Grossbach Zaino & Associates, CPA's, PC

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Tax-wise Diversification for Concentrated Stock Portfolios

Diversification is a key strategy for controlling portfolio risk. But, when a portfolio is heavily concentrated in one stock, diversifying can be a challenge. Potential taxes call for careful planning.



Selling highly appreciated, low-basis stock and using the proceeds to diversify can be costly. The maximum 20% federal income-tax rate on long-term capital gains, while lower than an investor’s regular tax rate, is a serious obstacle. For example, an investor who has $5 million in stock with a $100,000 cost basis would clear only about $4.02 million on the sale of the stock — after paying the 20% tax on the $4.9 million gain. Fortunately, there are some effective tax-wise diversification strategies.



One possibility is to borrow against the stock and invest the loan amount in a diversified mix of securities. Success depends on generating an investment return that is greater than the cost of borrowing the money. A low interest rate environment clearly helps. However, borrowing on margin can be risky if the market drops.



Another approach you might want to consider is staying with your concentrated stock but controlling your risk of large losses with a hedging strategy called a “collar.” You would sell a call option on your stock and buy a put option to limit your downside risk. A well-structured collar can effectively limit your risk of loss at a low cost. However, a collar also limits your possible gain.


To control risk and diversify your portfolio, you might combine borrowing with hedging. You diversify by investing the amount you borrow with your stock and the put option as collateral. Option strategies are not simple. If you’re considering one, you’ll need professional help.


Creating a Trust

A charitable remainder trust is another tax-efficient way to diversify a low-basis stock position. After you place the stock in the trust, the trustee can sell it and reinvest the funds to diversify without any immediate capital gains taxes. You receive an income for life, or for a fixed term up to 20 years. The trust is an irrevocable gift to charity. So, you also qualify for a large, immediate income-tax deduction.


Receiving Plan Distributions

Your tax-qualified retirement plan may present a tax-wise opportunity to diversify. If you receive a distribution of appreciated employer stock, you’re immediately taxed — but only on the stock’s cost basis. Taxes on the appreciation (at the capital gains rate) are deferred until you sell some of the stock and realize a gain. To diversify, simply roll over a portion of the stock distribution to an individual retirement account (IRA). The stock can then be sold without immediate taxes and the proceeds reinvested in a mix of securities. A downside to this strategy is that IRA distributions will be taxed as ordinary income when you withdraw them.


With tax-wise planning, you can restructure a concentrated stock portfolio to achieve the diversification you need.


Stepped-up Basis to the Rescue?

You may not have any compelling reasons to change your highly appreciated, concentrated stock portfolio. If not, and you’re comfortable with the risk, you might simply continue to hold the stock. That may let your beneficiaries take advantage of the tax law’s basis “step-up” rules. For estate-tax purposes, estate assets are generally valued as of the date of death (or an alternate valuation date). The basis of an asset received from an estate is the estate value. So, if the beneficiary later sells the asset, any appreciation that occurred before the date of death is not taxed.

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Tax-efficient Investing

When it comes to investment decisions, taxes should never be the deciding factor. But a smart investor looks to minimize taxes wherever possible.


Some Background


The following is a refresher on some basic tax and investing facts:


  • Generally, taxpayers may hold their investments in two types of accounts — taxable accounts, such as brokerage accounts, and tax-deferred accounts, such as an individual retirement account or a 401(k).


  • Bond interest is generally taxed at ordinary rates unless the investment is held in a tax-deferred account. The ordinary rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. A major exception is municipal bond interest, which is generally tax exempt.


  • Taxable capital gains are subject to lower rates if the gains are considered “long term” (generally, securities were held longer than one year). For most taxpayers, the long-term capital gains rate is 15%. For those in the 39.6% ordinary tax bracket, the rate is 20%; for those in the 10% or 15% brackets, the rate is 0% (gains are not taxed).


  • The same long-term capital gains rates apply to qualified dividends.


