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5 Tax-Efficient Strategies for Diversifying a Concentrated Stock Position

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Being an employee with equity compensation is like having a front-row seat to your company’s growth. Each milestone your employer achieves can translate into personal wealth for you, especially as your position in company stock grows.

Yet when it comes to investing, the asset that helps you create the most wealth can also pose the biggest threat. That’s why proper diversification is essential for preserving your nest egg long-term.

In this blog article, we’ll explore five tax-efficient strategies you can leverage to diversify your portfolio, so your net worth and financial future aren’t tied to the performance of one asset.

Understanding Concentration Risk

While holding a large amount of company stock can indeed be rewarding, holding too much company stock can be risky. Just as your wealth can rapidly grow with the company’s success, it can also decline with any downturns in performance.

This level of exposure to a single asset can lead to significant fluctuations in your net worth and, in some cases, permanent capital loss. Financial planners and investment managers call this concentration risk.

Diversification offsets concentration risk by spreading your investment dollars across a variety of asset classes, sectors, and markets that behave differently from one another. The idea is that when one part of your portfolio is performing poorly, another part is performing well. While this can limit your upside potential, it can also help minimize your potential losses over the long run.

Of course, diversifying a concentrated position in company stock can be easier said than done. Aside from the potential tax implications, there’s often an emotional attachment to holding company stock that can make selling it a challenge.

Nevertheless, any financial planner will tell you that although concentration builds wealth, diversification preserves it. The following strategies can help you achieve proper diversification and reduce portfolio risk without triggering an unnecessarily large tax bill.

Consider these tax-efficient strategies for diversifying a concentrated stock position:

#1: Exchange Funds

An exchange fund, also known as a swap fund, allows you to pool your company stock with other investors’ stocks, creating a diversified portfolio. Each investor then owns a share of the portfolio.

The primary benefit of an exchange fund is that you can diversify a concentrated stock position without selling your shares outright. That means you can avoid paying the capital gains tax, which you’d incur if you sold your appreciated shares on the open market.

The downside is that exchange funds often have a lock-up period during which you can’t access your funds. In addition, there may be restrictions as to who can invest.

#2: Tax-Loss Harvesting

If your company stock shares decline in value below your cost basis, you can sell them for a loss and avoid paying capital gains taxes on the sale. However, if you have embedded gains, you may want to consider tax-loss harvesting when diversifying a concentrated stock position.

Tax-loss harvesting involves selling securities at a loss to offset your potential capital gains tax liability. You can use this strategy to reduce your position in company stock over time and reinvest the proceeds in a diversified portfolio.

While it can be an effective strategy, tax-loss harvesting requires careful management and understanding of your full financial picture to ensure your investment portfolio remains aligned with your goals and risk tolerance.

In addition, selling investments at a loss can be challenging during prolonged bull markets. As a result, this strategy may not be ideal if you don’t have the luxury of time on your side.

#3: Donating Appreciated Shares to a Donor-Advised Fund (DAF)

Donating appreciated stock to charity can be another tax-efficient method for diversifying a concentrated stock position. When you donate securities you’ve held for more than a year, you’re eligible for a tax deduction equal to the fair market value of the shares at the time of the donation (up to IRS limits, and assuming you itemize).

That means you can potentially eliminate the capital gains tax you would have owed if you sold the shares outright. This benefit can be particularly valuable if your shares have increased significantly in value since you acquired them.

One option is to donate your shares directly to a charity of your choice that accepts noncash donations. By taking advantage of this strategy, you can support the causes you care about and potentially realize significant tax savings while diversifying a concentrated stock position.

Alternatively, you may want to consider donating your shares to a donor-advised fund (DAF). This approach allows you to take an immediate tax deduction in the year you make the donation without having to decide right away which charities you want to support with your grants.

#4: Gifting Shares to Family Members

If you’re in a high tax bracket, gifting shares to family members in a lower tax bracket can also be a tax-efficient strategy for diversifying a concentrated stock position. They can then choose to hold the shares as part of their investment portfolio or sell them at their lower tax rate.

However, keep in mind annual gift tax exclusion limits apply to gifts of stock. In 2023, this limit is $17,000 per beneficiary, per donor. Anything above this amount will be subject to the gift tax.

A potential benefit of gifting your shares is you can efficiently transfer part of your wealth to your beneficiaries while reducing concentration risk. The downside is you relinquish control of your shares once you gift them, so their long-term value depends on how your beneficiaries manage them.

#5: Charitable Remainder Trusts (CRTs)

With a charitable remainder trust (CRT), you can convert highly appreciated shares of stock into a steady stream of income for a set period. At the end of the period, you donate the remainder of the trust to a charity of your choice.

When you contribute to a CRT, you may receive a partial tax deduction based on the contribution amount. The CRT can then liquidate the shares tax-free, and you receive annual distributions from the trust.

Thus, CRTs can be a helpful estate planning tool, as well as a tax-efficient strategy for diversifying a concentrated stock position. However, setting up a CRT can be complex and requires careful planning. It’s important to work with a financial planner or estate planning attorney to avoid potentially costly mistakes.

Diversifying a Concentrated Stock Position Can Be Complicated. Simplicity Wealth Management Can Help.

Diversifying a concentrated stock position is an important step for mitigating risk and preserving wealth long-term. At the same time, it requires careful planning and a thorough understanding of tax-efficient financial strategies. It’s important to work with an expert to make sure you’re capitalizing on all available opportunities while minimizing the associated costs.

At Simplicity Wealth Management, we specialize in the financial and tax planning needs of tech professionals with equity compensation.  If you’re looking for professional guidance when it comes to managing your equity compensation and maximizing your wealth, we can help. Please schedule a call to learn more.

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