Imagine a Colorado Springs–based couple, Jeremy and Irene. They’ve long dreamed of owning a vacation property in the foothills outside Hailey, Idaho. But after 10 years of diligent saving, Jeremy and Irene realize they have no idea how to manage such a large portfolio withdrawal. Should they take the money out over time, as they search in earnest for their dream home, or wait, and withdraw it all at once? Which investments should they sell? How will the withdrawal affect their taxes? And what can they do to ensure the transaction doesn’t throw the rest of their portfolio off-balance?
“There’s plenty of advice out there about how to save for your goals,” says Robert Aruldoss, a senior financial planning analyst at the Schwab Center for Financial Research, “but very little guidance regarding how to tap your investments once you reach one.” As a result, many investors approach a sizable withdrawal as they would a smaller one—with potentially negative consequences for both their taxes and overall portfolio performance.
Here are three of the most common mistakes people make when managing a large portfolio withdrawal—and how you can avoid them.
Mistake #1: Withdrawing all at once
“Depending on the size of the withdrawal, you might want to split it up over multiple years,” Robert says. “If you don’t, you could get hit with a big tax bill.” Why? Because selling substantial assets in a single calendar year—versus staggering the distribution over two or more years—could be enough to bump you into a higher tax bracket. “If you’re near the upper end of your tax bracket, withdrawing a large amount of capital across several years can shave percentage points off your tax bill,” Robert says.
“Keep in mind that delaying a sale for tax purposes only makes sense if you expect the investment to maintain its value or go higher,” notes Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.
Start by figuring out how much money you’ll need and how soon you’ll need it, and work backward from there. Say you need $50,000 next year for the down payment on a second home. If you’re currently in the 25% tax bracket, you’re single, and your taxable income for the year is $60,000, you can realize up to $31,900 in capital gains without being bumped into a higher bracket. Then you’ll need only $18,100 in the second year—giving you a cushion should your taxable income increase.
Mistake #2: Avoiding losses
Investors have a natural antipathy toward selling investments at a loss. This so-called loss aversion can cause us to overlook our underperforming investments when deciding which assets to sell. “It’s hard for many people to stomach losses, but they can actually be a boon, tax-wise,” Robert says.
Not all underperforming assets are fit for the chopping block, but those with weak future prospects or that no longer fit your investment strategy are prime candidates. Indeed, when you sell an investment for less than you paid, you can use the capital loss to offset capital gains, thereby reducing the taxes you owe on your appreciated assets (see “Cutting your losses can cut your tax bill,” below). What’s more, if your capital losses exceed your capital gains, you can use those losses to reduce your ordinary taxable income by up to $3,000; anything above that can be spread out over an indefinite number of future tax years.
A large withdrawal is also an ideal opportunity to rebalance your portfolio. “As withdrawals and market fluctuations alter the proportions of your portfolio holdings, your asset allocation may stray from its target,” Robert says, causing some positions to be overweight and others underweight. In such instances, Robert suggests that investors raise capital from their overweight positions, selling in order of quality, from lowest to highest. A selling hierarchy like this one can help return your portfolio to its target asset allocation and improve its overall performance:
- First, sell underperforming assets that no longer fit your investment strategy.
- Next, look at your portfolio’s overweight asset classes. Within those classes, identify the individual holdings and their quality. For stocks, you can use Schwab Equity Ratings® at schwab.com/equityratings; for funds, you can review Morningstar ratings and make comparisons at schwab.com/comparefunds.
- Finally, sell your lowest-rated stocks or funds, moving up in quality until your portfolio is back in balance.
Mistake #3: Neglecting your other goals
“It’s easy to lose sight of your investment plan when you’re reaching a major milestone,” Robert says. “But you need to make sure your overall finances are still in order—particularly your retirement savings.”
Once you’ve fully executed your withdrawal, you should revisit your overall financial plan. “The money you were putting away to reach the goal you just achieved can now be reallocated to help you meet other ones,” Robert says. If you’re not yet maxing out your retirement savings, for example, use the newly freed-up funds to help get you there. After all, it’s one thing to buy that dream house—or whatever your goal might be—and quite another to make sure you can live comfortably ever after.
Plus, remember why you saved in the first place. “Very few people save and invest just to have a big portfolio to admire,” says Rande. “For most of us, reaching our goals means eventually spending the money or leaving it to our heirs. That’s really what it’s all about.”
When to consider borrowing
If you need access to capital but are hesitant to liquidate part of your portfolio because of tax consequences, a down market or other considerations, it might make sense to borrow to fund your goal. Robert Aruldoss, a senior financial planning analyst at the Schwab Center for Financial Research, notes that if you were to borrow the funds at an interest rate that’s less than your expected portfolio return, you’d likely come out ahead. “And if you borrow against your home,” he continues, “interest payments may be tax-deductible, further reducing the cost of borrowing.”
You could also consider borrowing against the value of your investments with a margin loan or with a securities-based loan (also known as a Pledged Asset Line, or PAL). Both involve risk, and it’s important to understand these risks before borrowing.*
Margin loans and PALs make the most sense for sophisticated investors who have low-volatility assets to borrow against, who are in control of their debt, and for whom the level of risk is appropriate.
Pledged asset lending, in particular, involves a high degree of risk. If the value of your collateral declines, you may need to deposit more cash or securities to avoid default. In addition, your pledged securities could be sold without your consent, which could result in tax consequences.
To learn more about Schwab Bank’s Pledged Asset Line, call your regional banking manager at 888-577-7040.
*Charles Schwab Bank requires that the assets pledged as collateral for the Pledged Asset Line (PAL) be held in a separate Pledged Asset Account (PAASB) maintained at Charles Schwab & Co., Inc. Charles Schwab Bank establishes collateral requirements regarding the type of assets, value of assets and concentration of assets that are required to be maintained in the PAASB as collateral for the PAL, and reserves the right to change the requirements from time to time. Brokerage fees and commissions apply to the PAASB.
What you can do next:
- Meet with a Schwab financial consultant at your local branch to discuss your large withdrawal.