  • Capital gains on securities held one year or less (“short term”) are taxed at ordinary rates.


  • High-income investors may have to pay an additional 3.8% net investment income tax.


  • Withdrawals from tax-deferred accounts are generally taxed at ordinary rates, even if the withdrawn funds represent long-term capital gains or qualified dividends.




There are several tax strategies you can use to minimize taxes on investments.


Maximize retirement contributions to tax-deferred accounts. By making tax-deductible or pretax contributions to IRAs or employer-sponsored retirement plan accounts, you delay the payment of income taxes. Investing the tax savings can boost returns.


Minimize turnover. Constant trading of securities within a taxable account turns unrealized (“paper”) gains and losses into realized gains and losses that are reportable for tax purposes. One way to minimize turnover is to avoid frequent trading. Another is to avoid mutual funds with high turnover ratios. Certain funds trade more frequently than others, and at the end of the year, they may distribute more taxable capital gains to their shareholders. Passively managed index funds trade relatively infrequently and tend to have lower tax costs.


Compare yields. Before choosing tax-exempt bonds, calculate whether they make sense for you. To determine how the yield on a taxable bond compares to the yield on a tax-exempt bond, subtract your marginal tax rate from one and divide the result into the yield on the tax-exempt bond.


Example. Laura is in the 33% federal income-tax bracket. She wants to know how much a taxable corporate bond would have to yield to match the 1.75% yield offered on a tax-exempt bond. She subtracts .33 from one and divides the result (.67) into 1.75% to arrive at 2.6%. Therefore, a taxable bond at that rate or above generally would be preferable.


Generally, the yield differentials between taxable and tax-exempt bonds make tax-exempts more suitable for higher bracket taxpayers.


Asset allocation. Because higher tax rates point toward tax deferral, a logical strategy is placing assets that are taxed at relatively low rates in taxable accounts and assets taxed at higher rates in tax-deferred accounts.

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Tax Tweak

Did you know you can adjust the federal income-tax withholding on your regular paycheck to cover any additional taxes you might owe from other income sources, such as consulting work, side jobs, interest, and dividends? All you’ll have to do is fill out a new Form W-4 and give it to your employer.


You can adjust your withholding by:


  • Reducing the number of withholding allowances you claim or


  • Indicating an additional dollar amount that you want your employer to withhold from each paycheck.


Or, if you’re married, you can indicate that you want tax withheld at the higher single rate.


The IRS has a withholding calculator on For detailed information, see IRS Publication 505.

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What’s the True Value?

If you could choose between a tax deduction and a tax credit of the same amount, which would be more likely to benefit you? Understanding the difference can help you plan your taxes.


A tax deduction lowers the amount of income on which you’re taxed. The amount of your tax reduction will depend on your tax bracket. For example, if you’re in the 25% tax bracket, you’ll generally get a $25 tax break for every $100 you deduct. Many tax deductions are available only if you itemize on your tax return.


A tax credit is generally more valuable than a tax deduction. A credit reduces your tax liability dollar for dollar. Tax credits are available whether you take the standard deduction or itemize, and some tax credits are refundable.


Tax credits and deductions aren’t either/or propositions. You may be able to benefit from both types of tax breaks on your return.

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What? Me Audited?

You thought you were done when you filed your tax return in April. But then the letter from the IRS arrived. Here’s how you can avoid common audit mistakes and keep your tax pain to a minimum.


Read and follow the notice. It will tell you which year’s tax return the IRS is questioning and the items that are being examined. The audit notice also will give you a time frame for responding, generally 30 days. If you don’t respond, the IRS can take action, such as readjusting your tax liability and assessing interest and a possible additional tax penalty.


Contact your tax professional. If your return was professionally prepared, you should contact your preparer for assistance in handling the audit process. If you prepared your own return, you may want to consult a tax professional.


