4 Tips to Help You Diversify in a Tax-Efficient Manner
If you decide to leave an employer after accumulating a significant amount of company stock, you may face several investing and tax challenges. An investment portfolio that’s disproportionately weighted in company stock can expose you to significant risks should the company face future financial hardships.
Perhaps the most infamous example of this risk occurred in 2001 when Enron went bankrupt. Due to highly concentrated stock positions, many Enron employees simultaneously lost both their jobs and their life savings.
Having a concentrated stock position can not only put you at risk if an unexpected situation were to reduce the value of the stock but it can also expose you to significant tax liabilities should you decide to sell your appreciated shares. That’s why it’s important to take steps to diversify your holdings and minimize your tax liabilities. Consider the following diversification strategies.
#1 – Gradual sale
One of the easiest ways to diversify your concentrated stock position is by gradually selling shares over time, allowing you to spread out your tax liability over several years. Further, you’re creating an opportunity to reinvest the proceeds from the proportionate sale of stock into a diversified portfolio, such as a direct indexing strategy, to reduce capital gains tax in the future. Direct indexing is a strategy where a custom portfolio of individual stocks is built to mirror the performance of a specific index (like the S&P 500) rather than purchasing an exchange-traded fund (ETF) or mutual fund that tracks the index. This approach gives investors more control over their holdings, including the ability to implement tax management strategies. Consult with your wealth manager to determine whether a direct indexing strategy is appropriate for your circumstance.
The downside risk in gradually selling your concentrated position is that you’ll continue to have a concentrated stock position for a longer period of time, making you rely heavily on one company and potentially missing out on the benefits of diversification. If that particular stock performs poorly or faces challenges, your entire portfolio could be negatively affected, which could disrupt your financial independence goals.
#2 – Equity exchange fund
An exchange fund is a type of investment that’s typically created by a bank, investment company or other financial institution to help investors diversify concentrated stock positions. Also known as a swap fund, the investment is, essentially, a partnership among various shareholders with substantial holdings in a single stock. The shareholders submit their holdings into a pool in exchange for units in the entire partnership’s portfolio. As more investors participate, the portfolio becomes increasingly diverse — as do the holdings of each individual investor.
Because no stock is sold, the participating investors aren’t subject to immediate capital gains tax on their individual stock holdings, and the capital invested is able to continue generating returns.
It’s important to note that equity exchange funds are only available to accredited investors. These funds often have minimum investment requirements as well as a minimum holding period (typically seven years). Be sure to consult with your wealth manager prior to investing.
#3 – Net unrealized appreciation (NUA)
If you hold concentrated stock within your employer-sponsored retirement plan, you may be eligible to take advantage of a valuable tax planning strategy called net unrealized appreciation (NUA) when you distribute your account.
NUA refers to the difference between the cost basis of employer stock and the stock’s current market value. Typically, retirement plan distributions are taxed as ordinary income. However, the NUA tax benefit allows participants with company stock in a retirement plan to qualify for capital gains tax treatment on investment gains from shares held for more than one year as long as the stock is sold to fund the investor’s retirement expenses.
In order to qualify for the NUA tax benefit, you must meet all four of the following criteria:
- Distribute your entire vested retirement account balance within one year. You can request multiple rounds of distributions, but you must completely liquidate the account within a year.
- Distribute all assets held within all qualified plans of the employer, even if you only hold company stock in one of the plans.
- Distribute company stock as in-kind shares. You won’t qualify for NUA treatment if you sell the shares prior to the distribution.
- Experience a qualifying event, such as:
- Retiring or terminating from the company that sponsors the plan
- Reaching age 59 ½
- Experiencing a total disability (if you’re a self-employed worker)
- Death
Successfully executing NUA is a complex process with both tax and financial implications. Be sure to work with an experienced financial advisor who can guide the process and help you avoid potential pitfalls.
#4 – Charitable donations
If you’re already planning on making charitable donations, it may be beneficial to both you and the charity if you donate appreciated stock rather than cash.
For example, let’s say you decide to donate $3,000 in appreciated stock to your favorite charity. Your cost basis on the stock is $500. If you sell the stock for $3,000 and donate the proceeds, you’ll owe capital gains taxes on $2,500. At a 15% capital gains tax rate, that means you’ll need to pay $375 in taxes following the sale, and $2,625 will be left to donate to the charity. Assuming you itemize your taxes, you’d be eligible to deduct $2,625 in charitable donations from the transaction.
On the other hand, if you were to make an in-kind transfer of the appreciated stock directly to the organization, you’d avoid triggering a taxable event and the charity would receive the entire $3,000 value of the stock. Because charitable organizations are tax-exempt, the charity could then sell the stock without paying taxes on the transaction.
As a result, you could claim a charitable deduction of $3,000 on your itemized tax return and the charity would receive the full $3,000 market value of the stock, meaning you’d have successfully diversified $3,000 of concentrated stock without triggering a taxable event.
As with most investment-related decisions, it’s wise to consult with a qualified wealth manager prior to making any changes to your concentrated stock positions.
