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Capital Gains Tax Proposal a Wake-Up Call to Assess Concentrated Holdings

Letting concentrated positions ride is a classic case of putting the tax cart before the horse.

“Phew, it looks like I’ll dodge that tax hit.”

If you’re like most investors, that thought crossed your mind as you read the fine print about President Biden’s proposal to increase the tax rate on long-term capital gains.

On the surface, the proposed increase looks significant--and it is. The top capital gains rate would nearly double, to 39.6% from 20% currently, and the additional 3.8% Medicare surtax that currently applies would bring the highest capital gains tax rate to 43.4% from 23.8% currently. In addition, the “step-up” in cost basis after death--the ability of heirs to claim an inherited asset’s value upon date of death as their cost basis--would apply only to the first $1 million of a deceased person’s assets.

But here’s where the “phew” part comes in for many of us: The proposal will have to get through a divided Congress first. And even if it passes, most people will never pay the new, higher tax. That’s because it will be levied only on people who have incomes of more than $1 million--estimated to be just 0.3% of U.S. taxpayers. And in any case, most middle- and upper-middle-income investors hold the bulk of their assets in retirement accounts (where capital gains taxes are a nonissue) rather than in taxable accounts.

Yet even if you won’t be on the hook for them, the prospect of a higher capital gains tax rate can be a healthy prompt to reconsider highly appreciated, long-held positions that may be taking up an unhealthy share of your portfolio. Many investors have such holdings, an outgrowth of the long-running rally in stocks, but they may be reticent to lighten up on them for tax or other reasons.

That’s shortsighted. Capital gains rates are at historically low levels, as low as 0% for investors in the lowest tax brackets and 15% for most others. More important, hefty positions in individual holdings can introduce significant risk into an investment plan. Neglecting to lighten up on them because of the potential tax bill is a classic case of putting the tax cart before the investment horse.

Behavioral Issues Abound

Behavioral factors likely explain, at least in part, why some investors might be disinclined to lighten up on long-held positions that have appreciated a lot since purchase. Whether their holdings are concentrated or not, investors may be hesitant to part with winners.

Moreover, highly concentrated positions are often “special situations” to which the investor has an emotional attachment. Many investors have concentrated holdings in their employer’s stock or the stock of the companies they started themselves. Their views on the stock may be hopelessly intertwined with their views on their workplace, colleagues, and their own contributions to the company’s growth.

Alternatively, concentrated positions may arise following an inheritance: You may have an emotional attachment to a stock because it was a position your loved one tended to, talked about, and wanted you to have.

Further complicating matters is that such positions often have a “mad money” quality to them: They may have been inherited from a relative or granted by an employer as a bonus in addition to salary. Because the gains weren’t necessarily expected, the investor may not have any expectations about prospective gains or losses, either. The holdings may not even be formally considered part of the investment or financial plan. Such mental-accounting considerations can complicate rational decision-making.

Asymmetric Decision-Making

Another potential headwind to de-risking concentrated positions is the asymmetry of information about the wisdom of selling. The capital gains taxes associated with selling are eminently quantifiable, whereas the benefits or selling pre-emptively are merely theoretical and not at all guaranteed.

To use a simple example, let’s say you purchased 1,000 shares of a non-dividend-paying stock for $50 a share in early 2000. Fast-forward 20 years, and the stock price now sits at $250. If you were to sell, you’d owe tax on the appreciation of $200,000—the spread between the initial $50,000 you sunk in and the $250,000 value of your holdings today. Even at today’s low capital gains tax rate, that’s still a $30,000 tax bill for investors in the 15% tax bracket.

The stock would have to drop by more than 12% for selling pre-emptively to be worth it. And if the stock subsequently goes up after your sale, you’d be out the $30,000 in capital gains taxes, plus any additional appreciation that you could have earned if hadn’t sold. Is it any wonder so many investors sit tight with concentrated holdings?

What Are the Risks?

At the same time, concentrated holdings can add significant risk to a plan. Notwithstanding well-publicized blowups in market history--Enron, Worldcom, and so forth--it’s not unusual for companies to badly underperform the broad market, harming investors who bet heavily on them.

