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 from a taxable brokerage account or, as the following example uses, an individual retirement account (IRA)—and how to avoid them.
Mistake #1: Withdrawing all at once
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.
“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.” Particularly if you’re near the upper end of your tax bracket, spreading a large withdrawal across several years can result in a significant savings, he says.
Start by figuring out how much money you’ll need and how soon you’ll need it, and work backward from there.
Let’s say, Jeremy and Irene are both age 62 and have determined that they can afford a second home, which they plan on purchasing in 2020. They’ve decided to take the $50,000 needed for the down payment from their traditional IRA, but they don’t want to push themselves into the next higher tax bracket with this withdraw. For 2019, they have $72,000 of income (used to pay for living expenses), which means their taxable income would be $47,600 after taking the $24,400 standard deduction for a married couple — putting them in the 12% marginal tax bracket.
That means they could withdraw $31,350 of the $50,000 this year, without being bumped into the next higher tax bracket of 22%. They would pay roughly $3,762 in taxes (at the 12% tax rate) on the withdrawal. Then they could withdraw $25,469 from their IRA next year paying about $3,056 in taxes (at the 12% tax rate) — giving them $50,000 after taxes, for the down payment.1
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 , 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 the sale of other assets in a taxable brokerage account that have appreciated, reducing your tax bill.
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.
A large withdrawal is also an ideal opportunity to your portfolio. As withdrawals and market fluctuations alter the proportions of your portfolio holdings, your asset allocation may stray from its target, causing some positions to be overweight and others underweight. “It’s important to keep your portfolio in line with your risk tolerance and time horizon,” Robert says.
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.
Mistake #3: Neglecting your other goals
“One of the benefits of tax diversification is having different types of accounts—taxable brokerage, traditional IRA and 401(k), Roth IRA and 401(k)—you can choose from to minimize the tax impact of a withdrawal,” Robert says.
Contributions to Roth 401(k)s and Roth IRAs, for example, are made with after-tax dollars, meaning contributions won’t reduce your current taxable income but neither will you owe taxes on appreciation, income or withdrawals in retirement (provided the account holder is over age 59½ and has held the account for five years or more).
Withdrawals of earnings and pre-tax contributions from tax-deferred accounts, on the other hand—which include 401(k)s, 403(b)s and traditional IRAs—aren’t taxed until you withdraw the money.
Withdrawals are subject to ordinary income taxes, which can be higher than preferential tax rates on long-term capital gains from sale of assets in taxable accounts, and, if taken prior to age 59½, may be subject to a 10% federal tax penalty (barring certain exceptions).
Withdrawals from a taxable brokerage account, meanwhile, may be subject to capital gains rates of 0% to 20%—plus an additional 3.8% Net Income Investment Tax for single filers with a modified adjusted gross income greater than $200,000 ($250,000 if you’re married filing jointly).
Of course, a particularly large withdrawal needn’t come from a single account. Rather, you can pick and choose, based on the overall composition of your portfolio and what makes the most sense for your situation.
When to consider borrowing
If you need access to capital but are hesitant to liquidate part of your portfolio because of tax consequences, such as 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 could come out ahead. Of course there is no guarantee your portfolio will achieve its stated objective, and you should consider whether you are willing to assume the risk that it won’t.
If you borrow against your home, interest payments may be tax-deductible so long as you use the proceeds to improve your home or purchase a second home2, and your total itemized deduction is larger than your standard deduction. “That can further reduce the cost of borrowing,” Robert says.
You could also consider borrowing against the value of your investments with a margin loan or with a securities-based line of credit. Both involve risk, and it’s important to understand these risks before borrowing.3
Margin loans and security-based lines of credit might make 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.
Entering into a securities based line of credit and pledging securities as collateral involves a high degree of risk. Before you decide to apply for a security-based line of credit, make sure you understand the risks.
1 Example assumes a $31,350 withdrawal in year 1 followed by a $25,469 withdrawal in year 2, for a total withdraw of $56,819 over 2 years. $56,819 taxed at 12% equals $6,818 in taxes, leaving 50,000 after taxes for the down payment.
2The Tax Cuts and Jobs Act of 2017, enacted Dec. 22, suspends from 2018 until 2026 the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.
The law imposes a lower dollar limit on mortgages qualifying for the home mortgage interest deduction. Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The limit is $375,000 for a married taxpayer filing a separate return. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.
3 The lending bank will generally require securities used as collateral to be held in a separate, pledged brokerage account held at a broker-dealer which may be an affiliate of the bank. The bank, in its sole discretion, generally determines the eligible collateral criteria and the loan value of collateral.
What You Can Do Next
Talk to a Financial Consultant about tailoring a large withdrawal to your individual circumstances.
Learn more about Schwab Bank’s security-based line of credit.
Make sure that you’re considering the potential tax implications of your investments and withdrawals. If your tax situation is complicated, you may want to consult a tax professional.