3 tax tricks financial advisors can use for risky, overweight portfolios

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Many wealthy investors whose retirement nest eggs swelled during the pandemic now own dense blocks of valuable stock in a single company — along with a twin problem.

The paper profits are obviously a blessing. But they’re also a curse, because they account for a greater chunk of retirement savings and make an investment portfolio less heterogeneous — and therefore riskier over the long-term. Meanwhile, diversifying can create a cascade of tax bills.

Enter a growing focus of wealth managers with affluent clients. The task: extracting the value of appreciated stock and rebalancing a portfolio while not getting slammed with taxes in the process.

“There are a lot of people in this position,” said Eric Bronnenkant, the head of tax at robo advisor Betterment. "If they sell, then they have to pay capital gains taxes, plus state and local" levies. "They don't want to do that."

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Unlike the volatility roiling markets due to Russia’s invasion of Ukraine, what’s known as “tax lock” — paper profits with embedded tax bills in the future — is a permanent feature of strong markets over the longer term. A milder version of the over-concentration that can emerge confronts less well-heeled investors who have poured all their money into an S&P 500 index fund. Around 20% of the value of the benchmark, the standard benchmark of the top 500 U.S. companies, comes from just five players (Apple, Microsoft, Amazon and Alphabet’s two share classes), according to SlickCharts — leaving investors with what investment manager Invesco recently called “levels of concentration risk not seen in nearly half a century.”

Whether a client’s appreciated shares are in a private startup whose value has soared or stock options in a publicly traded employer that has performed well, here’s what they and their advisors can do:

Swap meet
Lots of rich investors are in the same position. Banding together can be the solution.

Large investment management firms, including Eaton Vance, Goldman Sachs and Morgan Stanley, offer so-called exchange funds, in which investors swap their individual shares for a pro-rata share of a diversified fund that holds others’ individual shares. Presto, diversification, plus no triggering of the 23.8% capital gains tax due when stock is sold. Wealth managers say exchange funds can work well for investors whose nest egg is tied up in an employer’s stock, entrepreneurs whose net worth is in a startup and family members who inherit a business.

Not to be confused with exchange-traded funds, the typically private funds are usually open only to qualified investors with at least $5 million in investments; some have a lower threshold and accept accredited investors with a net worth of at least $1 million and income of at least $200,000 in recent years.

The funds, also known as swap funds, aren’t registered securities, so they’re not overseen by the SEC.

Andrew King, the vice president of tax policy and research at Goldman Sachs Ayco Personal Financial Management, said that under IRS rules, investors have to wait seven years to receive their share of a diversified basket of stocks. And while a retirement portfolio may get more diversified, it may still be too concentrated.

“The investor should determine if this option is suitable based on their investment objectives and risk profile,” King said.

Morgan Stanley noted in 2020 that fees can run 2%, and not waiting the full seven years can mean getting back only your original stock.

Win by losing
Financial advisors already know that losses are valuable for offsetting gains in a well-diversified portfolio. But they can also be a good thing for diluting a concentrated position.

Tax-loss harvesting involves selling a stock or other investment that has declined and then reinvesting the proceeds in another asset. The capital loss from the sold shares offsets the capital gains, or taxable profits, on winning investments. Anything left over can be used to offset up to $3,000 of ordinary (non-investment) income and be carried forward or backward for further use.

A twist on the strategy involves direct indexing, which is when an investor buys the individual underlying securities of an index, then dumps the ones that lose money. That technique allows an investor to rake in the profits of the benchmark while using losses from individual stocks to offset those gains. The result: a better return than if the investor had bought into the index through an index fund or exchange-traded fund.

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Say an investor works for Microsoft and owns a ton of its stock. By using a custom index tailored to him that doesn’t include technology stocks, he can use that bespoke gauge’s losses to offset his gains on Microsoft, all the while broadening his exposure to the market.

Ehren Stanhope, a principal and client portfolio manager at O’Shaughnessy Asset Management in Stamford, Connecticut, cited a client who was an early investor in consulting firm Accenture, which emerged out of shuttered auditor Arthur Anderson after the Enron scandal. The client had 90% of his wealth tied up in Accenture stock. When the COVID-19 pandemic hit in early 2020, Stanhope intensified tax-loss harvesting of the client’s losses in a custom index that tracked Russell 2000 stocks, minus its accounting and financial firms.

“What tends to happen with tax-loss harvesting is that the most advantageous times are during a down market,” Stanhope said. “We’ve harvested 80 basis points this year” — an extra 0.8% boost.

Straddle the bull
This one is for wealth managers with sophisticated clients sitting on hefty paper profits in a single stock. Taxpayers with such gains can “lock in” their unrealized appreciation, even if the shares fall in value. How? Through a complex type of derivative known as a collar.

Here’s how it works: The investor buys a “put” — the right, but not the obligation, to sell a certain amount of stock at a set price within a given time. It’s for people who are worried that the stock market will decline and want to magnify their profits from those losses.

Simultaneously, the investor “writes a call” on the same stock, essentially betting that it won’t appreciate. A call provides income in the form of “premiums” that help pay for the put option. Together, the two moves comprise a “collar” that protects an investor against losses (but also limits the upside) while minimizing and deferring capital gains taxes.

A collar can potentially create a situation that makes the IRS unhappy and cancels out the tax benefits of the move. The situation, known as a “tax straddle,” materializes when an investor with profits simultaneously creates artificial offsetting losses, potentially triggering wash sale rules. Those rules ban investors from claiming a tax loss if they replace a stock with the same or “substantially identical” stocks within 30 days.

Goldman Sachs’s King said that “there are no bright-line rules” from the IRS on when a collar results in a cancellation of the tax benefits.

“These options-hedging strategies,” he added “can come with some tax complexity.”

Bronnenkant said that “you want to be careful about not completely neutralizing your downside risk.” He said he’d heard of situations in which investors who protected 20% to 30% of their risk through collars saw their tax benefits canceled out.