A few weeks back, I described how to conduct an “extreme portfolio makeover”—to scour your investments for holdings which no longer fit your financial plan. There are at least seven ways in which an investment might end up in the “doesn’t fit” category. But at a high level, they fall into one of two categories:
- Risk: Some investments are just inherently unsuitable or excessively risky. Or an investment might be perfectly fine, but it could represent a risk because you simply own too much of it.
- Return: You might have an investment that has chronically under-performed or that carries excessive fees or that is tax-inefficient. These investments may not be especially risky in the short term, but over time they could corrode your financial security.
If you hold an investment like this in a retirement account, the solution is easy: You can sell it without any tax consequence. But what if it’s in a taxable account, where a sale would trigger a taxable gain? There is no one-size-fits-all solution, but here are several strategies to consider:
This first group of strategies could be implemented entirely free of taxes:
1. Do nothing. While it might not seem like much of a strategy to do nothing at all, it’s an option to consider. That’s because—at least under current law—there’s what’s known as a step-up in basis at death. What this means is that down the road, when your heirs inherit your assets, they won’t pay any tax on your unrealized gains. And while that is hopefully many years down the road, it’s worth keeping in mind. Here’s why: If you sell an investment at a gain today, you’ll owe some amount of tax. That means it will necessarily take time to break even. Depending on how long that break-even period is, you might decide it’s worth holding the investment for the long term. This will, of course, depend on the specifics of the investment, your tax situation and other variables. To help weigh these factors, I recommend this free online spreadsheet.
2. Donate it. If you have charitable intentions, there is no better solution for an appreciated asset you don’t want to hold than to donate it to charity. Of course, you’ll get a tax deduction. Better yet, you’ll never pay tax on the unrealized gain—that is, the difference between the price you paid and the price on the day you donate it. The best way to do this, in my view, is with a donor-advised fund, which combines tax efficiency, flexibility and simplicity.
3. Give it away. If you have an adult child who is in a lower tax bracket, and you want to make a gift to your child, this could be a tax-efficient solution. Suppose you have household income of $500,000. Under current rules, you’d pay 23.8% on long-term capital gains at the federal level. But if your son or daughter earns less, he or she might pay just 15%. For married taxpayers with household income under $75,000, there would be no tax at all. This tax advantage would be amplified if you live in a high-tax state, and your child lives in a low-tax, or no-tax, state.
4. Adjust elsewhere. Suppose you’ve earned big gains on a stock or fund in your taxable account such that you now feel overly exposed to the stock market. If you also have a retirement account, you could change the investment mix in that account—making it less aggressive. That would allow you to reduce your overall market exposure without incurring any taxable gains.
5. Find a pair. If you have a mix of investments—some with losses and some with gains—that opens the door to another solution. As long as you do it in the same year, losses count against gains, allowing you to offload holdings without incurring any net tax. Remember, though, that taxes are just one piece of the puzzle. As you make these kinds of sales, be sure you don’t distort the composition of your remaining portfolio.
What if you’ve exhausted all of the above tax-free solutions and are still left with investments you’d like to unload? Then I recommend one of the following:
1. Bite the bullet. Sometimes you need to take care of a problem all at once. In general, I recommend this only in situations where the risk is very high. Suppose you’ve retired from a public company with a boatload of company stock. Or maybe you had the foresight to load up on Tesla or some other high-flyer. If one stock accounts for enough of your net worth that it could jeopardize your goals if it declined, then this might be the best solution. The prospective tax bill might seem distasteful, but as noted above, taxes are just one piece of the puzzle.
2. Use a formula. Suppose you want to reduce a holding but don’t feel the urgency to do it all at once. In these cases, you can set up a formula to guide your sales. There are many ways to do this: You could sell a specific dollar amount periodically. This is similar to dollar-cost averaging, but in reverse. You’d end up selling fewer shares as the investment’s share price rose and more as it fell. An alternative I prefer: Instead of targeting a dollar amount for each sale, target a share count, and increase or decrease that count as the share price increased or decreased, respectively. This would result in selling more shares as the price rose and fewer as it fell.
3. Wait. Life isn’t a straight line. Markets rise and fall, and your income might have years when it’s higher and when it’s lower. Depending upon the urgency of what you want to sell, it might make sense to wait for a more opportune market environment or tax year.
I have implemented all of the above approaches with clients over the years. One common theme: Hindsight invariably offers a better solution. But as I noted a few weeks ago, you can only make decisions with the facts in front of you. And in my view, it’s much better to take some steps along these lines than none at all.
A final note: You may have heard of exchange funds—a construct designed to help investors with extreme concentrations in one stock. While they might seem like the perfect solution to this problem, unfortunately they have so many drawbacks and limitations, including a seven-year-lockup, that I don’t recommend them.