The current market environment has left many tax-sensitive investors with concentrated, highly appreciated assets in their portfolios. Unless they plan to donate or die holding these assets, they will eventually sell and pay taxes on the gains. The value added by deferring capital gains depends on the size of the embedded gain, the amount of time that gain can be deferred, the future return on the asset, and an investor’s current and future tax situation. