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AFTER YEARS OF heady gains in the stock market, many investors are facing the same question: To manage risk, they’d like to cut back on one or more of their holdings. But because of the potentially costly tax bill that might result, they aren’t sure exactly how to do that.
How can you square this circle?
One easy option would be to donate appreciated assets to charity. But that would make sense only if it aligns with your charitable goals and, of course, if you don’t need those funds for other uses.
How else could you strike a balance between managing risk and limiting taxes? Here’s how I would answer this question.
Step 1. I’d start by estimating the potential risk level among your holdings. While there’s no single litmus test, you could ask the following questions.
First, how large a portion of your assets does any single holding represent? As a rule of thumb, I’d focus first on individual stocks that top 5%.
Why 5%? My operating assumption is that any individual stock could experience a 50% decline during a crisis. So if a holding is limited to 5%, then a 50% drop would result in an overall portfolio impact of just 2.5%. I see that as very manageable. To be sure, stocks can certainly decline by more than 50%, but I view this as a reasonable figure for risk management.
While I worry most about the risk posed by single stocks, it’s also important to examine the overall composition of your portfolio. That’s because, counterintuitively, a portfolio of 30 stocks could end up being riskier than a group of just 10. Harry Markowitz, the father of Modern Portfolio Theory, explained why.
In his initial work back in the 1950s, Markowitz used railroad company stocks to explain the concept of diversification. There’s nothing inherently wrong with railroad stocks, Markowitz explained. But if a portfolio consists of only railroad stocks, then that would be a problem—because companies in the same industry are often impacted by the same economic factors. In other words, a portfolio consisting of a large number of holdings might only appear diversified, so it’s important to look under the hood.
Another risk factor to consider: Do you work for a public company and own the company’s stock? If so, that would be a reason to consider diversifying more quickly (within the permitted time windows).
What if you own only mutual funds or ETFs? Diversified funds tend to be less risky than individual stocks, but that’s not always the case. The fund industry launches as many as 1,000 new funds each year, including many with very aggressive strategies. So it’s important to check each fund’s holdings. You can find that information on the fund company’s website or on a site like Morningstar (Here, for example, are the top holdings in Vanguard’s S&P 500 index fund).
Step 2. Next, you’d want to estimate how much a loss might impact you. As with most questions in personal finance, there are two answers to consider: how it might affect you in dollar terms, and the degree to which a loss would simply be upsetting. Both are important.
Step 3. If you determine the holding in question does represent a material risk, then you’d want to estimate the potential tax impact. Here are questions you might ask: What would the tax be if you exited the entire position? Would it push your income into the next capital gains bracket? Are there tax lots with less appreciation you could take advantage of? Do you have losses you could use to offset some of the gains? Do you expect to be in a higher or lower tax bracket next year?
Step 4. If you conclude that the tax bill might be significant, what steps could you take to reduce a holding tax-efficiently? Here are strategies to consider:
For starters, I suggest deciding on a target percentage for the holding. While ideally I prefer bringing any individual stock down to a 5% weighting, that figure isn’t a rule. All things being equal, the larger a portfolio, the more risk you can afford.
After deciding on a target percentage, the simplest approach would be to set up a long-term sale plan—like dollar cost averaging but in reverse. Suppose you’d like to sell 1,200 shares of a given stock. You could sell 100 shares each month for twelve months. You’d do that regardless of whether the stock happens to be up or down that month.
That 12-month schedule isn’t a rule. If your holding is very significant, you might opt for a longer timeframe. On the other hand, if you feel the stock has a particularly highflying valuation, you might choose a quicker pace. The key, in my view, is just to get started. As the writer Carveth Read wrote, “it’s better to be roughly right than precisely wrong.”
Selling a stock down over time is the simplest way to reduce risk, but it’s hardly the most tax efficient. Another approach that’s been gaining in popularity is known as a 351 exchange fund. With a 351, the idea is that a group of investors, each with their own portfolios of appreciated securities, come together and collaborate to diversify their respective holdings.
