Tax becomes a portfolio-management cost when selling appreciated assets realizes capital gains. Rebalancing therefore involves both trading costs and potential tax consequences, except in tax-advantaged accounts such as 401(k)s. section 13.1.2
Avoiding a taxable ETF rebalance
An ETF holds $500,000 of Stock A with a $300,000 cost basis. Rebalancing by selling A would realize a $200,000 gain. A heartbeat trade instead exchanges new securities for Stock A without selling it, aligning the portfolio without creating a realized gain. section 4.2.3
Tax-aware portfolio decisions include:
- Sell lots with the least tax exposure first when rebalancing. section 13.5
- Compare taxable, tax-deferred, and tax-exempt account locations when distributing assets. section 1.3
- Extend retirement-income analysis to include taxes on Social Security income and benefits withheld above an income threshold. section 1.3
Table 4.2 Old and new index weights
| A | B | C | D | E | |
| Old weight | 50% | 30% | 20% | 0% | 0% |
| New weight | 0% | 45% | 30% | 15% | 10% |
Compare old and new index weights to see why an ETF must exchange holdings during the heartbeat trade. section 4.2.3
