Many long-term investors have amassed substantial capital gains since the market bottomed out in March 2009. While great-looking on paper, such gains have real tax implications for engaging in even routine investment adjustments.
Fortunately, there are relatively straightforward tax strategies that can help investors warm to the idea of unwinding these investments — and, if managed properly, they can provide yet another clear way for advisors to add value to their offering.
First and foremost, strategies to avoid capital gains are less effective than most people realize.
The conventional view is that if an investor purchased an investment for $60,000 that is now up to $100,000, there’s a 15% long-term capital gain that will come due in the form of a $6,000 tax burden. Thus, the longer the investor holds on, the longer they can keep that $6,000 invested and working for them.
But unless there’s a plan to die with or donate the asset, the investor will pay $6,000 in taxes; the liability is already established on the personal balance sheet. In other words, the investment’s net worth is already reduced to $94,000. The tax obligation is there, even if it hasn’t come due yet.
Consequently, the real value of managing capital gains is just the growth on that $6,000 in taxes. Presuming an 8% growth rate, that amounts to only $480 of value, or a 0.51% return on the net $94,000 that would have otherwise been available to reinvest.
Obviously, an extra 0.51% per year of return certainly is better than nothing. But it’s still rather modest compared to the overall investment risk of a portfolio that can lose 20% or more in a bear market. And this is for an investment that rose from $60,000 to $100,000, a 66% gain. For larger gains, it is more valuable. On the other hand, for typical, more moderate gains, the annual value of tax deferral is even less.
For investments with a relatively modest gain of 20% to 30% — which could still represent several years’ worth of growth — the additional annual value of tax deferral doesn’t amount to much more than a single day of potential investment volatility. And even with gains of 100% or more, the annual value of tax deferral is still barely 1% per year, when equities have a 15% or more standard deviation.
The key point: The actual value of waiting to recognize a long-term capital gain, even when it’s sizable, is easily bested by even a moderate level of additional investment risk. The same is true with respect to the limited value of tax-loss harvesting as well.
One important caveat to this general principle is that deferring can cause capital gains to cumulatively grow to the point that there’s no way to liquidate without bumping the investor into a higher capital gains tax bracket, which can actually reduce wealth, despite the value of tax deferral. For instance, five years of a $50,000 capital gain at 15% tax rates may result in more wealth than one year with $250,000 of capital gains at the end — some of which is destined to fall in the 18.8% capital gains tax bracket, thanks to the 3.8% Medicare surtax.
As a result, one strategy for managing highly appreciated investments is to set a capital gains budget — i.e., the maximum amount of gains the investor is either willing to absorb and pay the taxes on, and/or the amount of capital gains that can be triggered and absorbed in the current capital gains tax bracket without increasing them above the next threshold. In practice, those thresholds would be from the 15% rate into the 3.8% Medicare surtax, or from the combined 18.8% rate into the 23.8% bracket once the underlying capital gains rate lifts up to 20%.
Example No. 1: Jeff and Susan are a married couple with a combined AGI of $170,000. They are looking to switch to a new advisor with their $800,000 portfolio, but are afraid to follow through because of the nearly $200,000 in capital gains embedded in the portfolio, due to the market’s recent run-up.
Given that they have another $80,000 of room before hitting the $250,000 AGI threshold where the 3.8% Medicare surtax kicks in, the couple sets an $80,000 capital gains budget. Accordingly, the advisor can then go through the portfolio and try to identify investments to be sold and transitioned into the new model, that in aggregate would total $80,000 of capital gains.
Notably, this will allow the advisor to transition far more than just $80,000 in total value, as a portion of the portfolio may not even have gains, and even highly appreciated investments still have some cost basis as well.
Thus, in the example above, Jeff and Susan’s portfolio might need to hold its larger core position in the S&P 500, but the capital gains budget would be sufficient to liquidate and transition everything else. That means even just an $80,000 gains budget still made it feasible to transition approximately $440,000 of total assets.
