**The example below is a hypothetical illustration based on composite, real-life situations and does not describe an actual client. Names, amounts, and circumstances have been changed for illustrative purposes. Results will vary based on individual circumstances. There is no guarantee that any diversification strategy will improve investment results or reduce risk. Diversification does not protect against market loss. Investors should consult their advisor before implementing any of the strategies discussed.
The Tax-Informed Framework for Balancing a Single-Stock Portfolio
Whether you received shares as part of your compensation, inherited them, or have simply held an investment that has grown substantially over time, letting go of a concentrated stock position can be difficult. That’s where thoughtful investment and tax planning can help you explore options for diversifying while considering the potential tax impact.
One profile we often see looks like this: a client with a total net worth of $4 million, including $2 million in stock from a single company, which represents 50% of their total assets. Holding 20% or more of your portfolio in a single stock or asset can create overconcentration risk, tying too much of your financial future to the performance of just one investment. When that concentrated investment is also your employer, the risk compounds. A significant downturn could affect both your income and your portfolio simultaneously.
Diversification of a Concentrated Stock Position
Rather than simply selling a large portion of the concentrated stock position and potentially incurring significant capital gains tax, we can review the client’s entire financial picture and explore strategies to reduce concentration while managing the tax impact. There are many ways to diversify concentrated stock positions. These are some of the options we could discuss:
- Exchange Fund: This type of fund can help investors reduce a concentrated stock position without immediately realizing capital gains. There is usually a required holding period, and these funds are not available to all investors. They carry illiquidity risk and may not be appropriate for investors who may need access to their funds on short notice.
- Long/Short Overlay: This strategy can generate tax losses to help offset gains realized during diversification, using long and short positions to manage tax exposure without forcing an immediate sale of primary holdings. Short selling involves significant risk, including potentially unlimited loss, and may not be suitable for every investor.
- Options-Based Hedging: This risk management strategy allows investors to maintain their stock position while taking steps to help reduce — though not eliminate — the impact of a significant decline in its value. Options strategies involve costs, can cap potential upside, and do not guarantee against loss.
- Prepaid Variable Forward (PVF) or Collar Advance: This strategy can provide access to funds by unlocking some of the stock’s value upfront, while potentially delaying capital gains taxes. It comes with tradeoffs, including potentially limited upside participation, counterparty risk, and important tax considerations.
Depending on a client’s goals and circumstances, combining strategies can provide additional flexibility when addressing concentration, diversification, and tax efficiency.
The Concentration Reduction Strategy
After reviewing all options, an approach was modeled to diversify the example portfolio utilizing an exchange fund, charitable giving, and thoughtful tax planning:
- $1 million of concentrated company stock was moved into an exchange fund to begin diversifying the position.
- $100,000 was contributed to a Donor-Advised Fund (DAF), creating a potential charitable tax deduction, subject to applicable rules and limitations.
- The model assumed the sale of an additional $125,000 in company stock based on the example’s tax situation and the deductions available that year.
- The resulting capital gains were offset by the $100,000 DAF contribution and $25,000 in other itemized deductions, minimizing the additional tax impact of the sale, based on the example situation’s specific circumstances.
The modeled strategy reduced the concentrated company stock position from $2 million to $750,000, lowering the stock from 50% to 19% of the total $4 million net worth. This brought the exampled overconcentrated position below the 20% threshold, while managing the tax consequences of diversification.
A decision to diversify an investment can create tax consequences, while a tax strategy can create opportunities to make investment decisions more effectively. By considering the two together, we can look at the full picture and build a strategy around the client’s goals. At Storen Financial, we take a tax-informed approach to financial planning. Our team of tax and investment professionals works together to consider not only where your money is invested, but how those decisions may affect your taxes today and your financial goals in the future.
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Blog by Ronnie Jackson – Partner, Wealth Advisor
Learn more about Ronnie and the rest of the Storen Financial team here.