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 research 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—increases your total taxable income and 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.
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 selling at a loss
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 from other investments that you sell for a gain. These losses offset gains and reduce the taxes you owe on appreciated assets that you also sell to realize gains. 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 carried forward over an indefinite number of future tax years.
Cutting your losses can cut your tax bill
Offsetting capital gains with capital losses—a.k.a. tax-loss harvesting—can significantly lower your taxes.
For illustrative purposes only. The long term capital gains rate of 20% assumes a combined 15% federal rate and 5% state rate. Investors may pay higher or lower long term capital gains rates based on their income and filing status.
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 potentially improve its overall performance:
- First, consider selling 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®. For funds, you can review Morningstar ratings and make comparisons using other tools and screeners.
- Finally, consider selling 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 Robert. “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.”
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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 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 generally make the most sense for 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. Margin loans and pledged asset lending are different and the characteristics and risks unique to each should be understood before borrowing.
Pledged asset lending, in particular, involves a high degree of risk. If the value of the investments you borrow against declines, you may need to deposit more cash or securities to avoid credit default. In addition, your pledged securities could be sold without your consent, which could result in tax consequences. Proceeds from a PAL may not be used to purchase securities or to pay down margin loans.
To learn more about Schwab Bank’s Pledged Asset Line, call your regional banking manager at 888-577-7040.