Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
Time Stamps
[0:00] – Strategies to mitigate concentrated stock risk
[6:20] – Company stock in a 401k plan
[9:08] – The right approach to generate retirement income
[16:00] – Peter Mallouk tip of the month
[17:34] – Jonathan Clements tip of the month
Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, Director of financial Education, here at Creative Planning in Overland Park, Kansas. And I’m here with Peter Mallouk, president of Creative Planning, and we are Down the Middle. It’s October 1, we’re deep into the fall. We’re looking towards the end of the year. And lot of people at this part of the year are starting to think about their portfolios and thinking about taking tax losses, thinking about whether it’s time for rebalance and so on. And one of the issues that you had mentioned to me, Peter, was people who have substantial holding to the single stock and what they should do about it. And I guess this is something you come across with clients all the time.
Peter Mallouk: Yeah. You see a lot of folks either worked for a company where they had the company stock and it’s done well, so they hold it or they made a bunch of picks long time ago and a couple of them are wind up being amazing and they hold them forever. Oftentimes they’ll hold them for tax reasons, if we sell them we’re going to lose 20 to 30% in federal and state capital gains taxes. And so, you think, well, that’s a pretty big hit, so we’ll just work around them. But the problem with that is every stock eventually dies. Every company eventually dies, means the stock eventually dies.
If you look at the companies that were in the original Dow, when GE dropped off, it became the last one to drop off. And companies that no one could ever fathom closing decades ago, like Sears, I mean they have their day and it will happen to companies like Netflix and companies that no one can imagine, it can happen to Amazon someday too. So if you have that philosophy, I’m going to hold that stock forever. Let’s just pretend you had that 30, 40 years ago, the odds are very great, that stock has really done you a disservice as of today, of course there are exceptions as there are to everything. So, the goal should be, how do I get that stock under control as a portion of my portfolio and diversify it. And there are a lot of different ways to approach that.
One easy choice is, “I’m just going to sell some of it and pay the taxes. And I’m going to sell a little bit every year and just accept that I’m going to pay the taxes.” That’s the least tax effective way to do it. But it solves the too many eggs in one basket problem. The only people I would recommend do that are people where almost all their money or their independence is dependent on this one stock. In those scenarios, it does make sense to diversify and take the tax hit because the risk is so great if the stock doesn’t work out of you not being independent.
Oftentimes at a case where there was a married couple and this person was an executive in a financial services firm and they had one and a half million dollars in one stock and almost nothing outside of it, but he was terminally ill. And we actually transferred the stock, which had been owned a little bit by both of them all to him. And when he passed, there was a step up in basis, which basically means the wife could sell it all tax free. That’s a really rare deal, but I mean, if you’re older and you have highly appreciated stock, maybe it does make sense to hold that stock and then get the step up on death.
Some more practical options for everyday folks that don’t want to pay the taxes and then they’re not 90. And the biggest one is you’ve got other investments and you look for opportunities to tax harvest. So if you own, say the S&P 500 and it’s dropped in a negative territory and you can sell it and replace it with the S&P 100, which is 99% correlated, you stay invested in the large-cap US market, but you now have a loss on your tax return, you can now sell some of the concentrated stock and take the loss and offset it with the gain, pay no taxes and increase your diversification.
If you’re charitably inclined, there are a couple solutions available to you. You could take some of that stock, put in a charitable remainder trust, that’s an irrevocable trust, that trust can then sell the stock tax free. And the trust can give you income back for the rest of your life, and even for your spouse’s life, and maybe your kid’s life. And then the catch is, and it’s a big catch, is on your death no one in your family gets that money, it has to go to charity. But it’s a great way to diversify and get income.
It’s an interesting tool because, let’s say you have a $100,000 in a stock and you sell it and you wind up with, say 75, and you live off 6% of that. But instead you put the $100,000 in charitable trust and sell it, you have a hundred, and if you live off 6% of that, that’s a bigger number. You diversify and have higher income, but the big catch is it goes to charity on your death. But if that’s what you were going to do anyway, it’s a great solution.
