TWO WEEKS AGO, I described how to scour your portfolio for holdings that no longer fit your financial plan. At a high level, these investments fail at least one of two tests:
If you hold an investment like this in a retirement account, the solution is easy: You can sell it without tax consequences. But what if it’s in a taxable account, where a sale would trigger a taxable gain? There’s no one-size-fits-all solution. But here are five strategies that’ll allow you to unload the investment without unleashing a tax bill:
1. Do nothing. While this might not seem like much of a strategy, it’s an option to consider. That’s because—at least under current law—there’s the step-up in basis at death. That means that, when your heirs inherit your assets, they won’t pay any tax on your unrealized gains. 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 breakeven 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’s no better solution for an appreciated asset. 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’s 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 pretax household income of more than $520,000. 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 pretax household income under some $105,000, there would be no tax at all. This tax advantage would be amplified if you live in a high income-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 stock fund in your taxable account and you now feel overexposed 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. Keep in mind, however, 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 the above tax-free solutions and you’re still left with investments you want to unload? Consider one of these three strategies:
1. Bite the bullet. Sometimes, you should take care of a problem all at once, though 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 highflyer. If one stock accounts for enough of your net worth that it could jeopardize your goals if it imploded, selling the entire position right away might be the best solution.
2. Use a formula. Let’s say you want to reduce a holding but don’t feel the urgency to do so all at once. In these cases, you can establish a formula to guide your sales. For instance, 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. Increase that count if the share price climbs and reduce it if the price decreases. This would result in selling more shares as the price rose and fewer if it fell.
3. Wait. Life isn’t a straight line. Markets rise and fall—and so, too, will your income. Depending upon the urgency, you might delay any sale until a more opportune market environment or tax year.
Over the years, I’ve implemented all of the above approaches with clients. 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 currently in front of you.
A final note: You may have heard of exchange funds—a construct designed to help investors with extreme concentrations in one stock. They might seem like the perfect solution to this problem. But unfortunately, they have so many drawbacks and limitations, including a possible seven-year lockup, that I don’t recommend them.
Adam M. Grossman’s previous articles include Making Time, Portfolio Checkup and Don’t Feel Bad. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.
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