The essence of the capital gains budget strategy is to set a target that is palatable, whether because it fits within a capital gains harvesting strategy — e.g., to fill a current tax bracket but avoid jumping into a higher one — or simply because it reflects a total bill that the client is comfortable with and willing to pay. Harvesting any available capital losses to further offset gains can help too, although ironically, for long-term investors in a strong bull market, there simply may not be any losses left to harvest.
For those who are eligible for 0% capital gains rates, this strategy is even more appealing because the gains are effectively tax-free — at least for federal tax purposes. State income taxes may still apply. And some families may be able to further accelerate the process by shifting capital gains via gifting to other family members at their more favorable tax rates. Nonetheless, even those who are subject to higher capital gains tax rates may eventually be able to work through their cumulative gains in just a few years of gains budgeting.
Staged selling: Another approach to working through the need to diversify out of, or simply rebalance, highly appreciated investments is to sell assets in stages over time.
This kind of staged-selling strategy is already popular in the context of concentrated positions. Basically, by agreeing in advance to the decision to sell at certain thresholds — and securing a pre-commitment from the investor to do so — it will be easier to sell at those stages when the time comes. You’re no longer making a real-time investment decision about whether to sell or hold, you’re simply executing a pre-determined plan to sell.
This strategy can be especially helpful for clients who feel like they may be losing out on additional upside by selling too soon, as the targets allow for more upside to play out before the sale occurs. It’s also useful as a means of more disciplined risk management to help clients transition if the market moves the other way — keeping the investor from holding and riding a bear market all the way down. Of course, a sale from one investment into another, particularly of a similar asset class, means the investor will still participate if the overall market continues to rise — albeit minus the haircut of the capital gains tax.
Example No. 2: In March 2009, a rebalancing trade after the market crash re-allocated 10% of David’s portfolio into small-cap stocks. Now, more than nine years later, his small-cap ETF is up nearly 300%, and David is reluctant to sell or even rebalance, even though his small-cap allocation is now up to 14%, which is higher than he originally intended for a conservative growth portfolio.
Accordingly, David’s advisor sets a series of targets for sales. With a current price of $140 for his small-cap ETF, David and his advisor agree that they will sell 1% for every five points that the fund moves up or down. Thus, should it move to $145 he would sell 1%, at 150 he would sell 2%, up until a maximum target of 160, at which he would sell all 4% to return to his originally intended 10% allocation. And were small-cap stocks to have a pullback, the same will apply to the downside.
David doesn’t necessarily have to sell everything immediately — triggering all the capital gains — but at least he agrees that should small caps continue to rise, he can begin reducing his exposure while not immediately absorbing the entire shock of the capital gains. At the same time, should small caps or the overall market decline, David has a strategy to diversify out of his overweighting, and take some of his risk off the table.
Of course, a tolerance-band threshold approach to rebalancing can implicitly help to set similar upside and downside sale targets. Any time investments are outside of a certain range, such as when a 10% allocation falls below 8% or above 12%, it’s agreed to automatically rebalance. Thus, systematic rebalancing strategies can actually help prevent embedded gains from ever becoming so sizable in the first place — albeit not always, especially when all asset classes rise together.
For those who didn’t already have rebalancing thresholds in place, or otherwise found themselves with an overly concentrated investment allocation with big embedded capital gains, establishing sell targets as a form of pre-commitment device to get buy-in to a future decision to sell — which is usually less painful than just selling today and incurring capital gains immediately.
An important caveat to the strategy is that it still requires clients to actually follow through and sell when the time comes. It also requires that the market not move too abruptly — particularly to the downside — such that the investor doesn’t want to sell after the crash because they already feel it’s too late. One alternative to handle this challenge is to implement a cashless collar, by selling a call option at the upside sell targets, and buying a put option to cover the downside risk. This can trigger the sale simply by virtue of the options following their natural course.
Example No. 2b: Continuing the prior example, to help ensure that David follows through on his strategy, David’s advisor helps him sell a call option on the small-cap ETF at a strike price of 160, and buys a put option with a strike price of 120, in an amount equal to approximately 4% of the current allocation. Thus, if the price actually does rise above 160, the call option will likely be exercised and the shares will be triggered for sale. Meanwhile, if the price falls below 120, David can still exercise the put option to have the sell locked in at the 120 price.
