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.