Holding a significant portion of your wealth in one or a handful of individual stocks can be both exhilarating and nerve-wracking. While the rewards of watching a single company’s meteoric rise can be life-changing, the risks of a lack of diversification are just as great. The problem is that liquidating these positions often means getting hit with daunting tax bills. We walk through practical solutions and the new tools now available to investors interested in diversifying without a big tax bill.
The Real Risk of Concentration
It’s tempting to simply hang on to a winning stock, postponing taxes until you’re in a lower tax bracket or retired. But over 90% of stocks underperform the market long term. Individual company fortunes can change abruptly—think Enron, Lehman Brothers, or stock collapses from $50 to $0.50. Banking your whole plan on one company’s continued success is a risk that can jeopardize even the soundest of financial plans. Taking calculated steps to shift your assets, even if taxes will eventually be due, is often essential for long-term stability.
Modern Options for Tackling Concentrated Stock
Technology and innovation in the investment industry are opening doors once reserved for the ultra-wealthy. Here are four tax-deferral solutions we discuss:
1. Exchange Funds
Exchange funds allow investors to pool their highly appreciated stocks with others, resulting in a diversified basket—often 20–30 stocks. You maintain your original cost basis, and after a 7-year lock-up period, you can access a more diversified portfolio.
There are usually high entry minimums ($250,000–$500,000), and the investor must be accredited. It requires a long holding period and comes with added complexity, costs, and delayed K-1 tax forms. At the end, you still owe taxes if you sell, but you’ve reduced single-stock risk.
Section 351 Funds
If you hold several different stocks or even ETFs that no longer fit your strategy, Section 351 exchanges allow you to transfer them into a new, broadly diversified fund with tax deferral. This is similar in spirit to a 1031 real estate exchange but designed for securities. This option gives you flexibility, but it only works with publicly traded investments in taxable (not retirement) accounts
Separately Managed Accounts (SMAs)
SMAs have become popular for allowing greater customization. In an SMA, instead of owning an index fund, you hold the constituent stocks directly—allowing for tax loss harvesting and the exclusion of specific stocks. This offers personalized values-based investing but creates more complex tax reporting and can create complications for you and your CPA.
Tax Aware Long/Short Strategies
Recently popular but highly complex, these leverage SMAs and add a long/short overlay, aiming to maximize loss harvesting regardless of overall market conditions. This uses leverage and shorting, increasing risk and management costs. It offers greater potential for tax-loss harvesting but introduces tracking error and liquidity constraints. This is best for specific, high-need scenarios.
Always Return to Your Broader Financial Plan
Look at that accumulated stock position in the context of your overall financial plan and everything else that’s happening in your goals and life. These tactics are tools, not silver bullets. Sometimes, the simplest (if less glamorous) move—selling, paying taxes, and reinvesting—might be your best decision.
Concentrated stock positions can be both an opportunity and a source of anxiety. Before chasing the latest “shiny object,” evaluate your situation with the help of an advisor. Find the approach that aligns with your risk, liquidity needs, and long-term goals. Sometimes, boring really is better—for both your taxes and your sleep.
Outline of This Episode
- 00:00 Discussing tax deferral options
- 03:42 Risks of relying on stocks
- 09:14 Evaluating stock donation options
- 12:49 Explaining Section 351 funds
- 14:29 Using ETFs for tax deferral
- 18:24 Considering life changes for tax planning
- 21:57 Evaluating investment advice sources
Resources & People Mentioned
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