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.

A Questionable Revenue Generator?

What also seems unappealing about this aspect of the proposed tax bill is that it seems to be an asymmetric adverse outcome for the retiree. In other words, it may be bad for middle class investors/taxpayers/retirees and neutral for the government in terms of tax revenue. The retiree could be adversely impacted by the requirement to liquidate more assets early in retirement to cover the additional tax liability, decreasing the probability their assets could last through retirement. From the government’s perspective, however, the difference in revenue ultimately collected seems likely to be negligible, it is just a matter of timing. If all assets are liquidated, taxes will be paid on all unrealized gains. In fact, in some scenarios, tax revenues might be enhanced by not forcing the retiree to liquidate as much of their assets, allowing more money to remain invested and appreciate, leading to a larger realized gain and more tax revenue than if those assets were liquidated earlier.

Ready, Set, Debate

While debate among senators and their constituents has continued through the Thanksgiving holiday, a final vote on the tax proposal could take place by the end of November. Any final Senate bill will then have to be reconciled with the tax reform proposal recently approved in the House. Regardless of what shape the final tax reform bill takes, financial professionals and their clients should be aware of any potential changes to the tax liabilities faced by individual investors if and when they chose to sell shares out of taxable brokerage accounts.

Curt Overway is president and portfolio manager with Managed Portfolio Advisors, a division of Natixis Advisors L.P. Based in San Francisco, California, Managed Portfolio Advisors offers overlay management, product development and portfolio construction capabilities. Mr. Overway is also the president of Active Index Advisors, another division of Natixis Advisors L.P. also based in San Francisco, California, which specializes in managing index-based separate account solutions.

Prior to joining Natixis, Mr. Overway was a vice president and principal at Jurika & Voyles, an investment management firm. Previously, he worked as a financial analyst in the Municipal and Corporate Financing group at USL Capital. Mr. Overway has more than 20 years of investment management experience. He received a B.S. degree in industrial and operations engineering from the University of Michigan and an M.B.A. from the Haas School of Business at the University of California, Berkeley. He also earned an M.S. degree in development finance from the University of London. Additionally, he has served as an officer in the U.S. Navy. Mr. Overway is a CFA charterholder and is a member of the CFA Society of San Francisco.

Mr. Overway was selected for Separate Accounts Player of the Year for 2006 by the Institutional Investor News Publishing Group, based particularly on his work with multiple discipline products. He was also nominated for the same honor in 2004.