What to do if much of your wealth is in a single asset and you don’t want to be clobbered by capital gains taxes.
Anice problem to have: You’re sitting on an immense unrealized gain on a volatile stock, and it’s making you nervous. Should you sell and pay a lot of tax? Hold and run the risk of losing it all? Are there other options?
This affliction of the wealthy is one Andrew Whitehair is in business to cure. He’s a 44-year-old CPA at Baker Tilly, a firm that assists businesses and prosperous individuals with tax and accounting challenges. He lives near Cleveland, a consequence of being the dutiful husband of a high-powered doctor, but has a national clientele.
We’ve had a bull market, especially in tech startups. The countryside is now littered with undiversified millionaires. In what follows, Whitehair looks at seven exit ramps for people with concentrated long-term positions in taxable accounts. They are presented in increasing order of cost, complexity and uncertainty.
By temperament, Whitehair leans toward simple solutions. “The things people do sometimes to jump through hoops to avoid tax is just not necessary,” he says.
1. Sell
The first option Whitehair considers: “Bite the bullet.” Give up maybe a third of your money to tax collectors. What’s left can go into a diversified index fund or a blend of stocks and bonds.
ADVANTAGE: simplicity.
DISADVANTAGE: missing out on various ways to avoid capital gains tax, such as the step-up at death.
2. Exit slowly
“Space those sales out over a number of years and soak up some of the lower tax brackets,” Whitehair says.
Unload a $1 million position in equal doses over ten years and you’ve got a shot at paying tax at the 15% federal rate rather than the 20% rate for rich people. You might also duck the 3.8% investment surtax, imposed on incomes above $250,000 on a joint return.
DISADVANTAGE: risk. Going into the second year, 90% of your money is still exposed to a crash in the stock.
3. Donate
Use some of the appreciated stock to fund an account at a donor-advised fund offered by your stockbroker. The donated shares are immediately sold, with the proceeds reinvested in something safer and then dribbled out to charity over an indefinite period. The charitable deduction is calculated from the value of the stock, the gain never taxed.
Giving away a tenth of a $1 million position might facilitate an additional, taxable sale of $100,000. Now you’ve reduced your risk exposure to $800,000.
Pay attention to tax brackets before doing paired sales like this, Whitehair advises. You want, if possible, to have itemized deductions reducing high-taxed ordinary income, not lower-taxed long-term gains. Be aware that in any year you itemize you are losing the standard deduction.
4. Arrange a CRAT
The charitable remainder annuity trust is a well-established tax maneuver for asset holders willing to part with some of their loot. You need a lawyer to set up the trust.
EXAMPLE: On retiring from Microsoft with $5 million of its stock acquired at a negligible cost, you deposit the stock into the trust and immediately sell it, reinvesting in a stock index fund. You retain the right to collect $347,000 a year from the trust for 20 years, after which whatever is left goes to United Way.
The payouts have to be small enough that the charity’s remainder interest is worth at least 10% of the starting value. If your Microsoft cost basis is zero, all the money coming to you is taxable. In this hypothetical, it would be a mix of dividends, mostly low-taxed, and low-taxed long-term gains.
BENEFIT: You have eliminated the single-stock risk and spread out the income so that it maybe won’t be taxed at top rates. Disadvantage, per Whitehair: “If you’re not charitably inclined it might not make sense.”
5. Buy a CGA
A charitable gift annuity typically has the donation element up front and the payouts later, in which case it’s a mirror image of No. 4.
EXAMPLE: At age 50, you send $500,000 of Nvidia shares to Pomona College and ask for a lifetime annuity starting at age 60. Pomona promises you $44,000 a year. If you live to 85 you’ll collect $1.1 million. You get a $144,000 tax deduction immediately, but it may take you more than one tax year to absorb this deduction (because of a 30%-of-income limit).
Pomona has made CGAs into an art form and has an online calculator that gives you a pretty good idea of what to expect. You might prefer to work with your alma mater.
BENEFIT: You have converted a stock position into a low-risk income stream useful to a retiree. The payouts are mostly taxed as a mix of long-term gain and ordinary income. Your Nvidia cost turns into a nontaxable return of capital.
DISADVANTAGES: counterparty risk (what if higher education goes bust?), no inflation protection and a rotten, possibly zero, return if you die young.
6. Buy a put
You could hedge a stock with put options while slowly liquidating it (see No. 2).
These things are expensive. When Nvidia was trading at $195, a December 2027 put with a $130 strike price was priced at $15. Repeat purchases would be called for over the years. And your stock might still lose a third of its value.
The tax treatment is somewhat unpleasant. The long stock and long put combination brings into play the restrictions on “straddles.” Result: If the put expires worthless, your $15 cannot be immediately claimed as a capital loss. Instead, that sum is added to the cost basis of the stock, reducing the capital gain down the road.
What if the option ends up in the money? Say Nvidia goes to $125. You could sell the put for $5, incurring a $10 loss that is, again, not immediately deductible. And you are $80 a share poorer.
7. Get a collar
You could buy a put and finance it by selling a call. For a $100 stock, the strike prices might be $85 and $125. (Strikes for equally valuable puts and calls are asymmetric because of the way stock prices drift.)
The collar has to have a fairly wide spread. If it’s tight, you’ve pretty much eliminated your exposure to movement in the stock’s price. When you do that, you have committed the sin of engaging in a “constructive sale,” and your gain in the stock becomes immediately taxable.
PROBLEM: You have to repeat the exercise every year or two, because option expirations reach only so far. If the stock goes into a slow-motion decline you will walk it all the way down.
Tax treatment? Not lovely. Whitehair has had clients who were sold on the idea by stockbrokers and came to him only after suffering unpleasant surprises at tax time.
If the stock ends up in the dead zone—in our example, between $85 and $125—you have taxable income from the call but no immediate deduction for the money lost on the put. If the stock makes a big move up or down, you have a choice of two evils. You deliver it, giving rise to the capital gain you were trying to duck. Or you close out the option that’s in the money, which will entail writing checks to the IRS and/or the call owner.
CONCLUSION: There are many ways to deal with a lopsided portfolio. There isn’t one that is entirely painless.