How do we manage accounts when everything is up?
- With cooperative markets, many investors have accumulated substantial capital gains in their investment accounts.
- We analyze the trade-off between ideal allocation & paying tax to achieve it.
- In general, we advocate paying tax along the way to avoid over-concentration.
When I was growing up, my granddad had a tradition with his dozen grandkids. Each time school report cards came due, he offered $5 to each one of us who achieved top marks in conduct. Once, when I received a less than stellar report, I asked why he didn’t pay for A’s rather than behavior (it would’ve cost him less and made me more!). He said if all his grandkids would behave themselves and be respectful to their teachers, that would be a good problem.
My granddad was a farmer, not a financial planner, but I’ve thought about him lately when I consider another good problem. Financial markets are near an all-time high, that followed the longest bull market in history and one of the shortest recessions on record. Many of our clients took our advice to install new cash last spring, adding to the “problem” that in some cases, every single position in their portfolio is appreciated. For the vast majority of people I know who don’t get excited about paying taxes, this represents a good problem.
What Can We Do with Appreciated Stock?
We all know that retirement accounts, like 401k’s and IRAs, can be traded without respect to tax consequences; instead, they generate tax when we take distributions. But for non-qualified accounts, we must consider capital gains tax when we buy and sell. Generally, there are only three things we can do with appreciated securities.
- Give them away: When we donate capital gain property to charity, we get to avoid paying tax on the gain. We’ve written extensively about our love of helping you maximize the impact of your giving, and now is a great time to consider if this fits for you:
- Will them to heirs: By current law, your heirs receive a full step-up in basis for the property at your date of death. Depending on the composition of your assets and your age, holding low-basis stock until death can be a viable strategy.
- Sell & Recognize Gain: Most of the time it makes sense to keep appreciated stock. We can hold indefinitely with no tax consequence and choose when to sell, knowing we will generate a taxable gain upon sale.
What is Our Tax Management Philosophy?
If we don’t plan to hold stock for future giving or perpetually for our heirs, we like to have a game plan for tax management. As mentioned previously, we trade retirement accounts without respect to tax. With that in mind, considering taxes when managing a non-qualified account is, at its core, a trade-off between having our ideal portfolio allocation and the cost of generating some taxes. Our philosophy, then, is to minimize the risks and costs of living with this tradeoff. Several considerations go into the hold vs. sell decision in taxable accounts.
- Asset Allocation Drift: We’re strong believers that periodic rebalancing improves risk-adjusted returns over time. Each time we consider a rebalance, we weigh the tax cost of our trades vs. how far away from our target the allocation has strayed. For example, if we’re only slightly out of balance, we may delay trading until we’ve held some positions for one year and can take advantage of lower long-term capital gains rates.
- Portfolio Risk: In up markets, especially if the investor took advantage of an attractive entry point as was available last year, we must keep a close watch on equity asset class exposure and consider if the mix is still appropriate.
- Income Need: A chief driver of our activity is your individual income need. If your income is being covered by sources outside of your non-qualified account, or if we don’t expect to utilize it for income for years, we have a greater ability to tolerate risk.
- Tax Picture: The most important takeaway for our clients is that tax management is done best in collaboration. Unless we have an ongoing dialogue with you or your CPA, we can’t make informed decisions. Perhaps you’ve had a banner year and will be in a higher tax bracket this year; it may make sense to defer gains. Or perhaps your maternity leave lasted longer than expected; it may make sense to accelerate gains.
Is This a Year to Take Gains?
I liken tax management to a lecture I received on the first day of a difficult college course. The professor told us that his class is like eating ten pancakes a day. He said, “That’s pretty doable…but if you wait until each Sunday and try to eat seventy pancakes, it’s going to hurt!” Unless we have a valid planning motive to defer tax, we tend to like to take a little bit along the way. As with almost every financial planning scenario, we put great value on the flexibility this creates. In general, we try to limit gains in any one year and balance with losses if we have some to harvest. This year, there are fewer losses to provide this balance, and it’s likely we will advocate for some recognition of gains as we manage portfolios during the fourth quarter.
Do I Need to Increase My Tax Withholding?
One reminder we will leave you with is that your portfolio is your long-term income engine. Our goal is to have you positioned to maximize income generation potential at the time that it is needed. In many cases, especially for long-term investors, that engine outstrips the income you earn from your “day job.” We are great advocates for letting that engine cover any tax it generates in its growth. If this year ends up producing more portfolio gains than the last several, that’s a good problem, and we can distribute funds to help cover the tax. As with all tax planning, we can optimize best if we are in touch about your specific picture.
Ballast, Inc. is a registered investment adviser with the SEC. Registration with the SEC does not indicate that the adviser has achieved a particular level of skill or ability, nor is it an endorsement by the SEC. All investment strategies have the potential for profit and loss. Ballast, Inc. is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation.
