediately reinvest the proceeds from any loss harvesting sales in similar funds. If there is another loss after thirty-one days the investor can swap back and receive yet another deduction, and again reset the cost basis. The evidence suggests there is about a one-in-six chance of having a gain in excess of 5 percent within the wash sale window. It is important to choose a substitute fund you would be willing to hold for a full year (in order to obtain long-term capital gains treatment) or longer. Any choice should be low cost and tax efficient.

Investors should coordinate any tax-planning activities with their CPA or tax attorney to ensure all activity is beneficial to their overall situation, not just when viewed in isolation.