Nuances of Senate Tax Proposal: What Is First-In-First-Out?

The tax bill currently being considered by the U.S. Senate would require investors who are selling an investment they own in a taxable brokerage account to sell the shares they have owned for the longest amount of time first—known as the first-in-first-out method (FIFO).

How could FIFO affect investor tax liabilities?

Requiring the use of FIFO accounting for individual tax lots rather than allowing investors to specify the lot being sold has the potential to hurt investors, particularly those in the middle class that are more likely to need to liquidate much of their portfolios to fund their retirement.

Consider an individual who has invested in a stock index fund over the course of their 40 years of working. The initial investments they made in that fund may have appreciated significantly and so their initial sales in their early years of retirement could generate significant realized gains and tax liability. With current tax policy, investors have the option to choose which tax lot they sell and manage the timing on when they realize any gains.

Retirement Saving vs. Retirement Spending

It is well documented that market downturns in the early years of retirement can have a dramatic impact on the expected period that a retirement portfolio can sustain a retiree’s spending requirements. Unlike the accumulation phase of saving, the decumulation phase that occurs in retirement is path dependent, meaning that it isn’t just the average return realized during retirement, but the actual sequence of returns that impacts whether a retiree’s savings will last through their retirement. This is because if the market is down in the early years of retirement, the retiree is then forced to liquidate some of those assets during that dip and won’t get the benefit of the recovery when that happens.

A Potentially Increased Tax Burden

Enforcing FIFO under any new tax reform bill could have a similar effect. Having to sell the first tax lots in the early years of retirement means retirees may need to liquidate more of their assets in those early years to cover that additional tax liability. Taking more assets out early and not benefiting from the appreciation those assets might have seen increases the risk that they will run out of savings during their lifetime. This would be especially problematic for retirees who experience a difficult market in the early years of retirement as the impact of the FIFO requirement would further compound the adverse impact of their unfavorable sequence of returns.

This effect is likely to impact middle class investors far more than high-net-worth investors. High-net-worth investors are likely to have more flexibility in which assets they liquidate and may be able to avoid sales of many assets with large gains and benefit from the step up in cost basis when they pass assets on to heirs. They also are likely to have more options such as gifting and other strategies to manage around this issue.