Given that the call option being sold and put option being purchased are both almost equally out of the money, their cost would likely be similar — which means the premium received by selling the call option can cover most or all of the cost of buying the put option, thus ensuring that David will get a price no worse than 120 and no better than 160, with little to no net out-of-pocket cost for the guarantee.
Donate and replace: Another way to help investors work through highly appreciated investments is with a donate-and-replace strategy.
The basic idea, as the name implies, is to donate appreciated investments to a charity or, more commonly, a donor-advised fund, and then replace the investments by buying them back with outside dollars — i.e., those that would have been used for charitable giving anyway.
Example No. 3. Donna is very charitably minded, typically donating almost $10,000 per year toward various causes. She also holds a portfolio of investments with substantial capital gains, thanks to the recent years’ bull market run.
To help work through her cumulative capital gains, Donna makes a one-time $50,000 contribution to a donor-advised fund of her most appreciated investment: a small-cap fund that was originally purchased for just $20,000. By making the $50,000 charitable contribution, she receives a $50,000 tax deduction, and her $30,000 embedded capital gain disappears entirely.
Over the next five years, Donna then takes the $10,000 per year that she would have contributed to charity, and instead adds it back to her portfolio to replace the small-cap fund in her portfolio that was donated to the donor-advised fund in the first place.
To the extent that the donor-advised fund grows — given the funds can remain invested and even managed by the advisor in a DAF — and can cover six or seven years’ worth of Donna’s charitable giving, she can ultimately replace $60,000 or $70,000 of portfolio investments with new contributions. Each of these will consequently have a new higher cost basis set at the time that Donna makes the investment, rather than with the much lower cost basis and big capital gain from her original investment years ago.
The biggest caveat to the donate-and-replace strategy is simply that it only works for those who are already inclined to charitable giving and are actively making contributions. If there isn’t actually a charitable intent, it’s more advisable to hold the investment, sell it and pay the capital gains taxes — whereby the investor keeps 85 cents on the dollar after a 15% capital gains tax rate — rather than donate it for just a tax deduction but no longer have the money.
In addition, the strategy is generally only viable for those who are still accumulating and saving, and who can actually add dollars to the portfolio to replace the contribution. Though even retirees can donate appreciated investments to fund contributions they were making, even without replacing them, which in some cases is preferable to qualified charitable distributions from RIAs.
Also note that the donate-and-replace strategy only produces a charitable benefit for those who contribute enough to exceed the standard deduction and actually itemize in the first place. This is important, as with a new, higher standard deduction it’s harder for many taxpayers to itemize small, ongoing charitable contributions at all. On the other hand, charitable clumping of multiple years’ worth of donations via a donor-advised fund can already be a superior strategy for this exact reason. And this is only further enhanced by also whittling down exposure to the investments with the largest embedded capital gains as part of a donate-and-replace strategy as well.
Ultimately, for anyone who wants to use their investments while they’re alive, capital gains taxes must be reckoned with. And the economic value of deferring inevitable taxes is actually far lower than most investors realize, as deferral doesn’t actually save on taxes, it merely defers them. At typical growth rates, this often adds up to just basis points of value each year.
Nonetheless, it’s unappealing for most investors to pay taxes any sooner than they feel they have to. That’s because tax deferral does have some value, and because the mental challenge — i.e., the pain of paying taxes — matters in some cases as much or more than the personal economic impact.
Accordingly, educating clients better about the true and more limited value of tax deferral — combined with strategies like establishing a capital gains budget, setting targets to sell in stages or a donate-and-replace strategy — can help both ameliorate the actual consequences of capital gains taxes by navigating tax brackets and itemized deductions, and also make it mentally easier to simply sell the investment and accept the capital gains consequences.
So what do you think? How do you talk investors through the decision of whether to make a sale or investment change when there are significant capital gains on the table? What else, if anything, have you found that works? Please share your thoughts in the comments below.