Watch for taxes when creating your perfect portfolio

— -- Q: I've measured my taste for risk and selected my asset allocation. When is a good time to start selling my existing portfolio to match my asset allocation?

A: First, congratulations are in order. Unlike many investors, who go blindly chasing hot stocks and tips, you've done this the right way.

By first defining your risk tolerance and designing an asset allocation, then picking investments, you can create a portfolio that will give you the best chance of getting returns you deserve for the amount of risk you take. Most likely, your allocation calls for you to buy a menu of stocks or investments that fall into certain categories, such as large-cap value-priced stocks or small-company stocks.

But, now that you have designed your ideal portfolio, how do you implement it? If your ideal portfolio is close to what you have now, you can rework it without selling by just directing new money to the investments you want to build up.

If your ideal portfolio is pretty far from what you have now, you will need to sell the investments that don't match your allocation. And that raises the danger of triggering unfavorable tax consequences. So, what's the plan?

The first strategy is to sell winners along with losers. Remember that you're entitled to use your capital losses to offset your capital gains. If you're careful about selling off losers with winners, you might be surprised how little net capital gain you can be left with. That's especially true this year, since the stock market has fallen so much.

You'll also want to be careful to see how long you've owned investments before you sell them. If you sell stocks before you've owned them more than a year, your gains won't be taxed at the lower capital gains tax rate; instead, any gains will be taxed as ordinary income, at a higher rate.

Finally, be careful about dumping large amounts of winners all at once. Depending on your total income, generating too much in capital gains could force you to pay the Alternative Minimum Tax. The AMT is a secondary tax system designed to make sure the IRS gets what it thinks it deserves from taxpayers with lots of deductions. You don't want an abnormally high level of stock sales to create an AMT headache. AMT can be a big reason why it may not be a good idea to sell all your older stocks to reach your new asset allocation.