Are Withdrawal Mistakes Draining Your Savings?

Your investment portfolio likely consists of various retirement accounts, brokerage accounts, and regular savings accounts, each with its own tax status. However, there are some basic mistakes one can easily make when trying to figure out precisely how much and from where to withdraw; in this article, we’ll examine some of the more common mistakes investors make 

Sizeable Withdrawals

Suppose you need $100,000 for a down payment on a mortgage. You sell off some assets from your brokerage account and collect your check. When you file your taxes, you’re shocked by the tax bill; besides being more than you can afford, it also bumped you up a tax bracket and derailed your long-term tax goals and, if you’re old enough, your Medicare premiums.

Before you sell off assets that can cause a surprising and adverse tax event, sit down with a CPA or a Financial Advisor, try to figure out your taxable income for the year, and determine how much you can withdraw from your brokerage account without getting bumped up a tax bracket or an unaffordable tax bill. There may be alternative methods for generating the cash needed for your down payment, such as staggering withdrawals over a couple of years, selling from multiple accounts with different tax statuses, or even margin loans. 

Withdrawing from the Wrong Account

Where you withdraw from is nearly as important as how much you withdraw, if not more so. Brokerage accounts typically generate a lower capital gains tax rate, tax-deferred accounts such as Traditional IRAs generate regular income tax rates, and Roth accounts don’t generate any tax at all, as long as regulations are adhered to. There are two primary withdrawal strategies: 

1. By Tax Status (Fixed Order Strategy)

Brokerage Account —> Tax-Deferred —> Tax-Free

Assets held in a brokerage account are more likely to bear a more significant tax drag due to the greater amount of taxable events they experience. A mutual fund, for example, generates distributions that count as income tax that you’ll have to take into account each year if it’s held in a brokerage account. That means the slower generation of compound gains. The theory goes that it’s better to offload those investments first and let your tax-advantaged grow for longer, i.e., traditional and Roth accounts. 

However, that doesn’t paint a complete picture, as different assets may have different tax rates. Bond interest is taxed as general income, while any increase in value would count as a capital gain upon capture. ETFs are also tax-efficient as you can defer your gains by reinvesting and generally create fewer taxable events. 

Then, you move on to your tax-deferred retirement savings, such as those in an IRA or 401(k). Eventually, Required Minimum Distributions will activate, so you’ll need to take withdrawals that will be counted as taxable income, generally at a higher rate than your brokerage accounts. If you’ve already offloaded your brokerage assets, then, presumably, you can execute higher withdrawals without going up a tax bracket. 

Finally, you have tax-free accounts, such as the Roth. Any withdrawals won’t affect your tax situation, and since they don’t come laden with Required Minimum Distributions, you can let them grow for as long as you’d like and even leave a tax-free gift for an heir. Therefore, it might make sense to hold off on touching your Roth assets for as long as possible. 

2. Dynamic Withdrawal Strategy

One of the most significant flaws with the fixed-order strategy is its rigidity; it fails to consider a few factors: the tax status of individual asset classes and accounts, market conditions, and your tax bracket. You likely need to withdraw a minimum amount to live off of, and withdrawing a sufficient amount from just one kind of account may negatively affect your tax strategy. The situation could worsen if the assets in that account suffer disproportionately from poor market returns. 

Instead, a dynamic withdrawal strategy attempts to factor in all of the factors mentioned above – varying tax statuses of accounts and assets, market conditions, projected future income sources, and future tax rates. The point is to withdraw only what is necessary from each account to maintain a lower tax bracket and tax diversification for a lower lifetime tax bill.

Avoiding Losses

Let’s go back to that $100,000 withdrawal. You sell off assets you’ve held for over a year for a profit of $100,000, and you now owe long-term capital gains tax rates. However, the sale of assets shouldn’t occur in a vacuum – perhaps the strategic sale of other assets could be beneficial.

For example, you have Stock A and Stock B. Stock A is up $100,000, while Stock B is down $10,000. You have also determined that Stock B isn’t a suitable investment for your risk tolerance or financial goals. Instead of holding an unsuitable investment, you can purposefully sell at a loss and use those losses to offset the taxable gains of Stock A. Now, you only owe taxes on $90,000. 

Scenario 1: Selling only Stock A

Capital Gains: $100,000

Tax Rate: 15%

Tax Bill: $100,000 * 15% = $15,000

Scenario 1: Selling Stock A & Stock B

Capital Gains on Stock A: $100,000

Loss on Stock B: $10,000

Net Gain: $100,000 – $10,000 = $90,000

Tax Rate: 15%

Tax Bill: $90,000 * 15% = $13,500

Here, the point is not to avoid a loss but to leverage that loss for a smaller tax bill. You also get the additional benefit of offloading assets that no longer fit nicely into your portfolio while potentially maintaining a lower tax bracket. Since you need to sell those assets anyway, you may as well make the most of it. 

Ignoring Market Conditions

Market conditions play a crucial role, particularly in the years surrounding retirement, when the risk known as the Sequence of Returns becomes most critical. If the market downturn occurs well before retirement, there is typically enough time for your savings to recover. Conversely, a downturn early in retirement (or heading into retirement) can be more problematic, as you’re starting to make withdrawals and may have less time for your investments to recover. Your savings’ ability to generate enough gains to last through retirement will be significantly affected, potentially leading to an early exhaustion of funds. 

It would be advantageous to have alternative sources of income to fall back on during these times. If those don’t exist, then hunkering down and trying to live off of Social Security and smaller withdrawals may be necessary to overcome the sustained losses.