How to Rebalance a Three-Fund Portfolio in 2026 Without Wrecking Your Tax Bill

The simplest equity portfolio in the world is three funds: one large-cap index or flexi-cap, one mid-cap or small-cap, and one debt or liquid fund as ballast. Even at this minimum complexity, the three sleeves drift over time. A bull run pushes equity from 70% to 82% and your portfolio is now carrying risk you did not explicitly choose. The fix is rebalancing. Done wrong, rebalancing is how investors gift the Income Tax Department a five-figure cheque every March for no benefit.

What rebalancing actually is

Rebalancing is the act of returning your portfolio to its target allocation. If you wanted 70% equity and your portfolio is now 82% equity, you have three ways to reach 70% again:

1. Sell equity, buy debt. Simple, clean, and tax-triggering.
2. Redirect future contributions to debt only. Slow, no tax, works only if you are still accumulating.
3. Withdraw from equity for a real expense. Rebalances incidentally; tax applies only to that specific redemption, which you would have done anyway.

Most investors reach for option 1 without considering whether 2 or 3 would achieve the same result for free.

The trigger rule we recommend

Do not rebalance on a calendar. Rebalance on a drift threshold. The research on calendar-vs-threshold rebalancing shows threshold-based is more tax-efficient and gives slightly better risk-adjusted returns. Our recommended rule:

• Rebalance when any sleeve drifts more than 5 percentage points from target.
• Check once a quarter. Do nothing if no sleeve has drifted past the threshold.
• When rebalancing, bring the drifted sleeve back to within 2 percentage points of target, not exactly to target. This reduces nuisance trading.

Using new money first

If you contribute ₹50,000/month via SIP and your portfolio is now 82/18 equity/debt against a 70/30 target, the cheapest rebalance is to redirect 100% of new SIPs to debt for a few months. A ₹10 lakh portfolio rebalances to 70/30 organically as roughly ₹1.2 lakh of new money flows into debt. No tax, no hassle.

This only works if you are still accumulating. A retiree drawing down the portfolio cannot use this trick.

When you must sell to rebalance

If drift exceeds 8–10 percentage points and redirecting contributions cannot close the gap within 6 months, you will need to sell. Minimise the tax bill:

1. Sell from the sleeve in the least painful tax bucket first. LTCG units in the equity sleeve are taxed at 12.5% above the ₹1.25 lakh annual exemption. Use the exemption before touching anything else.
2. Avoid selling STCG units when rebalancing. 20% tax on STCG is 60% more expensive than LTCG. If you must reduce equity, sell the oldest (LTCG) units first, even if they represent a smaller gain in percentage terms.
3. Use switches inside the same fund house with care. A switch from an equity fund to a debt fund is still a sale for tax purposes. It is not a tax-free rebalance.
4. Never sell debt-fund units bought after 1 April 2023 unless you have to. Every rupee of gain is taxed at slab. If you need liquidity, draw from the equity sleeve's LTCG exemption bucket instead.

Worked rebalance, March 2026

Starting state: ₹20 lakh portfolio. Target 70/30. Current 82/18 → equity has ₹16.4 lakh, debt has ₹3.6 lakh. To return to 70/30 you need equity at ₹14 lakh and debt at ₹6 lakh. You must move ₹2.4 lakh from equity to debt.

Assume the equity sleeve has a ₹6 lakh unrealised gain, with ₹4 lakh of it in tranches held >12 months (LTCG), ₹2 lakh in tranches held <12 months (STCG). You have not used this year's ₹1.25 lakh LTCG exemption.

Rebalance plan:

• Redeem ₹2.4 lakh worth of oldest (LTCG) units. These units have a cost basis of ~₹1.6 lakh, so the redemption releases ~₹0.8 lakh of gain.
• ₹0.8 lakh of LTCG is within the ₹1.25 lakh exemption → zero tax.
• Buy ₹2.4 lakh of a low-cost debt fund or a liquid fund.

Net tax on a full rebalance: ₹0. Compare to the naive approach of selling proportionally from all tranches, which would have generated STCG of ~₹40,000, taxed at 20% = ₹8,320 of tax for the same rebalancing outcome.

Tools and process

• Use a portfolio tracker that shows per-tranche cost basis (the AMC's own CAS is fine for this).
• Run your rebalance decision once a quarter. Do not open the tracker in between.
• Whenever you rebalance, note the reason and the amount in a log. Over years this log is what tells you whether your targets are actually realistic or whether your risk tolerance has quietly changed.

Use our portfolio rebalancing workflow to simulate the tax impact of a rebalance before you execute. Investments are subject to market risks. This article is not tax advice; consult a qualified CA for your specific tax bill.