Whether you received shares as part of a compensation package, an inheritance, a lucky bet on an early-stage company or any other way, some stocks can be hard to part with.
"If you've developed a connection to the position, some investors may not want to sell based upon that emotional relationship," says Nicholas Ashjian, vice president of advanced planning at Fidelity. If the investment has performed well you might also be concerned about owing capital gains taxes upon the sale.
But a single holding that makes up more than 5% to 10% of your portfolio can create unwanted risk. Ashjian explains: "If that stock or sector experiences a significant decline, your portfolio may suffer much greater volatility than if you held a diversified asset mix."
Another reason to diversify concentrated holdings now: Recent market volatility may offer an opportunity to de-risk in a more tax-efficient manner. Explains David Peterson, head of wealth planning at Fidelity: "Lower asset values mean smaller capital gains and therefore less owed in taxes."
When deciding on your game plan, it's important to weigh the potential tax consequences in the context of your long-term planning goals, risk tolerance, and time horizon. Below are some strategies to consider.
1. Selling or diluting your position
One option is to simply sell a portion of the concentrated position and reinvest the proceeds in a diversified portfolio, says Ashjian. If the position is held in a tax-advantaged account, that may be a straightforward decision since you can exit the position without suffering a capital gains tax liability. In a taxable account, however, it may not be possible to avoid capital gains taxes altogether if you are selling the position. In that case, "a multiyear selling strategy can help spread out the realization of the gains," Ashjian says. In a volatile market, it also may be possible to offset some of the gains with losses, either on your own or through a managed investment account. Alternatively, by investing new funds into diversified positions, you may be able to gradually dilute the concentration of a single stock in your portfolio.
2. Gifting to family
Another option is to gift some of the shares of your concentrated holding to family members, either directly to the recipient or to a trust established for the recipient's benefit. One caveat to gifting appreciated holdings: In this scenario, the family member who receives the gift would be responsible for paying the capital gains tax on the appreciation when they sell the position. By contrast, someone who inherits shares of a stock receives a step-up in basis, therefore potentially wiping out much, if not all, of the capital gains. "You have to weigh the risk of holding the position to receive a step-up in basis at death versus gifting the asset and saddling the next generation with future tax obligations," says Peterson. "However, if the family member is in a lower tax bracket than yourself, you may still achieve some tax efficiency."
In addition, younger family members with longer time horizons may be able to hold concentrated positions longer, enabling them to ride out downturns in the market or capture opportunities to exit the position in a tax-efficient manner.
3. Giving to charity
Gifts of stock to charitable organizations are typically fully deductible in the year of the gift, up to 30% of your adjusted gross income. "Charitable gifting is an often-overlooked tool for diversifying concentrated stock," says Nicholas Yoo, head of portfolio engineering for Strategic Advisers, LLC, the investment manager for many of Fidelity’s clients who have a managed account.
Individuals can make a gift directly to the charities of their choice or to a donor-advised fund (DAF). With a DAF, you realize the tax deduction now; decisions about where to donate the money can be made at a later date.
A charitable remainder trust (CRT) is another option that can potentially allow you to defer the realization of capital gains on a concentrated position. Appreciated stock that is contributed to a CRT can be sold and diversified into a new portfolio without the donor being required to realize an immediate capital gains tax liability—and the donor can then receive annual payments over the term of the trust. When the term of the trust ends (including upon the donor's death), the assets remaining in the trust would be distributed to one or more charities selected in advance by the donor.
With this strategy, it's important to keep in mind that you would be responsible for income tax on the annual payments from the trust, including capital gains taxes related to the original stock position. But the deferral of the tax payment and realization of the capital gains in smaller amounts over time may be favorable when compared to selling the original investment and realizing the capital gains all at once.
4. Exchange funds
An alternative that allows you to both diversify the position and continue to defer paying capital gains tax is contributing to an exchange fund. These are pooled investment vehicles structured as partnerships, where multiple individuals contribute their concentrated stock positions in-kind to the fund and receive a proportional share of the overall fund in return. Since the investor isn't selling the securities, no capital gain is realized. If structured correctly, an exchange fund can result in converting single security risk into a diversified portfolio that mimics the risk profile of a broad-based stock index without any capital gains realized.
If you exit the fund in the future, you’ll generally receive a distribution of a basket of securities instead of cash. However, the IRS mandates a minimum 7-year holding period to receive that basket. Alternatively, you can keep your exchange fund shares and pass them to your heirs, who will receive a step-up in basis.
Because exchange funds are typically structured as partnerships and sold as private placements, they may not be suitable for everyone. There are net worth qualifications that investors have to meet and limited liquidity in these funds.
5. Hedging strategies
For certain sophisticated investors, strategies such as purchasing puts can help manage the risk of potential losses in a single stock position. "But hedging strategies aren't for everyone," cautions Peterson. "Option premiums add expense and layers of potential complexity. They cover limited periods of time, may be difficult to use to hedge an entire position, and need to be renewed, opening investors to the risk of unfavorable pricing trends." Options strategies also tend to work better for highly liquid stocks. In addition, there can be unexpected tax consequences when buying puts. It's important to discuss this more with your tax attorney.
An individualized approach
"In many cases, a multi-pronged strategy can help clients to diversify a concentrated position," says Yoo. For example, you might decide to gift to charity highly appreciated shares—possibly the ones you received earliest in your career—while selling your least appreciated shares, realizing the capital gain and using the proceeds to diversify. At the same time, you might hold on to moderately appreciated single stock in a managed account and build a diversified portfolio around it.
You may also need to consider your time horizon. An individual who will be in a lower tax bracket when they retire may want to wait to sell their position so they can realize capital gains at a lower tax rate, suggests Ashjian.
"The right strategy for you all depends on what gives you the most bang for your buck when it comes to meeting your goals—and managing your tax liability," says Yoo.