My colleague John Rekenthaler recently examined the performance of the 5,000 biggest U.S. stocks between 1991 and 2000. He found that 42% of those stocks finished in the black, while 36% had losses and another 22% vanished altogether. Some of those vanished companies were acquired and generated a decent result for their shareholders, while others were delisted. In any case, the risk of a bad outcome wasn’t insignificant.

Similarly, researchers at JPMorgan found that between 1980 and 2014, roughly 40% of all stocks in the Russell 3000 Index had suffered a permanent decline of more than 70% from their peak values. The "catastrophic loss" percentage was even higher in volatile industries like technology and biotechnology. The researchers also found that the return on the median stock in the Russell 3000 Index was 54% less than the return on an investment in the index itself.

In other words, if you choose well and/or have some luck on your side, you may be able to start enjoying retirement at age 46. If you choose poorly and/or you’re unlucky, the consequences could badly derail your plan.

Moreover, if you own mutual funds alongside your concentrated position of a widely held stock, you could be magnifying your exposure not only to that stock, but also its investment sector and investment style. Those concentrations may work to their investors’ benefit, as has been the case for investors with a lot riding on growth-leaning stocks, especially technology names, over the past several years. But they can also work against them, as poor energy-stock investors can attest.

What to Do?

Given that we've already enjoyed a long-running bull market, it’s not a bad time to assess your portfolio for excessive concentration. Definitions of "concentrated" vary, but a position that exceeds 10% of your portfolio is a reasonable threshold for “too much.”

If you determine you have too much concentration in a name or two that you’d like to lighten up on, start by considering the company's fundamentals: its valuation alongside its growth prospects. If the company seems egregiously overvalued, that’s a case for lightening up all in one go, as soon as possible. Just be sure to consider the tax effects of doing so; you could push yourself into a higher tax bracket in the process. (If you happen to have high deductions or find yourself in a low-income year, that embellishes the case for selling all at once.) Life stage is also important: If you’re in the process of formulating your retirement plan and will need to be able to rely on the funds from your concentrated holdings, that argues for de-risking straightaway rather than waiting around for additional gains.

On the other hand, if your holding isn’t extremely overvalued or is inexpensive, a more deliberate approach, like selling chunks of the holding over a predetermined period, may make sense. That has two potential benefits: It allows you to spread the capital gains taxes over a period of years and it can help minimize the regret you might feel if you sold all at once and the stock went on to soar.

If minimizing the tax bill associated with the holding is top of mind, there are a few additional strategies to consider, apart from selling outright and moving the money into something better-diversified. One is to use an exchange fund, which enables the concentrated stock investor to swap into a better diversified mix without paying taxes, assuming the investor holds the exchange fund for at least seven years.

Highly appreciated positions can also be prime candidates for charitable giving. A charitable gift of appreciated, concentrated stock delivers a potential "four-fer" on the planning front: It removes the tax obligation associated with the position, the value of the donated position is tax-deductible, it reduces risk in the portfolio, and it helps the charity. Larger charities can readily accept and dispose of individual stock of public companies. But if you’d like to donate to a smaller charity and/or contribute a less liquid position, a donor-advised fund can be a great option.

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About the Author

Christine Benz

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Christine Benz is director of personal finance and retirement planning for Morningstar, Inc. In that role, she focuses on retirement and portfolio planning for individual investors. She also co-hosts a podcast for Morningstar, The Long View, which features in-depth interviews with thought leaders in investing and personal finance.

Benz joined Morningstar in 1993. Before assuming her current role she served as a mutual fund analyst and headed up Morningstar’s team of fund researchers in the U.S. She also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

She is a frequent public speaker and is widely quoted in the media, including The New York Times, The Wall Street Journal, Barron’s, CNBC, and PBS. In 2020, Barron’s named her to its inaugural list of the 100 most influential women in finance; she appeared on the 2021 list as well. In 2021, Barron’s named her as one of the 10 most influential women in wealth management.

She holds a bachelor’s degree in political science and Russian language from the University of Illinois at Urbana-Champaign.

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