Portfolio Management | February 10, 2022

3 Mistakes to Avoid When Making a Large Portfolio Withdrawal

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 to 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, but for many investors, there’s less guidance or clarity regarding how to tap your investments once you reach a goal,” says Rob Williams, CFP®, CRPC®, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research. 

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 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,” says Hayden Adams, CPA, CFP®, director of tax and financial planning at the Schwab Center for Financial Research. “If you don’t, you could get hit with a big tax bill.” 

To help minimize your tax bill, start by figuring out how much money you’ll need and how soon you’ll need it, and work backward from there. Then you can look at several strategies, such as tax-gain harvesting or topping off tax brackets, to get the cash you need with the least amount of tax impact.

Here’s how topping off a tax bracket could work to save taxes. 

Let’s say Jeremy and Irene are both age 62. For 2022, they have $72,000 of income, which means their taxable income would be $46,100 after taking the $25,900 standard deduction for a married couple—putting them in the 12% marginal tax bracket.

They’ve determined that they can afford a second home, which they plan on purchasing in 2024, and need $50,000 for the down payment. They decide the funds will come from Jeremy’s traditional IRA, so the withdrawal will be taxed as ordinary income. 

If Jeremy and Irene withdraw the full amount this year, their total taxable income—including the IRA distribution—would bump some of that withdrawal into the next higher tax bracket of 22%. That means they would need to take out $59,301 to cover the estimated $9,301 in taxes they would owe on that withdrawal to get them the $50,000 down payment they need.1

By splitting the distribution over two years, they can remain in the lower 12% tax bracket (assuming no income or tax changes) and would only need to withdraw about $56,818 over two years, potentially saving them $2,483 in taxes. It would work like this: They could take $37,450 out of Jeremy’s IRA this year and owe roughly $4,494 in taxes (at the 12% tax rate) on the withdrawal. Then the next year, they could withdraw $19,368 from his IRA, paying about $2,324 in taxes (at the 12% tax rate)—giving them $50,000 after taxes for the down payment.2

By using the tax strategy of splitting their distributions and topping off the 12% tax bracket, Jeremy and Irene would be able to reduce their overall taxes, thereby minimizing the amount they would need to withdraw from Jeremy’s retirement savings. Spreading a large withdrawal across several years—particularly if you’re near the upper end of your tax bracket—can often result in a significant savings, Hayden says.

Mistake #2: Avoiding selling at a loss

Investors often 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, if you hold the investment in a taxable brokerage account,” Rob 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. “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, potentially reducing your tax bill,” Hayden explains. This strategy is called tax-loss harvesting and can lower taxes on your investments if done wisely.

What’s more, if your capital losses exceed your capital gains from investments held and sold in a taxable brokerage account, you can use those losses to potentially reduce your ordinary taxable income by up to $3,000. Anything above that can be carried over to 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, 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,” Rob says.

Cutting your losses can cut your tax bill

Offsetting capital gains with capital losses—a.k.a. tax-loss harvesting—can potentially lower your taxes.

Two hypothetical scenarios: One in which you sell appreciated assets for a gain of $50,000, none at a loss. Your gain is taxed at 20%, and your tax bill is $10,000. Scenario two, you sell appreciated assets for a gain of $50,000, sell depreciated assets for a loss of $10,000, and have a net gain of $40,000 taxed at 20%, resulting in a $8,000 tax bill.

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

Jeremy and Irene are likely saving—and investing—for multiple goals, not only for their vacation home in Idaho. For this and other reasons, it makes sense to diversify your savings by the type of account you invest in, as well as the size—and timing—of your goals. This strategy is called tax diversification. 

“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,” Hayden notes.

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, and you won’t 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).

Pre-tax contributions to tax-deferred accounts—which include 401(k)s, 403(b)s, and traditional IRAs—generally reduce your current tax bill and 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 the 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).

Meanwhile, withdrawals from a taxable brokerage account 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 does not need to 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.

Rob 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 home3, and your total itemized deduction is larger than your standard deduction. “That can further reduce the cost of borrowing,” Rob says, subject to current limitations and caps from the IRS on how much you can deduct.

You could also consider borrowing against the value of your investments with a margin loan from a brokerage firm or with a securities-based line of credit offered by a bank. Both involve risk, and it’s important to understand these risks before borrowing.4

Margin loans and bank-offered, security-based lines of credit might make sense for investors with higher wealth or flexibility 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 risk if the value of your investments falls. Before you decide to apply for a security-based line of credit, make sure you understand the details, potential benefits, and risks.

1Example assumes that the first $37,450 of distributions would be taxed at 12%, and any withdrawal amount over $37,450 would be taxed at 22%. This means an additional $21,851 withdrawal would be necessary for a total distribution of $59,301. The estimated tax of on this distribution would be $9,301, leaving $50,000 after taxes for the down payment.

2Example assumes a $37,450 distribution in year 1, followed by a $19,368 distribution in year 2, for a total withdrawal of $56,818 over 2 years. The total $56,818 withdrawal would be taxed at 12%, resulting in an estimated tax of $6,818, leaving $50,000 after taxes for the down payment.

3Until it expires in 2026, the Tax Cuts and Jobs Act of 2017 suspends 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. Taxpayers may only deduct interest on $750,000 ($375,000 for a married taxpayer filing a separate return) of qualified residence loans. The limits apply to the combined amount of loans used to buy, build, or substantially improve the taxpayer’s main home and second home.

4For a bank-offered, securities-based line of credit, 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.

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