Most 401k participants who understand the need for rebalancing assume it requires selling appreciated assets and buying underperformers—a process that feels counterintuitive and, in taxable accounts, would trigger capital gains. But 401k accounts don’t work that way. Rebalancing inside a 401k involves no tax consequences regardless of how often you trade. The constraint isn’t taxes. It’s knowing you have better options than selling.
Why Rebalancing Matters
Asset allocations drift. A portfolio that starts 80% stocks and 20% bonds won’t maintain that ratio as markets move. When stocks outperform bonds, the allocation shifts toward stocks without any deliberate decision. Over time, this drift can double or halve your intended risk exposure.
Consider a $100,000 portfolio initially allocated 80/20. After five years of 10% annual stock returns and 3% bond returns, the portfolio grows to $152,026—but the allocation has shifted to 85% stocks and 15% bonds. The added stock exposure wasn’t chosen. It happened by default.
| Time | Stock Value | Bond Value | Total Value | Stock % | Bond % |
|---|---|---|---|---|---|
| Initial | $80,000 | $20,000 | $100,000 | 80% | 20% |
| After 5 years | $128,840 | $23,185 | $152,026 | 85% | 15% |
That five percentage point shift represents $7,220 in additional stock exposure—money that’s now subject to equity volatility rather than bond stability. If your intent was to maintain 80/20, the drift undermines it. If your situation has changed—age, income stability, proximity to withdrawal—the drift may now misalign with your capacity to absorb loss.
Methods That Don’t Require Selling
Redirect New Contributions
The simplest rebalancing method uses incoming contributions to restore balance without touching existing holdings. If stocks have grown beyond target, direct new contributions entirely to bonds until the allocation returns to the intended ratio. If bonds are overweight, direct contributions to stocks.
This method is slow but frictionless. It works best when contributions are large relative to portfolio size—early in accumulation when the account balance is still modest. As the portfolio grows, contributions become too small to meaningfully shift allocation within a reasonable timeframe.
Example: A $150,000 portfolio drifts to 85/15 when the target is 80/20. To restore balance, the bond allocation needs to increase from $22,500 to $30,000—a $7,500 adjustment. If the investor contributes $1,500 monthly and directs it all to bonds, rebalancing takes five months. The same adjustment in a $500,000 portfolio would take over a year.
| Portfolio Size | Current Allocation | Target Allocation | Shortfall | Monthly Contribution | Months to Rebalance |
|---|---|---|---|---|---|
| $150,000 | 85/15 | 80/20 | $7,500 | $1,500 | 5 |
| $500,000 | 85/15 | 80/20 | $25,000 | $1,500 | 17 |
Exchange Between Funds
When contribution-based rebalancing is too slow, direct exchanges work faster. Most 401k plans allow unlimited exchanges between funds without fees or tax consequences. Selling $10,000 of a stock fund and buying $10,000 of a bond fund is a single transaction that completes in one business day.
The mechanics are simple: calculate how much needs to move from overweight assets to underweight ones, log into the 401k platform, submit the exchange request. The plan administrator executes the trade at the next available price—typically end of day.
Some plans impose exchange limits—often six per year—to prevent active trading. This isn’t a meaningful constraint for rebalancing, which shouldn’t happen more than once or twice annually. If the plan restricts exchanges further, redirecting contributions becomes the default method.
Combine Both Methods
The most efficient approach uses both techniques. Handle large imbalances with direct exchanges to restore allocation quickly. Then redirect ongoing contributions to maintain balance over time, minimizing the need for future exchanges.
For instance, if a portfolio has drifted five percentage points from target, execute a one-time exchange to bring it back within one percentage point. Then adjust contribution allocations to prevent further drift. This reduces trading frequency while keeping allocation tight.
When to Rebalance
Two common triggers: calendar-based or threshold-based. Calendar rebalancing happens on a fixed schedule—annually or semi-annually. Threshold rebalancing happens when any asset class drifts beyond a set limit, typically five percentage points from target.
Calendar-based rebalancing is simpler. Mark a date, check allocation, adjust if needed. It requires no monitoring between scheduled reviews. The downside: it might rebalance unnecessarily when allocation is still close to target, or delay rebalancing if drift happens shortly after the last review.
Threshold-based rebalancing responds to actual drift rather than arbitrary dates. It reduces unnecessary transactions and captures rebalancing opportunities when they matter most. The cost is more frequent monitoring—quarterly checks at minimum.
Neither method is superior. Both prevent the same failure mode: letting allocation drift indefinitely until a market event exposes misalignment. Pick whichever fits your preference for automation versus precision.
The Math of Rebalancing
Calculating required trades is straightforward. Determine target dollar amounts for each asset class, compare to current values, then move the difference.
Example: A $200,000 portfolio targets 70% stocks ($140,000) and 30% bonds ($60,000). Current allocation is 75% stocks ($150,000) and 25% bonds ($50,000). The stocks are $10,000 overweight, bonds are $10,000 underweight. Solution: exchange $10,000 from stock funds to bond funds.
| Asset Class | Target % | Target $ | Current $ | Difference | Action |
|---|---|---|---|---|---|
| Stocks | 70% | $140,000 | $150,000 | +$10,000 | Sell $10,000 |
| Bonds | 30% | $60,000 | $50,000 | -$10,000 | Buy $10,000 |
For portfolios with multiple stock or bond funds, distribute the adjustment proportionally. If stocks are split between large-cap and small-cap funds at 60/40, sell $6,000 from large-cap and $4,000 from small-cap. This maintains internal allocation while correcting the broader imbalance.