To provide a simplified illustration, imagine two investors, each with a concentrated holding, one in Microsoft and the other in Apple. Each would benefit by diversifying, and that’s what a 351 exchange fund allows. Each would contribute their respective shares into a common pool that would then hold some Apple and some Microsoft. This new investment would be structured as an ETF, and each investor would be issued shares proportional to the size of their contribution. Importantly, the initial creation of a 351 fund doesn’t entail any tax. Taxes are due only when an investor later sells shares of that ETF.
This is a simplified example. In reality, a 351 exchange fund would hold many more than just two holdings. They’re actually required to meet various diversification requirements. As a result, investors in 351 funds may end up feeling sufficiently diversified and thus comfortable holding their fund shares for the long term. That would make this strategy potentially the most tax-efficient way to manage portfolio concentration risk.
This is just an overview, though. If you’re interested in 351 strategies, I suggest further research. In July, The Wall Street Journal discussed these funds in some detail. In addition, a firm called Alpha Architect, the largest player in this area, has a number of helpful explanatory videos on its site.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Great post. I have a handful of stocks that have appreciated over the years. Amazon is 11% of my portfolio, and Google class A and C are about 9%. The rest is spread over 7 ETFs and 5 other highly appreciated stocks. You mentioned the larger the portfolio the more risk you can afford. I think that applies here. Fortunately I have a lot in a VG federal money market so I don’t need these for income.The problem is the cost for both is only about 10% of their current value, so selling would be large taxable gains that would push me into higher IRMAA surcharges as well as higher tax brackets. I’m not familiar with the 351 strategy. I’ll take a look at that. There is always the risk of these dropping substantially, but if I never sell and they pass to my kids they will get the stepped up cost basis.
The Treasury Secretary made recent comments describing this IRC 351 strategy as “too good to be true”. Such comments may be a warning shot over the bow that indicate tax changes on this strategy may follow.
The historical use of IRC 351 has been to allow individuals or entities to transfer property to a corporation in exchange for stock without recognizing immediate capital gain or loss. The code section was designed to facilitate business formations and corporate restructurings and the recent use of IRC 351 to defer gains on investment assets is a relativity new use of this code section.
It seems odd to me that you’ve made 90% on these stocks, but fear a very manageable (and fair) IRMAA surcharge or extra percentage on your tax bill, when you’ve killed it in the market.
I’m surprised that seems odd to you. Tax management is an important part of wealth management. I don’t fear IRMAA surcharges, I’m looking for ways to avoid them. Why pay more for something you’ve contributed to on every dollar you’ve made, unlike social security. Medicare premiums with part B are already close to $10,000 a year.
Since I don’t know the amounts involved, perhaps you need the management, but if significant sums are present, paying the surcharge seems reasonable to access bundles of cash that allow you to pay without any stress. I’ll be paying higher IRMAA whether I sell my stock winners or not, which might explain spending my time doing something besides yet more tax management.
I also like the qualified charitable distribution (QCD) for IRAs. To quote Adam, “But that would make sense only if it aligns with your charitable goals and, of course, if you don’t need those funds for other uses.” I need to unload some IRA assets to reduce RMDs, so it works well for me. I have my IRAs at Vanguard and the system of QCDs is clunky, but workable. You request a check made out to the qualified charity and they send it to you, and then you send it to the charity.
I’ve used it at Vanguard a few times. It seems like they have improved the process because it is easier now. But you do have to allow time for them to send the check to you.
That is clunky. I will be doing my first QCD from my Vanguard IRA this year. You have to allow enough time for Vanguard to mail you the check to you, forward it to the charity, and they must cash it before the end of the year. I’m going to start the process in November.
FYI.
‘The recipient does not have to cash the check before the end of the year. When your IRA custodian mails the check to you and you mail it on to the charity, the distribution date counts for the year you place it in the mail, as long as the funds actually left your IRA account by December 31.
How the Timing Works
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I am always puzzled by this strategy to give away money to lower a tax bill that will cost much, much less.
It makes sense only if you were planning to donate to charity anyway.
For sure, but sometimes one gets the impression that some folks would rather give anyone $100 rather than give the govt $24 or whatever the marginal rate is. I don’t like paying taxes either, but lowering my RMDs by giving away my “surplus cash”…guess I’ve a way to go for that to make sense.
It might if all the money is in IRAs.