Preparing for the Tax Cliff Ahead: Diversifying Concentrated Positions

With US tax rates potentially rising sharply in January, now is a good time to consider taking gains on concentrated stock positions and exercising stock options.

US taxpayers face a conundrum: No one knows what tax rates will be next year. But if Congress doesn’t act, tax rates on ordinary income, investment income, short- and long-term capital gains, gifts and estates will rise sharply next year.

Perhaps none of this will happen. But the prospect of sizable tax hikes next year increases the potential benefit of realizing taxable income and gains before year-end. Here, we discuss the potential benefits of taking gains on concentrated positions in low-basis stocks and options. In future blog posts, we’ll discuss other tax strategies.

Our proprietary Wealth Forecasting SystemSM projects a modest after-tax benefit—some $27,000 per $1 million invested, over five years, after adjusting for inflation—from harvesting gains in a diversified portfolio in advance of a capital-gains-tax hike. The benefit could be much larger for investors with large, concentrated positions in low-basis stocks. We peg the five-year benefit of locking in today’s low capital-gains rate at $148,000 per $1 million, in inflation-adjusted terms, as the display below shows.

Quantifying the Potential Benefits of Realilzing GainsTax considerations aside, diversifying concentrated stock positions is usually a good idea, given the volatility of single stocks (roughly twice that of the market in aggregate) and the danger of relying too much on the fortunes of a single company. Think TWA, Pan Am, Polaroid and Wang Laboratories. All were industry leaders in their day, and all were consigned to oblivion or acquired at distress-sale prices.

Diversifying isn’t the best decision for all investors all the time. For example, there’s no tax advantage in accelerating a gain on a stock that you intend to hold for life and leave to heirs who would benefit from a step-up in cost basis.

The benefit of taking advantage of today’s income tax rates may be even greater for holders of stock options grants, since options (unlike stocks) must be exercised within a specified timeframe. We estimate that for an executive with large stock option grants the median five-year benefit of exercising this year would be $189,000 per $1 million, in inflation-adjusted terms. The benefits of accelerating gains may also apply to illiquid holdings, such as a business or real estate that an owner is contemplating selling in the not-too-distant future.

It can be emotionally difficult to part with a long-held nest egg, and the economic issues are complex and should be considered in light of each individual’s unique circumstances. Before making a decision about diversification or realizing gains, investors should have a thorough discussion with their tax, legal and financial advisors.

Bernstein does not provide tax or legal advice.

The Bernstein Wealth Forecasting System, driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.

Daniel B. Eagan

Daniel B. Eagan is a Managing Director and the Head of Bernstein’s Wealth Management Group; he assumed his current role in 2011. A member of the Private Client Investment Policy Group, Eagan joined Bernstein in 2001 as a senior portfolio Manager; in 2003 he assumed the leadership of Bernstein’s private client practice in the Northwest. Prior to joining the firm, Eagan was a senior portfolio manager and managing director with BlackRock for seven years. From 1986 to 1994, he worked in investment consulting, most recently with Mercer Investment Consultants. Eagan earned a BS in finance from the University of Illinois and an MBA with distinction from DePaul University.

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