A Simple Way to Reduce Taxes on Portfolio Withdrawals

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By Aaron Gubin

Imagine that you've been investing in a certain stock, mutual fund or exchange-traded fun over the last 18 months, buying 10 shares of it once every three months. Now, after some ups and downs in the share price, you'd like to pare back your position. Maybe you need that cash to pay bills, put a down payment on a house or buy a boat. Or maybe you've just retired and are starting to plan your withdrawal strategy for living expenses.

Whatever your circumstances, one of the most important factors to consider is how the sale will affect your tax bill.

The way many brokerages deal with a sell order is known as FIFO -- first in, first out. It prioritizes selling long-term positions before short-term positions. In other words, the brokerage will first sell the shares that you bought the earliest.

However, there's a better order that you should follow in selling your shares that can help you at tax time.

When selling shares at your broker, you can typically specify which lot to sell from (each buy creates a new tax lot). The list below suggests the order in which you should sell lots, though you can pull from multiple lots in the same sale transaction. Remember that it is usually preferable to minimize trading (and the transactions costs that it implies) as much as possible.

1. Sell short-term losses first.
  1. Offset any short-term capital gains (which would be taxed at your marginal rate) realized this year.
2. Sell long-term losses.
  1. Offset any long-term capital gains you've realized this year. If you have more total losses than gains, you can offset up to $3,000 of your current income.
3. Sell long-term gains (if necessary).
  1. The tax rate on long-term gains is lower than the tax rate on short-term gains, so it makes sense to prioritize the sale of long-term gains before short-term gains.
4. Sell short-term gains (if necessary).
  1. The tax rate on short-term capital gains is the same as your income rate, so there's no benefit to making sales of short-term gains before liquidating other types of lots.
Though the default order at the brokers is typically FIFO, you should see if you can change it: a loss harvester option should implement this order without forcing you to pick the specific lots. (It's worth noting that the loss harvester option may be default at some brokerages.)

Here's a visual example that will hopefully clarify the strategy further. The chart below shows the price movements of a fictional stock, which you first bought on Nov. 30, 2012, at $105.69. In the following year and a half, the stock price moved up and down, and you continued to buy, at anywhere between $129.45 on Aug. 31, 2014 to $108.87 on Nov. 30, 2014 (the last time you made a purchase).

Screen Shot 2015-02-11 at 10.55.54 AM.png

Now that you want to pare down your position, where do you start? Based on your per share lot cost basis and the stock's current price ($109.61), you would order a sale on three of your more recent transactions first. The most recent purchase -- that made on Nov. 30, 2014, is a short-term capital gain and should be sold last, if at all.

The chart below shows you how the rest of the lots should be prioritized, if they need to be sold at the current price.

Note that the information presented here is meant to explain general tax-efficient strategy and does not present specific investing advice. For that, investors should confer with their tax adviser.

TaxTipCapGains.jpg

Aaron Gubin heads research for SigFig's Asset Management team. Nearly a million people use SigFig to track, improve and manage over $300 billion in investments. This information was prepared to explain general tax-efficient strategy. Prospective investors should confer with their personal tax advisers. SigFig assumes no responsibility for the tax consequences to any investor of any transaction.

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