And then, another option is to use donor advised funds. When I’m sitting with a client, let’s say they’re giving $5,000 a year to their church or to a museum, instead, what we can do is say, hey look, you’ve got $50,000 in one stock, it represents a significant part of your portfolio, you’re giving $5,000 a year to charity anyway, why don’t we move this $50,000 to donor advice fund that allows you to get an income tax deduction, seller tax free. And from that fund, we get the break this year, but every year you can give $5,000 from the fund to the charity. So we’re giving to the charity what we’re giving to give to the charity anyway, but we’re also getting the benefit of an income tax deduction that will be greater because you’ve made a bigger gift in one year and also able to diversify the stock today.
And then lastly, there’s a very aggressive way to do this, that some of our younger clients have done, that are very risk on is, we did this lately with somebody who was involved in a tech company and it went public and they got wound up a $2 million, but it’s all one stock, and they don’t want to sell the stock. So they actually borrowed against the stock, borrowed about 20%, and that enabled them to go by $400,000 of diversified funds. Their portfolio overall is actually a little less risky and it then gave them other securities they can tax harvest and come back and sell. It’s a little sophisticated, it requires a lot of, you have to pay attention to something like that, and I’m always reluctant to discuss leverage as a risk reduction strategy, but it can be a solution for folks as well. So there’s a lot of different ways to approach it and it’s just, there’s so many tools and the decision someone makes around this can really have a ripple effect for decades.
Jonathan: We’re talking here mostly about people who own stock in a regular taxable account and if they sell it, they’re going to take the capital gains tax it. But of course a lot of people end up owning their own company stock in their 401(k) plan. And ordinarily you can diversify in a 401(k) plan and there’re no immediate tax consequences. The tax consequences only come down the road when you start to draw down the account.
Peter: Right.
Jonathan: But a lot of people hang on to that company stock because of this strategy called net unrealized appreciation, which allows them to essentially pull the stock from the account when they leave the employer, move it into a regular brokerage account and then that point they can sell it and pay taxes at the capital gains rate rather than the usual income tax rate that applies to withdrawals from a 401(k) plan.
My question to you Peter is, what’s the advice? You’ve got the stock, it’s a substantial portion of your net worth, it’s sitting in the 401(k), you’re probably not going to leave your employer for 10 years. Do you hang onto that big stock position so you can get that tax break from the net unrealized appreciation strategy, or do you go for a little risk and diversify today?
Peter: The answer is, depends on the situation, but it’s usually a hybrid. What I like to tell clients is, “How do we just make sure you’re going to be okay? Let’s create some baseline, then no matter what happens in the world, you’re going to be okay.” Because a lot of people think, well, my company’s stock, my company’s doing well. Well, everyone thinks that, right? But let’s just say they’re right.
Sometimes a company can be doing well and an entire industry can just get smashed. We saw it with real estate, we saw it with internet, we saw it with financials, we’ve seen it with energy. You could be at a great energy company but all energy companies have been smashed. And so, we’ve got that risk. And then, sometimes your company’s great but the market just gets smashed. So, there’s a terrorist event, everything gets cut in half, including you’re really great company stock, because the whole market got crushed.
And so, if we know you need a certain amount of money to be independent, let’s try to get a reasonable strategy to get close to that. Now, once we’ve got some baseline to make sure you’re not going to be destitute, I am all for taking the risk to have a major substantial tax break. And the difference between income tax rates and capital gains rates now is very, very great. Now that might not be the case, you look at some of the candidates for president now really talking about closing that gap a lot and the whole math on how we’re talking about this could change. But right now the gap is so significant that I do encourage some clients that, “Hey, we’ve made sure that you’re not going to live in a cardboard box in the street. Let’s go ahead and take the risk here, and hang on and just watch carefully, and be able to take advantage of NUA on your retirement, because the difference is so substantial, even if your stock takes a hit, you could wind up ahead.”
