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Opinion: 3 options for managing capital gains taxes

Industry Insight

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A lucky couple watched their joint investment account grow to over $1.6 million from $700,000 in just five years – thanks largely to the eye-popping growth of a single stock they purchased long ago. (It was a certain auto parts store you may have heard of.)

For some time, this stock had occupied a large portion of their account, and now even more so. A good rule of thumb is not to hold more than about 5 percent of your portfolio in any one asset; not that our couple should expect any problems with this red-hot stock, it’s really a fantastic company and has been for decades. But you never know, and their financial future is on the line.

So Mr. and Mrs. Lucky have been told by more than one adviser that they should diversify – sell some of that overweight stock and rebalance into other holdings, to spread their risk across the markets.

But if they were to sell most of that position, they would face a huge tax bill on the capital gains, i.e. growth in value. It’s a nice problem to have – after all, paying tax on a large gain still leaves you a profit. (This is not an issue for a tax-deferred account, such as an IRA, only for a taxable joint, individual or trust account.)

Sell or hold?
Our couple has a few choices.

Option 1: Sell enough shares of the stock to “correctly” diversify and pay significant tax.

Option 2: Work with a tax professional to “crawl out” of that holding over time. The 2018 capital gains tax rate is zero for married taxpayers filing jointly with adjusted gross income below $77,400 (or $38,700 for single filers). They could calculate the amount of capital gains they can absorb before taxation applies, harvest enough gains to stay below their pain threshold, then perform the same exercise each of the next few years until they’ve reduced their exposure to the desired amount.

New 2018 tax rules even allow investors to select which lots (bundles of stock or fund shares) to liquidate first. By selling a lot with the highest purchase price, therefore less gains since purchase, you can reduce the tax liability. If some of your holdings dip into loss territory, you can offset those losses against other holdings that have grown, effectively wiping out some taxable gains.

But keep in mind that short-term gains – on assets you’ve owned one year or less – are taxed at your ordinary income tax rate instead of the lower long-term capital gains rate applied to assets held longer than a year. Harvesting short-term and long-term gains against losses is a great technique but can be tricky. You must perform the offsets in a specific sequence to comply with IRS rules, so work closely with a financial professional.
 
Option 3: Hold on to the stock and earmark it for heirs to receive “stepped-up basis,” a fresh starting value upon which future taxable gains build. In other words, if beneficiaries sell the stock right after inheriting it, before much more growth occurs, there may be little or no capital gains tax. This can be a sensible strategy for any highly appreciated asset, especially if the plan is to leave something for heirs anyway.

Risk vs. reward
However, this couple now has about half of their account in a single stock, and they need to consider the risks of continuing to hold such a concentrated position.

But when a tax or financial professional invariably points out their overexposure, our lucky couple’s response is always the same: “We know. But we never expected this much growth from one stock, and we don’t need anywhere near that much money to meet our goals. So we’re letting it ride!

“Worst case, that stock tanks, but our retirement savings and kids’ inheritance will still be what we planned years ago from our other holdings. Best case, it will be a huge bonus for them. And besides, it’s fun to watch this stock. We’ve kept an eye on that company, and how they treat their employees, and how they give back to the community, and we think it’s a good bet that they’ll continue to be successful.”

It’s hard to argue with that – as long as they understand the potential risks and rewards of their strategy, and their alternatives, and think it through on a regular basis. In that case, this couple is not just lucky, they’re smart.

Certified financial planner Kenny Gott is president at Piatchek & Associates and author of the book “Bottom Line Financial Planning.” He can be reached at kgott@pfinancial.com.

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