When is a “Too Good to be True” Financial Strategy Truly Good?

In my role as a wealth manager, financial firms regularly approach me to discuss planning strategies or investments that they promote as innovative and unique. Most of the time, I find that they are not necessarily groundbreaking or different, but every now and then, I do hear about ideas that are truly worth exploring.

My last blog, “When a Terrific Investment Is Not So Terrific” got me thinking about one of these strategies. In that article, I discussed a problem faced by mid-life professionals who are in career transition and who own a substantial position in an individual stock that has seen extraordinary gains over recent years (often referred to as “concentrated” stock).

A large individual stock position, which may have been acquired through an employer-sponsored stock option or stock purchase plan, often poses a dilemma, especially for mid-life professionals in career transition. As they think about a future that may involve working less or not at all, they begin to consider reducing or liquidating these positions to try to manage their overall investment risk.

While that line of thinking is very sensible, it is sometimes emotionally difficult to sell an investment that has performed so well, even when the person’s financial situation is changing. And of course, the decision is complicated by the fact that selling will almost always involve paying a capital gains tax, which could be quite significant and may offset some of the advantages of diversifying.

My article gave pointers about how to approach the decision to diversify such an investment. The argument for diversification is not an “open and shut” case. It is nuanced and many factors should be considered. However, we would probably all agree that the advantages of diversification might be more attractive if you could sidestep paying the capital gains tax without getting in trouble with the IRS.

Well, here is the good news. There is a financial planning technique that may provide a way to accomplish exactly that goal…and more! As you will soon read, this technique sounds almost “too good to be true,” as the old saying goes. Usually, what seems too good to be true is exactly that. But in some instances, it is important to keep an open mind.

Although it is not at all a regular occurrence, something “too good to be true” sometimes turns out to be good. That applies to the technique I am about to describe and how it might benefit some people who own an investment that has seen a high level of appreciation.

This strategy involves donating all or some portion of the appreciated stock (or other highly appreciated assets) into a Charitable Remainder Unitrust (“CRUT”). In certain situations, the financial benefits of this strategy may be extremely compelling, even for those who are not inclined to donate money to charity. That is because the financial benefits of this technique sometimes substantially offset the fact that you are donating money for philanthropic purposes. Here is how it works:

You donate a significant portion of, or the entire stock holding, to the CRUT, which offers three important financial benefits to the donor. First, after the stock is donated to the CRUT, you can then sell the donated stock (to meet your diversification goal) and usually, you or the CRUT may not be subject to any capital gains tax.

Second, in most situations, you may likely receive a large tax deduction for the donation, which may be very beneficial to your income tax situation. This tax deduction might partially or fully offset other income sources you have and/or offset other long-term capital gains for any investment sales made from your personal accounts (not your CRUT).

The financial benefits do not end there! The CRUT can then pay you a percentage of the CRUT principal you donated (sometimes as high as 6%) for the rest of your life. When the Trust ends (usually when you die), the remaining principal will go to the charitable beneficiary (or multiple charitable beneficiaries) that you designate.

The combination of these three benefits may be attractive and even compelling for some individuals, especially those who want to diversify a single stock position and who need additional income to fund their long-term retirement needs.

While the CRUT donation strategy is powerful, I do not want to imply that this technique is a fit for every individual who owns a financial asset that has seen extraordinary gains. There are many trade-offs and risks. I do not see these as “too good to be true;” however, the devil is truly in the details that must be considered before deciding whether this strategy is right for you.

To effectively evaluate this method, you likely need the services of a financial advisor experienced in working with these trusts, along with an estate planning attorney. They should provide financial planning services and calculations that help you evaluate whether a CRUT is right for you based on your specific financial circumstances and needs.

Here are some important factors to consider if you decide to further explore this idea:

• You should first carefully think about whether you need or want to diversify the highly appreciated stock or property in question. There should not be an automatic assumption that diversifying the position is necessary or desirable.
• If you decide to diversify, you and your financial advisor should study other diversification approaches. I discussed other diversification strategies in this blog.
• If charitable donations are a primary goal in your next life chapter, there might be other planning strategies that may be more appropriate for you and which may result in your favored charities seeing a larger donation. These strategies include Donor Advised Funds (discussed in this article) or other types of Charitable Trusts.
• All diversification strategies involve investment risk. The strategy of donating stock to a CRUT does not mean that the investments will perform well or be subject to less volatility than the stock donated to the CRUT. If the new investments perform poorly, you may receive substantially lower annual payments from the CRT principal, or even no payments at all.

My office has experience helping mid-life professionals evaluate concentrated stock positions and with the diversification strategies mentioned in these recent articles. Please feel free to contact me with any questions about these techniques or to discuss a complimentary assessment of your specific situation.

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.

Itineris Financial Advisors and LPL Financial do not provide legal advice or tax services. Please consult with your legal advisor or tax advisor regarding your specific situation.

Investing involves risk, including loss of principal.