What About Employer Contributions?
Employer matches and profit-sharing typically default to the same allocation as employee contributions. If you’ve redirected contributions to bonds for rebalancing, the match follows unless the plan allows separate allocation settings. Check whether employer contributions can be allocated independently. If not, factor them into rebalancing calculations.
Some plans deposit employer contributions into a default fund—often a target-date fund or stable value option—regardless of employee elections. This complicates rebalancing. The deposited funds need to be manually redirected to the intended allocation through an exchange.
Limitations of 401k Rebalancing
Not all plans offer identical fund access. Some limit options to a handful of target-date funds and a stable value option. Rebalancing within such constraints is difficult. If the only stock option is a target-date fund with built-in bond exposure, maintaining a specific allocation becomes impossible without using funds in other accounts.
Exchange restrictions vary. Plans that limit exchanges to four or six per year make frequent rebalancing impractical. Annual or semi-annual rebalancing still works, but threshold-based approaches that respond to volatility become harder to execute.
Some plans impose redemption fees on certain funds if sold within a short holding period—often 30 to 90 days. These fees discourage frequent trading but shouldn’t affect annual rebalancing unless contributions were just made and immediately need redirecting.
The Cost of Not Rebalancing
Ignoring drift doesn’t feel costly. The portfolio still grows. Returns compound. But the risk profile changes silently, and the misalignment accumulates.
Consider someone who retires with a $500,000 portfolio intended to be 60/40 stocks/bonds. Over ten years without rebalancing, strong stock returns push the allocation to 75/25. The retiree now holds $375,000 in stocks instead of $300,000—an additional $75,000 exposed to equity risk.
If a market correction drops stocks 30%, the undisciplined portfolio loses $112,500 in stock value instead of $90,000. That $22,500 difference wasn’t a deliberate trade-off for higher returns. It was an accident of inattention.
| Scenario | Stock Allocation | Stock Value | Loss at -30% |
|---|---|---|---|
| Maintained 60/40 | $300,000 | After decline: $210,000 | $90,000 |
| Drifted to 75/25 | $375,000 | After decline: $262,500 | $112,500 |
The reverse scenario—drift toward bonds—reduces losses during declines but sacrifices growth during expansions. A portfolio drifting from 70/30 to 60/40 over a decade leaves $50,000 less in stocks. If stocks return 10% annually, that’s $5,000 in forgone annual returns, compounding over time.
Automating the Process
Many 401k platforms now offer automatic rebalancing—quarterly, semi-annually, or annually. The system monitors allocation and executes exchanges when drift exceeds a threshold. This removes the need for manual calculation and reduces the risk of forgetting.
Automation works well for straightforward allocations. It struggles with complex strategies involving multiple asset classes or when rebalancing needs to coordinate across taxable and retirement accounts. For most participants with simple two- or three-fund portfolios, automation handles the task adequately.
The trade-off is control. Automated systems rebalance mechanically without considering market conditions, pending contributions, or life changes that might warrant adjusting the target allocation itself. Periodic manual review remains necessary even with automation enabled.
Rebalancing Across Multiple Accounts
Investors with both 401k and IRA accounts, or 401k and taxable accounts, face a choice: rebalance within each account separately or treat all accounts as a unified portfolio.
Separate rebalancing is simpler. Each account maintains its own target allocation independent of others. The downside: it ignores opportunities to hold tax-inefficient assets in retirement accounts and tax-efficient ones in taxable accounts.
Unified rebalancing optimizes across accounts but adds complexity. Stocks might be concentrated in the 401k and IRA for growth, while bonds sit in taxable accounts for liquidity. Rebalancing requires calculating total allocation across all accounts, then adjusting individual holdings to restore balance. This approach saves taxes long-term but demands more planning.
What Gets Easier With Time
Early in accumulation, rebalancing is rapid. Small account balances mean contributions are large relative to holdings. Directing new money corrects drift within months. As the portfolio grows, this advantage fades. Contributions shrink as a percentage of total assets. Direct exchanges become necessary more often.
In retirement, rebalancing shifts again. Contributions stop. Withdrawals begin. Selling appreciated assets no longer contradicts the goal—it’s required to fund spending. Rebalancing happens naturally through withdrawal planning. Take distributions from overweight assets, leave underweight ones alone. The portfolio adjusts without separate transactions.
The transition from accumulation to withdrawal simplifies rebalancing mechanically but demands tighter attention to sequence-of-returns risk. Selling stocks during a downturn to maintain spending depletes principal faster than selling bonds. Rebalancing in retirement must account for this asymmetry.
The Discipline Advantage
Rebalancing enforces a behavior that contradicts instinct: selling what’s performed well and buying what’s lagged. During bull markets, this feels like leaving gains on the table. During corrections, it feels like throwing good money after bad. Both feelings are reliable indicators that the process is working.
Markets reward this discipline indirectly. Rebalancing doesn’t increase returns, but it prevents concentration in whichever asset class most recently surged—the one most likely to revert. Over full market cycles, this constraint reduces volatility without sacrificing much growth.
The advantage compounds through crises. Investors who maintained discipline through 2008, 2020, and other drawdowns had cash equivalents to deploy when stocks were discounted. Those who let allocations drift into heavy stock concentration faced larger losses and fewer options.
Rebalancing isn’t predictive. It doesn’t time markets or identify opportunities. It’s a mechanical process that keeps risk exposure aligned with capacity. That alignment is what most portfolios lack—not because the math is hard, but because the process is ignored until a downturn exposes the cost.
