Tax Strategies for Selling Winning Stocks

Tax Strategies for Selling Winning Stocks

Selling Winning Stocks: Tax Strategies

What are some strategies for selling your winning stocks? Say you bought Apple or Tesla a couple years ago, and now it is 20% (or more!) of your portfolio. What should you do?

What a nice problem to have! I’ll say that it is a pretty common problem, as people tend to sell their losers and hold their winners. Many people I know have invested in some single winner stocks and have outsized gains to deal with.

Let’s look at some tax strategies for your winning stocks.

It’s a Matter of (Low) Basis: The Definition of Highly Appreciated Stock

Highly appreciated stock strategies involve stocks with a low basis. A low basis means it was worthless when you bought it. So, now, if you sell it, you will owe long-term capital gains on the appreciation between the basis (price you purchased it at) and the current price.

Basis is the purchase price. It may not even be that it was cheap when you bought it, but it just has had explosive growth. I don’t think Apple or Tesla has looked cheap in a long time!

The definition of highly appreciated stocks: stocks that will have significant capital gain tax implications if you sell them to diversify your concentrated stock position. Your winning stocks are highly appreciated.

So, many people are asking what to do with their winning stocks. Let’s find out first: do you need to do anything?

What If You Lost It All?

What if your winning stock went to zero? What if you lost it all?

One saying I like: you get wealthy through concentration and stay wealthy through diversification.

This usually applies to entrepreneurs who start their own businesses. No, they don’t fund a 401k or have other investments. Instead, they put 100% of their time and money into their business endeavor. When it (rarely!) works out, they become wealthy. If they stay concentrated and continue to re-invest just in their business, they either get extraordinarily wealthy or lose it all… and start over again. This is concentration, and it creates wealth.

Many people have concentrated positions in their brokerage accounts after dabbling in stocks. Again, we tend to sell losers and let our winners ride. Now, they have massive capital gains taxes due if they sell. Remember: gains are just on paper until you sell and lock them in. But, given that only death and taxes are inevitable, what might be gained by deferring those capital gains? Or…

Consider the flip side: what if you lost everything? The money is not yours until you sell. If you don’t sell: how bad could it be?

If the highly appreciated stock is 20% of your net worth, but you have plenty to retire regardless of whether it goes to zero, it doesn’t matter what you do. You can ride that winner to the moon. Or crash and burn.

But if you need that money to retire, you must be very careful and… be honest with yourself. You created wealth through concentration. Now it is time to diversify: take some money off the table. Recognize the gains, pay the taxes. Diversify. Move on.

If you can’t afford to lose it all, it is time to diversify.

How might you do that? Next, let’s look at some strategies for diversifying highly appreciated stocks.

Tax Strategies for Selling Winning Stocks

Here are some tax strategies for selling winning stocks:

  • Hold them until you die and get a step up in basis for your heirs
  • Donate them to charity or your DAF
  • Use a CRUT for current or future income
  • Upstream Gifting (give them to your parents to get a step up in basis at death)
  • Hedge via put options or collaring (will get expensive if everyone is doing it)
  • Tax Loss Harvest like crazy (hard to do in an extended up market)
  • Bite the bullet and sell some now and the rest later – pay the taxes and move on!
  • Sell yearly up to an optimal capital gains bracket
  • Lose out on Oil and Gas, Opportunity Zones and/or Conservation Easements to get a deduction
  • Sell on a year you otherwise have a significant deduction
  • The best strategy for diversifying winning stocks may be directed indexing

Because I’m wonky, I want to dig in on some of the above specific strategies for highly appreciated stocks.

Specific Tax Strategies for Selling Winning Stocks

Charitable Bunching and DAFs

Given the high standard deduction, it is best to bunch charity into every other year (or less).  Giving away your highly appreciated stock to charity is a great way to re-set the basis. Consider a Donor Advised Fund (DAF). Use the cash you were going to donate to buy stocks at today’s higher basis, and give away the low basis stock that the charity can sell tax-free. Win-Win. Some call this flushing out gains. I have a blog you might want to check out on optimal giving to charities.

