When Is a Terrific Investment Not So Terrific?

Maybe you are a professional who has worked for one or just a handful of companies over a long and successful career. During that time, you have been a diligent saver and investor and now find yourself with what some people would view as a “first world” problem.

While most of your investments have done well, you own an individual stock that has performed exceptionally well. In fact, this investment may have grown at such a high rate that it now represents a large percentage of your total investment holdings, perhaps 30% or 40% or more of your portfolio.

Impact on Mid-Life Professionals in Career Transition

The combination of your professional success and the growth of such a stock has, perhaps, allowed you to now think about how you want to live your life, what kind of work you may – or may not – want to do, and even whether you want to continue working.

As you begin to think about your personal and professional goals, you are also wondering about that wonderful investment and how to deal with it. Should you hold, sell it all, or do something in the middle?

Over the years, I have worked with many professionals who have thought about these questions. They have often acquired the stock through a stock purchase plan, stock options, and/or other stock incentive rewards granted by a current or former employer. The questions about the individual stock come up when they reach a transitional phase and are thinking about leaving their employer (or have already done so). The decision about how to approach a large position in a single highly appreciated stock is often not straightforward in such circumstances.

In fact, it is the polar opposite of a “First World” problem because of the significance of the financial consequences. If you have made a decent chunk of change (or more) thanks to such a stock, you may have mixed feelings about parting with it. After all, holding it worked out well for you and selling any portion of it would subject you to capital gains taxes. Those taxes might be very significant!

The fear of missing out on the upside is real. However, there may be a potential downside: Only a small number of companies outperform the broad market over the long term. And the risk of a permanent drop in a stock’s value cannot be dismissed, even if the company has been successful during recent years or even longer.

Too Much of a Good Thing?
Financial professionals refer to such a stock as a “concentrated position”. When that single stock reaches the point where it represents more than 20% or 30% of your total portfolio, it is concentrated. And usually, these highly appreciated stocks are held in a taxable investment account and are subject to capital gains taxes.

Some financial professionals think that when a single stock reaches a certain percentage of your portfolio, it should be diversified. But what is the percentage when that single stock may pose too much of a risk? When should you diversify?

Unlike some financial advisors, I do not think there is a specific percentage that would dictate when you should begin diversifying. The decision involves many factors and in my opinion does not lend itself to a simple formula or rule, especially for individuals who have been saving and investing for three decades or more.

Think First; Make Decisions Later!!

I favor a more deliberate and thoughtful approach. Here are some important questions I think you should consider before taking action:

1. Do you expect to retire or are you considering a “working retirement” over the next few years? If not, then you may not have a financial need to begin diversifying the individual stock position. Of course, this does not mean you would not sell the stock, but such decisions might be primarily based on its investment merits and your opinion about its competitive position in its industry and financial performance.
2. Are you planning on beginning to withdraw money from your portfolio on a sustained basis during the years ahead due to retirement or a preference to reduce your hours?
3. How much money might you need to withdraw from your portfolio if you plan on reducing your hours or leaving the workforce in the not too distant future? If this individual stock were to sustain a significant decline in its value, would your remaining financial assets sustain your withdrawal needs?
4. What are your feelings about investment risk and portfolio volatility? Are those feelings changing due to your current or future career transition?
5. Is the single stock held in a 401(k) Plan or IRA? If held in a qualified retirement plan, the investment would be easier to diversify due to the lack of capital gain taxes in such accounts.

Financial Planning May Help Solve the Riddle

If faced with this good but difficult problem of a highly appreciated individual stock, you do not need to rush into a decision. Modern financial planning, using a cash flow-based methodology, may help provide the answers to the questions above and allow you to make a thoughtful, informed, and confident decision.

The financial planning process can help you assess whether there is truly a need to begin diversifying and the ways you may go about doing so. The options for diversification begin with considering gradual sales of the position over a period of two or more years. This can help reduce the capital gains tax impact of selling a large percentage of the position all at once (if held in a taxable account).

The cash flow-based planning methodology allows you to assess and compare a range of potential scenarios, including the tax consequences of selling over different timeframes, as compared to the risks of not diversifying. You can even create a scenario which would show the impact of the single investment unexpectedly posting poor returns over a number of years to determine the impact and how the single stock risk may impact your finances if faced with a prolonged downward slide.

There are also advanced techniques to diversify a highly appreciated investment and yet sidestep the negative capital gains tax consequences of diversification. These can also be modeled in a cash flow-based financial plan if they apply to your situation. The techniques include:

1. 1. • Diversification Strategies: There are a number of investment strategies that may allow certain investors to diversify a highly appreciated stock with a reduced capital gains tax impact. These strategies are too complex to describe in this article, but may be appropriate to consider for certain individuals. You can ask your financial advisor about other diversification approaches beyond a strategy of gradually selling the position over a number of years.
      • Donor Advised Funds: You can donate a portion of or all of the highly appreciated stock into a Donor Advised Fund. The donation may offer a very attractive income tax deduction, depending on your marginal tax rate. Such a donation may be appropriate for individuals or households who a) are or may be in a relatively high income tax bracket; b) have charitable intentions; and/or c) do not need the security donated for their long-term financial needs. It is important to evaluate this option with both your financial advisor and a qualified tax professional.
      • Trusts for Charitable Purposes: Some individuals use charitable trusts to leave all or a portion of a highly appreciated investment to charity when they die, both for philanthropic purposes and for certain tax benefits. They are sometimes appropriate for individuals who have a large, highly appreciated individual stock holding. The benefit of these Trusts is a potentially attractive income tax deduction for the donation. However, such Trusts come with the risk that the charitable beneficiary may receive much less money when you die. There are also different types of charitable trusts, each of which may benefit the donor and charity in different ways. A qualified financial advisor and estate planning attorney can help you evaluate the advantages and disadvantages of each of these structures relative to your situation.
      • Net Unrealized Appreciation (“NUA”): “Net Unrealized Appreciation” is an IRS provision that provides a tax efficient way to withdraw a highly appreciated individual stock from a 401(k) plan based on its cost basis and not its actual value. This means that any additional value gained since the stock was initially purchased is not taxed as ordinary income, and it will instead be taxed at a lower capital gains tax rate. However, the downside is that ordinary income tax must be paid on the cost basis of the employer stock immediately. The trade-off is that ordinary income taxes would not have been due until you sold the shares in the future, years or decades from now.

These techniques may often offer compelling tax advantages, but must be carefully evaluated based on your personal circumstances. You should obtain the services of qualified investment, legal and/or tax advisors to determine if they are appropriate for your needs and situation. My office has years of experience helping clients evaluate these strategies and can provide you with a no obligation, complimentary review of your situation, if appropriate.

I plan on writing a future article about these techniques in an upcoming blog. Stay tuned! In the meantime, if you have any questions about highly appreciated individual stocks or other financial topics, please contact me!

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.