Cash Withdrawal Considerations

Cash Withdrawal Considerations

Cash Withdrawal Considerations

IFA is often in the position of accommodating regular cash withdrawal by its clients. The question is how to best generate cash for withdrawals.

The important general considerations are the following:

  • Minimization of Transaction Costs: Schwab and Fidelity each charge unique amounts to process client trades. As of 12/1/2013 prices ranges from $50 a trade to free depending on the Custodian and circumstance. IFA’s policy is to minimize trading costs for clients whenever possible.
  • Cash Drag: As of 12/1/2013 the current yield on money market cash is essentially zero. While all of the IFA portfolios have a positive expected return, the actual realized return over any short period (say 3 to 6 months) can be positive or negative with almost equal probability. Thus, the decision to hold more cash then needed will often appear to be prudent in hindsight (after a period of negative returns), but the goal of maximizing client’s long-term ending wealth dictates that IFA should strive to minimize cash drag whenever possible.
  • Minimization of Taxes: Please consult your accountant for your situation. But, after tax law changes, qualified dividends and long term capital gains can be taxed as high as 25%, if you include limits on deductions and the new surtax. For clients that were tax loss harvested during the market downturn in 2008 and 2009, loss carry-forwards can be used to offset capital gains.
  • Risk Maintenance: One of IFA’s primary (if not the single most important) duties is to keep clients at or below the risk level that they agreed to in their investment policy statement. Every single time a portfolio is traded, the risk level is evaluated, and the trades are chosen to align the risk exposure of the portfolio with the risk capacity of the client. This is done with an eye on the three points above.

There are a few possible ways of addressing cash needs:

Take Cash Dividends

Normally IFA does not encourage clients to rely on dividends because they are very uneven (they are heavily weighted towards December) and they are somewhat unreliable as a source of cash. The reason for this is that DFA (or any responsible fund company) will take steps to minimize cash distributions because they are taxable events and they do not increase shareholder wealth. One way that they can do this, for example, is in their global fixed income funds where currency risk is hedged. If the value of the hedging instrument decreases, it will be used as on offset to interest income on the bonds held, and the resulting cash dividend will be decreased or perhaps not even paid. This happened in 2006.

The taxes owed on dividends are the same regardless of whether the dividends are reinvested. If the dividends are reinvested, the cost basis is increased by the amount of the re-investment. If the dividend paying mutual fund is partially sold to generate cash, the shares that were purchased via re-investment would not be the shares that are sold (assuming first-in first-out accounting). If the dividend paying mutual fund is completely sold immediately after reinvestment of dividends, there would be no capital gains on the newly purchased shares (other than the market movement that occurred between the reinvestment and the sale). To summarize, for a mutual fund that is either left untouched or completely sold, taking dividends in cash will not result in lower taxes. If however, a partial sell of appreciated shares can be avoided by taking dividends in cash, then this may be the appropriate course of action.

The primary advantages of taking cash dividends are the avoidance of transaction costs to sell and the avoidance of realized capital gains (particularly if FIFO accounting is used). These advantages come at the cost of cash drag (especially in December) and perhaps losing control over the risk level of the portfolio. Specifically, REITS and fixed income will normally deplete faster than equities because of their higher yields.

Sell to Create Cash

Mutual funds could be sold to create cash on a regular basis, say once every two months. The number of trades could be plausibly limited (depending on the size of the account) to one trade for each time cash is raised. This would limit the annual trading cost to a max of $300 (One $50 trade every two months). This strategy would minimize cash drag, as there would usually not be more than a single month’s worth of cash outstanding (assuming that the trades are placed fairly close to the withdrawal date.

Here is the wisdom of Ken French on this topic.

A General Method

When creating cash for regular withdrawals IFA examines the estimated trading costs and cash drag for various withdrawal scenarios between two and six months. To do this IFA requires the following inputs:

  • IFA Index Portfolio™ Number
  • Portfolio Value
  • Regular Withdrawal Amount and Frequency
  • Cost per trade
  • Expected Return of Portfolio
  • Expected Return of Cash
  • Minimum Trade Size

Using these inputs IFA determines how much cash to create.

For example, if the client withdrawals $10,000 monthly IFA will examine creating $20,000 every two months, $30,000 every three months, $40,000 every four months, etc. up to six months. Each scenario is analyzed according to trading costs (both transaction costs paid to the custodian and the additional cost of tracking and reporting the trades to the IRS) and estimated cash drag. IFA will then create cash for the number of monthly withdrawals that minimizes estimated cost. However, we must bear in mind that cash drag is uncertain. IFA does not claim that it knows beforehand how to produce the optimal outcome.