Depending on the situation, investors may find themselves holding a substantial amount of any company’s stock. This can lead to potentially complex tax situations where the stock’s gain could trigger a large bill to Uncle Sam if sold. There’s no “one-size-fits-all” solution to these situations, however, there are a handful of strategies that can be implemented to take the edge off. The “right” strategy is entirely dependent on the investor’s goals, risk tolerance, charitable nature, and much more. In this whitepaper we’ll discuss a few strategies that can be implemented to ease the tax burden on investors with highly concentrated positions.
Stock Held in Qualified Accounts
Qualified accounts (also referred to as retirement accounts such as IRAs or 401ks) typically pose fewer tax implication concerns when selling highly appreciated positions. Taxes are only triggered when money is withdrawn, not when trades are placed within the account. This enables investors to unwind any concentrated positions easily and allocate toward a more balanced approach. Non-qualified accounts can pose many challenges when concentrated stock is held. However, when employer stock is held in a retirement plan, a strategy referred to as Net Unrealized Appreciation (NUA) may be able to be used.
Net Unrealized Appreciation
The NUA strategy is applicable to individuals who hold employer stock within their employer retirement plans. However, if the account has been rolled over to an IRA, it disqualifies an individual from using the NUA strategy. Typically, when distributions are taken from retirement accounts, it’s taxed as ordinary income at an investor’s typical marginal tax rate. However, the NUA strategy enables the investor to take the entire account as a lump sum distribution, pay ordinary income tax on the cost basis (the original cost of the shares) and then pay long-term capital gains tax on the difference between the cost basis and the current value once the securities are sold. Since the long-term capital gains tax rate is 20% (and individual tax rates are often higher), it can save the investor substantial taxes. Sounds great, right? However, it’s important to understand the circumstances that qualify someone to use the strategy, and the potential tax implications a lump sum distribution can have. Here are a few considerations that should be made prior to engaging in the strategy:
- Not all retirement plans can facilitate this strategy. Investors should consult with their employer to ensure that the plan can support NUA.
- A 10% penalty is charged on distributions from retirement accounts if the account owner is under 59 ½ (with a few exceptions beyond the scope of this whitepaper). When an investor under 59 ½ uses the NUA strategy, they’re still subject to the 10% penalty, but only on the cost basis portion of the distribution.
- An alternate strategy to NUA could be a Roth conversion in later years. The choice between strategies is fully dependent on the individual’s situation. By taking the lump sum to take advantage of the NUA strategy though, the investor is no longer able to execute the Roth conversion with that account.
- If proceeds are to be passed onto an heir, the tax implication is different than most situations. Normally, inherited stock is stepped up in cost basis to the date of the decedent’s death. However, if the NUA strategy was used and that stock is passed down, the NUA portion is treated as ordinary income to the beneficiary once sold (rather than at the decedent’s advantageous long-term capital gains rate). Any appreciation in stock price beyond the value of the NUA does receive the step up in basis.
Stock Held in Non-Qualified Accounts
When investors hold highly appreciated positions in non-qualified (after-tax) accounts, their tax situation can become more complex. Any sale of the stock will trigger a capital gain, leading to liability in the year of the sale. However, there are many strategies to defer taxes with the help of some planning and timing of the sales.
Trusts are entities requiring their own tax return and have varying rules regarding contributions and distributions. There are many different trust structures that can accomplish the same things. However, we chose a couple worth discussing.
Charitable Remainder Unit Trusts (CRUTs)
Charitable Remainder Unit Trusts are most well-suited for charitable-minded investors with capital gains who want to reduce their exposure to their concentrated positions. In a CRUT, the investor contributes some appreciated stock to the trust, where the stock can then be sold or reallocated as the trustee or corporate trustee desires. When created, the trust document establishes a percentage that the trust will distribute to the grantor over the remainder of the grantor’s lifetime. At the death of the grantor, the remainder of the trust will be donated to a charity designated in the trust document. Distributions are taxable to the grantor as they’re received as income, but the capital gains on the initial appreciated stock is spread out over many years rather than taken all at once. Also, the rate of distribution must be greater than 5% and less than 50% of the value.