Optimizing Capital Gains Tax Brackets

Remember that capital gains stack upon ordinary income. There is a parallel, and some would say evil system of taxation for capital gains. Breakpoints to consider: the top of the 12% ordinary bracket (where you can capital gain harvest and pay no taxes), up to the top of the NIIT surcharge (250k married, 200k single), and up to the top of the 15% (or more accurately when 18.8% becomes 23.8% including NIIT) bracket. This 15% to 20% capital gains transition is pretty near the top ordinary marginal tax bracket (currently 37% but soon 39.6%). See why I called it evil?

The idea here: figure out where your next breakpoint is, then sell enough of the low basis stock to fill up your current capital gains bracket. This could save you 15%, or 3.8%, or 5% on taxes and is worth looking into every December with your CPA if you have highly appreciated stocks. Evil.

CRUT into DAF

Finally, I really like taking a ton of highly appreciated stocks and turning them into an income stream. With an irrevocable transfer into a charitable remainder trust, you can sell the low basis stock and diversify your investments tax-free. You get current income (or future income—these can be pretty nice given low current interest rates) which is taxed at capital gains rates. You also get a nice tax write-off the donation year, which means jumbo partial Roth Conversions that year. Of course, see your qualified estate attorney for trust and tax advice. Or, if you don’t care what happens to the remainder, visit your favorite local charity, university, or hospital. They will happily set up a gift annuity for you.

With a CRUT, think about leaving the remainder to your children’s DAF. They can donate the remainder during their lives, saving them money as they can spend theirs and donate yours—a CRUT into DAF. Brilliant move today for highly appreciated stocks if you want income, a present-day write-off, and future charitable donations for your children.

The Best Highly Appreciated Stock Strategy: Direct Indexing

Direct indexing is taking the investment industry by storm and is the best highly appreciated stock strategy. I suggest you get familiar with direct indexing and learn about the pros and cons.

Direct indexing has been around for a couple decades but is now more accessible to the individual investor. Technology, fractional shares, and feeless trading of equities all bring direct indexing into the present.

To be clear, index-based ETFs are the gold standard in investing. They are inexpensive, diverse, and very tax-efficient.

Direct indexing must be pretty special to beat a portfolio of 2-6 ETFs in a brokerage (taxable) account. We will discuss the Pros and Cons of direct indexing below, but first, what is direct indexing?

What is Direct Indexing

Say you want exposure to the S&P500. Instead of buying an ETF, you could own just 80-150 stocks in the index representing the whole.

The idea is that if you buy representative stocks from an index, you can get the same returns and that the “tracking error” (the difference between the index and your direct index) is minimal.

These days, direct indexing can be extraordinarily inexpensive and tax-efficient and will be available to non-advised (DIY) investors.

The tax efficiency comes from tax-loss harvesting. When one of your stocks is down, you can sell it and buy a similar stock from the index that will have the same tracking error. This allows you to recognize the loss that year on your taxes and re-sets the basis lower in the new position. Note that if you sell that position in the future, you will pay those deferred capital gains, but tax paid tomorrow is usually better than tax paid today!

Also, say you want an ESG portfolio, or a portfolio with a value or momentum or other tilt. It is easy to pull some levers when you set up your account and just select the equities that meet your criteria.

There are many Pros to direct indexing. Let’s look at them now.

 

The Pros of Direct Indexing

ESG-

You can exclude gun manufacturers, pharmaceuticals, dirty energy, or any other evil corporations you wish

Tilts-

You can select for momentum, growth, value, quality, or any tilt you wish

Diversify from your profession-

Say you work in an industry that is cyclical and might go down at the same time you lose your job; you can exclude your company (or even your industry) in your direct index

Diversify a concentrated position-

Moreover, if you have gains from stock options or equity reimbursement, you can diversify away from that position. If these positions have low basis, you can recognize other losses and sell your gains over time to minimize current capital gains tax

Diversify from old, tax-inefficient mutual funds-

If you have large gains in old fashioned, expensive, tax-inefficient mutual funds, you can get rid of those overtime without recognizing the gains and essentially buy back the individual holdings of that fund, if you like

High taxes now-

If you are in the 23.8% capital gains tax bracket now but likely will have access to the zero or 15% bracket later, you might defer your capital gains with direct indexing

Moving to a low tax State in retirement-

Similarly, if you are moving away from a high tax state, paying your taxes later may make sense

 

The Cons of Direct Indexing

There are, of course, important cons to direct indexing that need discussed.

