(Image credit: Getty Images)
Editor’s note: This is the first article in a two-part series on how to deal with a concentrated stock position. The second article looks at five more ways to manage it.
A childhood friend recently called me, looking for some guidance post-IPO of the company she joined as an early employee. A dream!
Employee stock used to be the most common reason I saw concentrated stock positions. But things have changed in the past four years as tech titans have challenged conventional wisdom about just how much money one company can make, powering the secular bull market we have seen since 2010.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Now, what I see more frequently as the cause of this uptown problem is a hunch: “I bought the first iPhone and knew it would change things forever.” Or, “I tried Tesla autopilot and felt like I had taken a time machine to the future.”
Some people define a concentrated position to be anything over 5% of your total portfolio. Others put that line at 10%.
For our clients, we start talking about it at 5%. At 10%, we want to take action to reduce that risk.
Our list of solutions has grown exponentially as this “problem” has become more common, and we have partnered with a firm with significant capabilities in this space.
This column will outline, at a very high level, most of the options that exist today for dealing with this issue.
It is not an exhaustive list, but it is comprehensive enough that you can say, “These two or three may make sense for me.”
Now, insert every possible disclosure about this not being investment advice. Options contracts can be risky. Illiquidity is also risky. And many of these strategies are available only to accredited investors.
1. Defer, defer, defer, die
This is the joke I always make with rental properties, as the capital gains and depreciation recapture upon sale almost always catch people by surprise in a bad way.
The way around this is to die with the property so that your heirs get a step-up in basis and skip out on the deferred tax bill from your lifetime.
The same strategy applies to stocks. If they are held in a taxable account or a revocable trust, there will be a step-up at death. Half of the account will step up in a joint account.
There are a couple of problems with this strategy: The company may die before you do, and hanging on to a loser may cost you more in lost returns than the tax bill would have been to sell it.
2. Gift up
This adds one step to the previous strategy, once again, to take advantage of the step-up in basis.
We advised a client about a decade ago who bought Apple (AAPL) in the mid-’90s. She now had more than she needed, but her aging mom had less than she needed.
Our client gave a large chunk of the stock to her mom by placing it in an account where our client was named as the beneficiary. Her mom now owns that stock, and when she dies, it will pass back to the original owner with a step-up in basis.
Here are a few drawbacks to this one: Whoever receives the stock now owns it. They can change the beneficiary, or they can spend all the money. The giftee must also live for at least one year post-gift. If they die within the year, you lose the step-up.
It’s also very important that you know you will not need the money.
For example, if you have $5 million and your plan says you need only $3 million to maintain your lifestyle, then $2 million would be the absolute maximum you would ever give. If you want access to a free version of the software we use to determine that number, you can access it online.
The example I have given here is for parents, but we have also done this between spouses when there is a significant age gap or when one spouse is ill.
3. Bracket bumping
Before significant innovation in this space, bracket bumping was the most common solution: Figure out how much room clients have in their current tax bracket and sell that much stock in each tax year until they no longer have the concentrated position.
This is by far the simplest solution, but it can get away from you.
We brought on a client in 2018 with about $1 million in unrealized gains. We came up with a five-year bracket-bumping proposal. We bumped those brackets, and by the end of year five, we had $2 million in unrealized gains because the stocks grew more than the amount we were able to realize each year.
Once again, a good problem to have, but one that necessitates one of the more complex solutions below.
4. Options: Covered calls, protective puts and collars
At the highest level, selling a covered call allows you to generate income in exchange for eliminating some of the upside of the stock.
Another option: Buying what’s called a “protective put,” which allows you to pay a premium in exchange for eliminating some of the downside risk of a stock.
Both strategies can be used for different purposes with a concentrated position.
When you combine the two by selling a call and using that money to buy a put, you have a zero-cost collar. This establishes a range at which you will sell the stock.
Let’s say XYZ stock is currently trading at $200. You may establish a collar that allows you to sell the stock at $180, even if the price goes lower.
At the same time, you will sell the stock at $220, even if the stock goes higher. These numbers are totally made up, and that range will depend on the options market for the stock you own.
Think of these options like setting up bumpers when you’re bowling. You now know the range of where your ball can line up. However, just like bowling, these options are not free and come with different types of risk.
Selling a covered call caps your upside — if the stock rockets, you won’t participate.
Protective puts require paying a premium, which can drag on performance. If your stock gets called away in a taxable account, it will have a tax consequence.
You also want to consider that some of these strategies may require margin, which could cause capital calls if the stock moves in the wrong direction.
We use these strategies more frequently to mitigate the investment risk than the tax risk. Which means that if you’re worried about your META (or any other) stock dropping by 15%, but most of it is held in a retirement account, this may be a fit.
5. Exchange funds
Exchange funds are pooled investment vehicles structured as partnerships, where all limited partners transfer their appreciated positions into the pool. The result in the aggregate is a diversified portfolio that you own a portion of.
I believe the two biggest drawbacks here are the restrictions on what can be transferred in and the illiquidity.
The exchange fund is attempting to track an index: S&P 500, Russell 3000, etc. To do that, the fund’s managers need people to exchange in all sorts of different stocks.
Most of the concentrated positions we see are in the same 10 to 15 stocks and are often the stocks that the exchange fund needs least to track its index.
The other possible issue is that most funds require a seven-year lockup. If you redeem early, you are typically assessed a redemption fee and handed back the stock you were trying to get rid of in the first place.
However, if you cross the finish line, you receive a diversified basket of stocks with your original basis. If you sell, you still have the big tax bill, but you did solve the diversification benefit.
Here’s a third drawback you should be aware of. When you swap into the exchange fund with your liquid assets, you may be swapping for illiquid assets. The fund managers are required to hold at least 20% in “qualifying” illiquid investments. This is often in the form of real estate or commodities.
Some may view this as a positive, just as some advisers will allocate a portion of assets to illiquid or private investments, but either way, you don’t want it to be a surprise.
This is the first in a two-part series. In the second part, I’ll cover some of the more innovative strategies, many of which have popped up in the past few years.
That doesn’t mean that I won’t use the strategies mentioned in this article. It just means that I can get much more granular as I diagnose the problem and prescribe the medication.