Review and organize your records. The information in the notice should help you determine which documents you need to support the information reported on your return. Replace or reconstruct any missing records. If you can’t produce supporting documents, a questioned deduction may be denied. Also, don’t give the IRS your original documents to keep. Send copies instead.


Be brief. If you’re called for an in-person audit, always take your tax professional with you and answer as many questions as you can with a simple “yes” or “no.” That way, you’ll avoid inadvertently furnishing any information that could prompt the auditor to expand the audit.


Don’t be too quick to pay up. It may seem easier to simply respond to an IRS notice by sending a check to the IRS for the assessed additional liability. But the IRS has been known to be wrong, and you shouldn’t pay tax you may not actually owe. Even if the IRS is correct, you may be able to negotiate a lower payment than the amount specified in the audit notice.

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If you want to take a charitable contribution deduction on your income-tax return, you need to substantiate your gifts. You must have the charity’s written acknowledgment for any charitable deduction of $250 or more. A canceled check alone isn’t enough to support your deduction.


It’s your responsibility to obtain the charity’s acknowledgment (receipt), and you need to have it when you file your return. The acknowledgment must include:


– The amount of cash you contributed

– A description of any property you gave

– A statement as to whether the charity provided services or goods (a meal or tickets, for example) as full or partial consideration for your donation, plus a description and good faith value estimate of the services or goods


A charity may acknowledge each gift of $250 or more separately, or it may give you a single statement covering all your gifts. The charity does not have to place a value on property you donate. That’s still up to you.


Also, a charity must provide you with an acknowledgment for a donation of more than $75 that is partially a contribution and partially in exchange for goods and services from the charity. This acknowledgment must:


– Tell you that your deductible contribution amount is the donation minus the value of the goods or services

– Give you a good faith estimate of the value of the goods or services


IRS regulations on substantiating charitable deductions cover two more contribution types:


– Goods Or Services That Don’t Have Substantial Value

A charity doesn’t have to include token items in its acknowledgment. Examples of these items include posters, mugs, and key rings.


– Payroll Deduction Contributions

Donations that employers make on behalf of employees who have signed payroll deduction authorization cards can be a problem because the charity lacks the individual donor information needed to prepare its acknowledgments. To substantiate these payroll deduction contributions, you can use employer documents that show the amount withheld (payroll stubs, W-2 forms, or other employer reports) plus the charity’s pledge card or other document with a statement that you received no goods or services in exchange for your contribution.

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What Taxes Are Deductible?

Individual taxpayers may choose between claiming a standard deduction* or itemizing their deductions for specified actual expenses. One potentially valuable source of itemized deductions is state and local taxes.


State income or sales taxes. A deduction is available for any state or local income taxes paid during the year, whether through payroll deductions, estimated payments, or amounts paid with a state return. Note, however, that certain states don’t have an individual income tax.


If extended through 2015, an alternative election permits a deduction for general state and local sales taxes instead of state and local income taxes.** Taxpayers may choose between deducting the actual sales taxes they paid (by accumulating receipts) or deducting an amount provided in IRS tables, plus the actual amount of sales taxes paid on purchases of motor vehicles, boats, and certain other items specified by the IRS.


Real estate taxes. Real estate taxes are generally deductible in the year paid. However, homeowners who pay taxes to their mortgage lender with their mortgage payments may deduct the taxes only in the year the lender actually pays them.


Personal property taxes. To qualify for deduction, the taxes must be charged annually and be based on the property’s value.


Limitations. Be aware that for computing alternative minimum taxable income, state and local taxes are generally not deductible. Also, taxes are among the itemized deductions that are subject to reduction once adjusted gross income exceeds a specified threshold.


* For 2015, the basic standard deduction is $6,300 for single and married-separate filers, $9,250 for heads of household, and $12,600 for married taxpayers filing jointly. An additional standard deduction is available to elderly and blind taxpayers.


** Currently, the sales tax election is available only through 2014. The election expired at the end of 2011 and 2013 and was later retroactively extended each time.