Defers the gains-

Understand that tax-loss harvesting just defers the gains. This is great if you get a step-up in basis at your death or want to give them away to charity, but eventually, someone will pay the taxes

Complexity in Statements-

An ETF may have a page of gains and losses, whereas you will kill multiple trees printing out your statements from a direct indexing account. All of the positions, all of the lots, while it is easy for technology, it is not easy for a mere human to sift through

Complexity in Taxes-

…let alone your tax professional. Give them the 280-page 1040 from your brokerage account and see the look on their face

Becoming Locked In-

Eventually, after about ten years, you will have nothing but gains in your account and thus will no longer be able to tax loss harvest. At that point, you have 80-200 individual positions you need to manage instead of 2-6 ETFs.

Complexity when Locked In-

And this complexity is a massive downside. Eventually, you will be locked into your portfolio. By “locked-in,” you will have painful, significant embedded capital gains that you need to recognize if you wish to use the money before dying and getting a step-up in basis.

Instead of having 2-6 ETF positions, you might have 150 individual equity positions. That’s a lot of decisions that need to be made and a lot of complexity for the older you!

What will you be doing in 10 years? What is your need for income? How to treat the multitude of individual positions? Will that company go bankrupt?

The idea with a broad market ETF is that you buy it when you have the money, and you sell it when you need the money. Then, you leave it behind for your heirs to get the step-up in basis. In that setting, the deferred capital gains you have are significant: no one ever pays the taxes on them!

But if you have 120 individual positions, you will need to decide individually which ones you will sell when you need the money and which you leave behind when you die.

What if you don’t die for another 30 years? Are those individual companies still going to be around in 30 years? We know the total market ETF will be there and will be valuable, as it has a self-cleaning mechanism.

True, individual stocks in an index ETF do go to zero, and you lose the value when they do. But since these ETFs are Cap Weighted, you have less and less to lose as their price goes down. “You” sell when they decline in value and buy those stocks that replace them and increase in value.

When you own the individual equity outright, you ride it to zero without getting out along the way.

 

Summary: Direct Indexing for the DIY Investor

In summary, consider where you will be in 10 years with your direct index.

What will you do with the 100’s of individual equities rather than the 2-6 ETFs over time? Will you be more likely to need someone to manage your account (and thus have the additional expense in the future)? Will you be willing to trim your losers, knowing the psychological headwinds? Can you let your winners ride to be inherited or given away at low basis?

If you have an indication for direct indexing (large capital gains you want to mitigate, or you currently live in a high tax state but are moving and retiring to a lower tax bracket—this is tax bracket arbitrage), you might consider direct indexing as a DIY investor.

Returns are not expected to be better with direct indexing than investing in ETFs. Can you get some tax alpha with direct indexing? Perhaps, but the cost is complexity when all is said and done.

 

Tax Strategies for Selling Winning Stocks

Many people have done exceptionally well with individual stocks as the tide has risen. It has raised all boats. It will not rise forever, and Apple and Tesla will go down in price, eventually. Remember the fallacy of time diversification: stocks are actually more risky the longer you hold them.

Do you want to hold them until you die and get the step-up? What if that was your strategy with GE, Sears, Kodak, Enron, or more than half of the Dow Stocks from just 20-30 years ago? Your children would not be happy with the result.

Holding the S&P 500 or a Total Market Index fund is a much better idea in the long run. If those go to zero, then we have more significant problems on our hands than stock prices or sunk boats.

As the tide provides highly appreciated stocks for you, so will the tide take them away. And only when the tide goes out do we see who is swimming naked (not diversified, that is). This is behavioral investing 101.

Concentration can make you rich, and concentration will take it away too. Recency bias makes you believe you are a good investor, able to pick stocks or even time the market. No, no you can’t. No one can. Remember that Chaos theory rules the market.

If you don’t need the money, it doesn’t matter what you do. But if you need the money to retire before the tides, please sell your winning stocks.

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