Jonathan: Let’s transition to our second big topic for today’s discussion, which is generating retirement income. I mean, it’s a huge topic, but the straw man, we always need to start with a straw man. The straw man that you hear from so many investors is, “When I retire I want to invest my portfolio in such a way that I have enough regular income to cover my expenses.” And for a lot of people, the net result of that thought process is, “I’m going to move a boatload of money into bonds, get enough yield so that I can pay my fixed expenses, I can pay for the travel I want to do.” And they end up with this super conservative portfolio, it sounds lovely, it makes intuitive sense, and it seems like a safe strategy, but is it?
Peter: I think that you’re right, even at the nail in the head, a lot of people have this bias of, I need to own things where I’ll never have to sell anything, and I can live off the income and that that’s very low risk. That’s not really the right way to look at it. We should really be looking at total return. How do we get between income and appreciation in the portfolio, everything someone needs. And when people take an income only approach, you have a couple problems. Well first of all, in today’s bond world, bond yields are less than stock dividends in many cases, and so it’s not really accomplishing a lot.
But second, if we create a portfolio that’s higher yield and so wind up with a portfolio that’s, bonds that are probably riskier, because with conservative bonds we’re not going to get the 3 or 4% you need. We’ve got to own riskier bonds, lower credit ratings, lend money for longer periods of time, maybe do things we wouldn’t normally do. Then we might own real estate, then we might own master limited partnerships and we might we’ll own stocks that pay higher dividends. We’ll go look for stocks that pay 5% dividends instead of two.
Well, the stock is paying 5% because it’s not as strong of a company usually is the one paying two. And so, you’re going to be more susceptible to all sorts of risks to the portfolio, namely interest rate risk. So if interest rates go up and you have a portfolio that’s very income oriented like that, the entire portfolio is going to get hit negatively at the same time by that rise in rates. So, you think you’re being conservative by buying things that only produce income, but what you’ve really done is you introduced a risk you didn’t need to, to the overall portfolio.
Jonathan: And so, you not only did you have that short term risk from rising interest rates which can really crush an income-oriented portfolio, but of course you also leave yourself vulnerable to inflation over the long term. Year to year, it may seem like prices increased very much, but over a 25 or 30 year retirement, a dollar of income by the time you’ve reached the end of that retirement might only have 50 cents of purchasing power.
Peter: Yeah.
Jonathan: So, you need to be cognizant of the risk from inflation, and the way you fend off that inflation risk is to continue to keep a decent portion of your portfolio in stock so that you get that long run growth. And of course immediately raises the subjection from investors which is, “Oh no, I can’t own stocks because stocks go down a lot and it’s risky. And what happens if we get another 2007 to 2009 and my stock portfolio drops in half, how will I pay for groceries? And goodness knows what else.” And I think that’s the point when you need to have this conversation about having sort of a bucket approach to generating retirement income.
You say to yourself, “Okay, I want to make sure I have a certain number of years of retirement income, really portfolio withdrawals in super conservative investments that so say, to be comfortable I want five years of portfolio withdrawals in short term bonds, in a money market fund, in certificates to deposit, stuff that I know is going to be there no matter what happens in the financial world.” In that way you’ve got five years of portfolio withdrawals covered. And then, that frees you up to invest the rest of portfolio for longer term growth. You can own somewhat riskier bonds, but more importantly you can own stocks.
Peter: Yeah.
Jonathan: And over time that portion of the portfolio should generate much healthier gains than a pure income-oriented portfolio. And then, every year if the market allows you cut off a little bit of the gains and you refund that cash bucket that’s going to cover the next five years or so.
Peter: That’s right. And I think it’s, the thing about when people say, well bonds are less risky or aren’t risky, every asset class is risky. They just have different sets of risks and relative risks. And by looking, because oftentimes with clients that are retiring they want that income approach and they’re 65, will google the price of a candy bar, and a soda, and healthcare just 20 years ago, because their life expectancies into their eighties. And it really opens their eyes to what you were talking about of, “Hey yeah, if I get the same income five years from now, 10 years from now, 20 years from now, it’s not going to do the same things.” Year to year, it doesn’t seem like prices change, but they change very dramatically over time.