Deferred Sales Trusts
The CRUT may sound like a nice idea, but perhaps the investor isn’t in a position to give away a significant portion of their net worth to charity. Another trust structure that can aid in spreading out capital gains tax is a Deferred Sales Trust. As a note, the Deferred Sales Trust is the structural term for creating an installment sale as described in the tax code – IRC 453. The strategy involves selling an asset (real estate, securities, etc) to the trust through the use of an installment sale, where the asset is transferred to the buyer (the trust) and the buyer agrees to pay back the seller (the investor) in a series of installments. Once the assets are in the trust, they can be invested however the trustee directs them. When installment payments (distributions) are made back to the seller, they’ll be taxed at the rate determined by where the proceeds came from. For example, if the principal is returned to the seller in the form of an installment payment, the seller will pay the gains rate assigned to their appreciated stock. However, if the trustee were to invest the assets in an interest paying investment, they could distribute the interest without recognizing gains as long as the distribution wasn’t paid from the principal.
It’s not realistic to expect that every investor with high exposure to one stock will be able to turn it into a charitable donation or bear even a discounted capital gains tax burden immediately. Often, the position should be unwound over many years. If it’s going to take place over a longer period of time, it’s important to plan for when it will be sold along with a plan to reduce volatility. A relatively new strategy to mitigate that risk is through direct indexing. Investment firms are now commonly able to offer personalized portfolio management through the combination of tailored tax planning for concentrated positions and risk management in a separately managed account.
The fund manager typically has a strategy with targeted returns, risk levels, sector exposure, or some other offering that attempts to obtain a specific goal. Much like any managed account with a portfolio manager, the fund manager and their team monitor the market environment, the positions in the portfolio, and other factors to determine whether trades should be placed to match the desired risk level. This is often accomplished through statistical measures of the positions in the strategy like portfolio variance (a measure of how wide a range the potential outcome of returns from the portfolio can be), performance relative to a benchmark index, beta (a risk metric that compares an investment’s risk to that of a benchmark), or other common metrics. Where the process differs from typical managed accounts is that the manager factors in the concentrated position as part of their strategy. Rather than keeping the typical balance of positions in their portfolio, they strive to reach the same metrics despite the addition of the concentrated position. Through these efforts, an investor can help reduce their risk exposure to holding the single position along with a remaining portfolio that doesn’t consider the additional risk taken on. Additionally, some direct indexing offerings will work with the investor to unwind their appreciated positions in a tax-friendly way (like offsetting the sale of an appreciated stock for an equal amount of stock with a capital loss to net out the tax on the gain). These direct indexing strategies come with a fee, although they’re typically priced similarly to other separately managed account strategies, hovering in the neighborhood of 0.30%.
One less complex strategy for avoiding capital gains tax is to simply gift it to family or friends. As complex as estate planning can be (typically created for the purposes of after one’s passing), another strategy may be to pass down cash or a portion of the portfolio while still living. The current gift tax exemption is $16,000, meaning that any gift to an individual under the $16,000 point won’t trigger gift tax for the donor. However, in the event that stock is gifted, it will retain the donor’s basis even after received by the recipient. This strategy is ideal for recipients who might need the money more immediately than after the donor’s death and who would be willing to pay the gains tax. Since the recipient takes on the donor’s basis, they also assume the donor’s holding period as well – meaning that if the donor had held it for over a year, the recipient would also be subject to a long-term gain if selling. Conversely, if the donor hadn’t yet held the position for a year, the short-term gain the recipient would pay could potentially be lower than the donor’s, depending on their tax bracket.
Another consideration for gifting is that when stock is inherited after death, the stock’s cost basis is stepped up to fair market value on the date of the giver’s death. If the recipient sells the stock immediately, this would trigger substantially less capital gains tax than if it’d been given as a gift during the donor’s life. Each situation is different, and the various scenarios of gifting now or later should be considered to ensure the most optimal outcome.
Whether in a qualified or taxable account, there are very real actual costs (and opportunity costs) associated with concentrated positions. Regardless, there are plenty of ways to guide a portfolio back to a more balanced and diversified allocation that’s better suited for the desired risk tolerance. Again, each situation is different, and investors should consult with their tax advisor before choosing a strategy to unwind highly appreciated stock.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. All investing includes risks, including fluctuating prices and loss of principal.
“Whether in a qualified or taxable account, there are very real actual costs (and opportunity costs) associated with concentrated positions.“
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