One of the core tenets of investing is diversification, which is why it is usually makes sense to avoid having too much of your wealth tied up in the stock of a single company. That being said, there are a number of reasons why individuals can accumulate concentrated stock positions. (At Leelyn Smith, we define a concentrated position as one that represents more than 5–10% of an individual’s net worth.) These positions can result from receiving company stock as compensation from an employer, inheriting stock from a loved one, or simply accumulating a large position in a specific company’s stock over time.
Regardless of how they come to exist, it is important to manage these holdings wisely. We share our perspectives on managing concentrated positions, beginning with the importance of clarifying the purpose of the assets and their long-term investment merits. We also discuss three common client scenarios and potential solutions for each situation.
Start by examining your goals and the stock’s investment merits.
No matter how a concentrated position was accumulated, it is important to assess its long-term investment merits today. Many investors hold onto stocks with large unrealized gains not because they believe the assets will continue to grow in value, but simply to avoid the tax consequences of selling them. This is generally a mistake — if you don’t feel confident in the company’s long-term prospects, it is better to sell the position and manage the tax consequences.
Your financial advisor can help to limit the tax implications when you sell a position. For example, rather than selling the entire holding at once, we often help clients determine the level of capital gains they are willing to recognize in a given year and sell the shares over time. Recognizing too much in capital gains in a given year can trigger higher tax rates, so it always best to work with a financial advisor to determine the best strategy.
Before deciding how to manage a concentrated holding, we recommend first reflecting on your goals for the asset. Some individuals want to benefit from the value of the stock during their lifetime. For example, you may want to use the asset to build your dream home or fund some special purchases during retirement. Others may view the stock as part of their legacy device and desire to pass it to the next generation. Still others may be charitably inclined and want to gift the stock to a cause that is important to them. The proper way to manage the stock depends entirely on what you are trying to accomplish.
Below, we provide more detail on three common scenarios for individuals with concentrated stock holdings and wealth planning strategies for each situation.
Scenario 1: You want to benefit from the position now / in your lifetime.
What should you do if you believe in the long-term investment merits of a concentrated holding, but you also want to benefit from its value now? One potential solution is a securities-based line of credit, also known as a pledged asset line. This is a line of credit backed by the underlying stock, and it allows an individual to obtain a loan of up to 50% of the stock’s value. These lines of credit can be easy and inexpensive to set up, and the borrower only pays interest (typically a floating rate, such as 30-day LIBOR + 2.5%) on the funds that are drawn. Unlike a mortgage application, the approval process is fairly painless, and there is flexibility with regards to cash flow — the borrower can pay the interest as it accumulates or simply let it accrue over time.
Stock options are another potential tool for investors with large stock positions who would rather not sell the shares. Options can be used to guard against a potential decline in the price of the stock. To use a simple example, an investor can purchase put options on the stock in question. These give the buyer the right (but not the obligation) to sell the stock at a specific price by a certain date. Put options effectively act as an insurance plan on the position, establishing a floor under the value of the holding. Options are not free, however, and purchasing puts can act as a drag on the portfolio’s performance.
Scenario 2: You want to pass the position on to the next generation.
Instead of benefiting from the asset in your lifetime, you may want to pass the stock to the next generation. In this case, you might consider taking advantage of what is known as the “step-up in basis” at death. Under current U.S. tax laws, when certain types of assets are being passed to the next generation, the value of the asset “steps up” at the owner’s death to become the new cost basis. This allows beneficiaries to inherit an asset without also inheriting a potentially large unrealized tax liability. Assets owned within tax-advantaged accounts, such as 401(k)s and IRAs, are not eligible for the step-up in basis.
While this tool is available today, this feature of the tax code has been in the political crosshairs in the past. Some politicians, including President Biden, have proposed eliminating it to raise more revenue, so it is important to monitor the latest tax laws and consult with your financial advisor.
Scenario 3: You want to donate the position to charity.
If you have a highly appreciated stock holding and you are charitably inclined, you may want to consider donating the stock to a qualified charity. This allows you to not only avoid capital gains taxes (as you aren’t selling the stock and realizing a gain) but also get an up-front tax deduction. (Individuals can currently deduct up to 30% of their adjusted gross income in market value of the stock.) Meanwhile, as long as the beneficiary is a qualifying 501(c)(3) organization, the gift is tax-free from the charity’s perspective.
If you have charitable intentions but don’t have a specific charity in mind, another option is to gift the stock into a donor-advised fund. A donor-advised fund is an account that the individual still controls, but the assets must be distributed to charity at a future date. The same rules generally apply — you can deduct up to 30% of your adjusted gross income in market value of the stock.
Always think about the big picture.
One of the most important principles of financial planning is understanding how all of the aspects of your wealth interact and avoiding having too many eggs in one basket. This applies not just to the stocks you own but also to your other sources of wealth and income. For example, if you work as a realtor, your income is tied closely to the health of the real estate market. And your home likely represents a large part of your overall balance sheet. As a result, you will likely want to limit your investment portfolio exposure to real estate investment trusts (REITs) and other real estate investment vehicles, and maybe even forego purchasing an additional property that you have been eyeing.
Do you have questions about a concentrated stock holding or your wealth concentration more broadly? Feel free to reach out to your Leelyn Smith advisor. We would be happy to discuss the best potential solutions for your unique situation.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.