How To Manage Risk Exposure And Taxes In Concentrated Stock Portfolios
If you are an employee of a large publicly-traded company, you may end up with a lot of stock in that company. There’s no better feeling than logging into your stock account and seeing a huge gain. That is, until you calculate the taxes you’ll be paying if you sell all of the stocks in one year or think about how much of your total net worth is concentrated in one stock. This is a discussion of some options for reducing risk and unwinding a concentrated stock position that has increased significantly.
It Depends On How Much
If you have less than $100,000 in total company stock, your options are somewhat limited because many of the investment vehicles are designed for larger sums of money. If you’ve held your positions for more than a year, long-term capital gains are taxed at a lower rate than your standard income bracket, so refer to a taxation table to calculate what you may owe on a sale. If you are a single filer with $44,625-$492,300 between your income and capital gains, you will be taxed at the 15% federal capital gains rate. It’s only when we look at a combination of income and gains above $500,000 that we see a significant need for some of the specialized tax strategies discussed in this article.
Outright Sale
The quickest way to de-risk and unwind your stock portfolio is to immediately sell your positions and invest in a diversified portfolio. This will result in an immediate tax hit on all portfolio gains. Some investors may choose to work with their tax advisor to sell portions of the stock over a number of years to mitigate taxes. One potential issue with this is that while taxes are being managed, portfolio risk is still much higher than in a diversified portfolio. Every year, large publicly-traded companies go bankrupt. In the event of a bankruptcy, the company stock drops near $0. You could have a $1,000,000 portfolio drop to $0 within a year, which is something that does not happen in a broadly diversified portfolio.
Direct Indexing
Many people have heard of index funds, which are baskets of stock packaged for you by a portfolio manager with the intention of tracking a list of stocks. An example of a popular index is the S&P 500. Direct indexing is an approach where a portfolio manager buys individual stocks to mirror an index. In this case, you own a large number of individual stocks instead of one fund.
Every year, within an index, some stocks will be up and some will be down. Because you own the individual stocks, the portfolio manager can sell stocks that have gone down, realize tax losses, and replace the stock you sold with that of a similar company. Think: sell Coke, buy Pepsi. This is known as tax loss harvesting and it’s a key advantage of direct indexing over investing in index funds. You can then use the losses you harvested to offset the capital gains you realize from selling some of your concentrated stock position.
This strategy works best when you have some sidelined cash or some portion of the concentrated stock you can immediately sell to start generating offsetting losses. Usually, minimums to get started are around $100,000 but they can vary from fund manager to fund manager.
Securities Lending
If you don’t have sidelined cash or any securities you can sell without a significant tax burden, some people choose to take a line of credit out against their existing positions. You may be able to borrow 30-60% of your portfolio’s value depending on the firm and the securities mix. When you take a line of credit against securities, the interest you pay is tax-deductible, and it allows you to invest in a strategy like direct indexing, where you can offset tax gains with losses.
There are two major risks with this strategy:
If the stock is volatile and goes down significantly, you may be subject to a margin call. This is a situation where you must add additional cash.
In today’s interest rate environment, the loan interest rate may exceed your rate of return, resulting in losses.
Options Strategies
Stock options are financial derivatives that give buyers the right to buy or sell a stock at a specific price if they choose. Options can be used to generate portfolio income, reduce portfolio risk, and/or increase the lending potential of a concentrated stock position.
Exchange Funds
Not to be confused with exchange-traded funds (ETFs), exchange funds allow an investor to pool their stock with other investors over the course of seven years without selling their stock upfront. These often come with hefty minimums above $500,000 and may opt not to allow you to join if your stock does not add diversification benefits to the fund. Exchange funds limit liquidity so they are not appropriate for anyone who may need to access their funds within seven years. They also do not provide significant tax benefits, only diversification benefits.
Involving Trusts
If you are charitably inclined, want immediate tax and diversification benefits, and would like to generate an income, you may consider a Charitable Remainder Trust. This type of trust allows you to donate significantly appreciated stock into a trust, take an immediate tax deduction, sell the stock to diversify your portfolio, take an income for life, and donate the remaining amount to charity upon your death. This is a complicated strategy that requires coordination between trustees, investment managers, and attorneys so it’s necessary to consult a professional to ensure it’s the best strategy for you. This is an irrevocable trust so once in place, liquidity above the projected annual income is limited.
Conclusion
For those who have concentrated stock with significant gains, there are many options for reducing portfolio risk and managing taxation. You must reflect on your personal priorities and financial goals to select a strategy that best accomplishes your objectives. For advice on your personal situation, consult a qualified financial and tax professional.
This article was originally published by me on Forbes.
This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-6531313.1 (4/24)(exp. 4/26)
