4 Strategies for Highly Appreciated Assets
Is there such a thing as too much investment growth?
Having too much appreciated stock in your portfolio may look like a great problem to have. It validates your good sense for having chosen those investments in the first place. It gives you a warm and fuzzy feeling when you open the quarterly account statements. Why is that a problem, exactly?
And yet, sometimes appreciated stocks can point to a big problem looming ahead. We are talking about well-paid executives with significant compensation in the form of stock options, RSUs, and company stock. Over time, those investments can grow to a very large part of their retirement savings. We have seen them get as high as 60-80% of the portfolio!
In the world of financial advice, we think of this situation as a “concentrated position” – and it can spell trouble.
There are three reasons why broaching this conversation is difficult.
Number one is emotional attachment to the stock. Many executives view these holdings as a symbol of their loyalty to the company. To them, selling any portion of the stock holdings is the same as selling out the company.
Number two is inertia. Leaving things as they are is a powerful magnet, especially when the stocks are doing well. No one likes to exchange something they know and like for something they don’t fully understand.
Number three is high hopes for the company’s future financial performance. No matter how well the company may have done so far, many executives believe it can do even better.
So, appreciated investments are a double-edged sword. Sure, those value increases look great on paper. But what would happen if the markets were to turn south? And what about the tax consequences of cashing out the appreciated positions?
If you are puzzling over this, here’s a model for thinking through your choices.
Sell appreciated positions
What are some of the pros and cons of selling an appreciated position?
The obvious argument in favor of selling is that it would give you the space to diversify your portfolio and reduce your overall risk. Let's say 80% of your portfolio is in Company ABC stock. If that stock tanks because of an economic meltdown/industry disruption/Black Swan event, most of your retirement security goes out the window.
Any arguments against selling? Yes! Take the potential for tax exposure, for example. Let’s say your basis in the investment is $40,000 and it has appreciated to $100,000. Assuming a 15% capital gains tax, you would owe $9,000 in taxes upon sale.
Hold appreciated positions
So, should you hold on to the appreciated stocks forever? Not necessarily. Here’s why.
First off, the tax deferral you get from holding on to the concentrated appreciated stock position isn’t the same as tax avoidance. That $9,000 tax bill you are trying to avoid will hit you eventually. Unless, of course, you plan to die while still holding the asset. That would turn it into a part of your estate, which is subject to the $11 million tax exclusion as of the time of this writing. Alternatively, you may consider donating the appreciated investments to a qualified charity.
In other words, if your lifestyle in retirement depends on these stocks/stock options/RSUs, you aren’t looking at tax avoidance. All you get is tax deferral.
There are other costs involved in holding a concentrated stock position. By hanging on to an investment that’s essentially “un-tradable”, you complicate simple investment management processes. Take periodic rebalancing, for example. Modern rebalancing software has powerful calculation engines and built-in tax awareness algorithms. Still, it can only work within the restrictions you set up. If a large portion of your portfolio is carved in stone, there isn’t much that can be done around that restriction.
A decision to hold a concentrated position indefinitely can also create problems if you ever want to change strategies or advisors.
Is there another choice?
Yes, there is! In fact, there are at least four strategies that you can and should consider if you are holding a concentrated stock position.
#1: Establish a capital gains budget
The problem with capital gains deferral is that they tend to accumulate and snowball. At a certain point, all that growth will push you into a higher tax bracket and erase the benefits of deferring the gains in the first place. One way to avoid that is by absorbing some of the capital gains (and related taxes) gradually and steadily.
Let’s say I am working with a married couple, John and Mary. Together, they make $180,000. Given the current limit of $250,000 AGI before the Medicare surtax is triggered, they have a theoretical $70,000 capital gains budget for the year. This would allow John and Mary to maximize their current tax bracket without triggering a higher tax rate. By following this strategy for a few years, they could diffuse the time bomb of unrealized gains. This can be an effective way to absorb tax gains at a pace that's controlled, measured, and comfortable.
#2: Sell strategically
The “strategic selling” approach works well for investors who worry about missing out on a growth opportunity. The setup is fairly simple. You sit down with your financial advisor and agree, in advance, on the plan for selling the position gradually.
There are dozens of ways to set this up. Perhaps you will sell a certain number of shares every quarter. Or maybe you will sell 1% of the holdings any time the value goes up or down by a certain percentage point to help control your risk exposure. The key is to come up with an objective trigger (whether calendar-based or performance-based) that will call for action regardless of how you might feel in the moment.
#3: Donate appreciated stock to charity
If your lifestyle in retirement doesn’t rely on the concentrated stock position, you may consider setting it aside in a charitable remainder trust. Done correctly, this method can help you avoid taxes altogether. If that sounds interesting, here’s what you need to know.
A charitable remainder trust is irrevocable. That means you can’t set it up and change your mind down the line. Let’s say that John and Mary from our example above have $50,000 in unrealized appreciation on company stock. They don’t think they will need that stock to fund their retirement. The couple feels strongly about giving back, especially to children’s charities. They have done their research and selected an organization that supports orphanages in Eastern Europe.
In this situation, John and Mary can establish a charitable remainder trust. By making the initial donation, they get a tax deduction. Specific limits would depend on which trust they select. The couple – or another beneficiary – will receive an income stream that looks like an annuity. Payment frequency can vary from annual to semi-annual, quarterly, or monthly. And, after John and Mary pass on, the rest of the balance will go to the charity.
Setting up a charitable remainder trust requires advice from an experienced attorney. There are some limitations on the income tax deduction. If you are considering following this path, you must work with a qualified team that will guide you.
If you want to avoid the administrative and legal setup (in exchange for getting a smaller tax relief while still donating your money to a good cause), look into donor advised funds administered by a well-established company. Work with your financial advisor to identify some options!
#4: Gift to family members in a lower tax bracket
There is one other, less written-about choice. It's gifting the appreciated stock to your family members who happen to be in a lower tax bracket than you are. This strategy assumes that you don’t need the assets to fund your needs in retirement.
In order to do this well, you need to carefully consider two factors. One, the annual gift limit is $15,000 per giver per recipient. This can sound a bit confusing, so here's an example. John and Mary each want to gift some of the appreciated stock to their niece Anna. Together, they could give her $30,000 per year before triggering the tax.
Giving that whole amount may or may not be a good idea, which brings us to factor number two: tax brackets. This strategy is most effective if Anna has no earned income. If she does earn some income, it’s important that the capital gains don’t push her into a higher-than-comfortable tax bracket. This situation may call for advice from a seasoned professional.
Your strategy for highly appreciated investments
If you are staring at highly appreciated concentrated stock positions on your investment statements, it’s important to understand that leaving them untouched exposes you to risk. That doesn’t automatically mean you should sell them all. However, at some point you will need to make a strategic decision about what you plan to do with those gains. It's better to make that decision without time pressure. As with everything that involves taxes and investments, it’s important to do your research and understand the landscape. Reading this article and considering your options is a great first step. You now see some of the potential pitfalls where you should involve an attorney, a tax planner, or an experienced financial advisor. Miscalculation here can result in expensive unanticipated consequences! Move thoughtfully to make sure that your legacy and your financial security are protected.