And on the flip side, while the stock market’s incredibly unpredictable year to year, I mean the odds are one in four you’ll be negative. Those are pretty high odds, versus bonds where it’s 1 in 10. And then, negative is a much different thing. It tends to be a couple percent instead of 30%, but over 10 years stocks are closing in on a hundred percent on being positive. It’s not a hundred percent, it’s in the high nineties, but you know inflation appears over 10 to 20 years in a big way, and you know the stocks deliver with a high probability over 10 to 20 years. And so, you really shift, you reduce your risk by adding that asset class and starting to look at total return instead of just income.
Jonathan: Yeah. I say to people now that I suffer from old person’s disease, I’m 56, but every time I go to the grocery store I am shocked by how much everything costs. And that is a function of age. I just remember when everything was so much cheaper. When I was a kid a candy bar was 10 cents and that is not true anymore.
Peter: I have that same disease, I got it in a grocery store too. But when I realized that I was getting old is when I wanted to linger in the grocery store longer because I liked the music. That was the beginning of the end for me. And I’ve been having a crisis about how old I’m getting ever since.
Jonathan: So, me, well, inflation that has this gradual erosion over time. We sit there day to day threading in about whether stocks are good investment or not, are valuations too rich, or we could get another 50% market decline and yet 30 years from now we will look back and say, “Why in the world did I own anything else?” Time gives you that perspective not only on the damage done by inflation, but also on the virtues of only a diversified stock portfolio.
Peter: Right. I agree.
Jonathan: It’s that time of the podcast, Peter, your tip of the month. What’s your tip of the month ahead?
Peter: My tip of the month is if you’ve got a kid that’s working, whether they’re mowing lawns or a part-time job or anything like that, they probably are using the money that they’re working really hard for saving it, but open up a Roth IRA for them, they can contribute up to the maximum amount and that money will grow tax free and come out for them tax free. And especially if they’re a teenager or in their early twenties in school, that’ll be a really amazing gift for them because it’s going to be compounding for 40, 50 years before they withdraw it.
Jonathan: Now, let’s have a moment of honesty here, Peter. I mean the kid is really not going to put a hundred percent of their money into their Roth IRA, so maybe you can get them to split it with you or maybe you put in 75 cents for every 25 cents they put in, but I think there’s going to need to be some sort of parental subsidy.
Peter: No, I agree. If the kid can do some of it, great. If the parent does all of it, fine. But either way it’s kind of a freebie that a lot of people forego, that the government will let you do and there’s no better time to put money in Roth IRA than when you’re a kid. Because you’ve got so long for it to grow. So if you’re thinking about making gift to your kid, that’s the way to make it to them.
Jonathan: And of course, it is the power of example because not only you start them on a lifetime investing by opening up that Roth IRA, but also you can help them pick the investment and whatever you pick the kid is probably going to be super reluctant to sell it. And so, you should make sure you pick something low cost, diversify that they will be happy to hold for the long haul.
Peter: That’s right.
Jonathan: And so, actually, sort of on the same theme, we’re now into October, we’re approaching the end of the year and you probably have a pretty good idea of what your income is going to be for 2019. If you are in the position where you have relatively little income and you’re looking at a year when you’re not going to be paying very much in taxes, this is really a terrible, terrible thing. And you should make sure that you take advantage of the fact that you have low taxable income for the year and look for ways to take advantage. And so, for instance, this might be the year where you convert part of your traditional IRA to a Roth and take advantage of the fact you have relatively little taxable income.
Earlier we talked about having a big position in an individual stock, if you have big stock positions that you’re looking to whittle down, if you have a year with virtually low taxable income, this may be the year to take some serious gains so that you have more taxable income and yet still pay taxes at a roughly low rate.
Peter: Great advice.
Jonathan: All right. Peter, it’s the end of another podcast and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed to be reliable but is not guaranteed.
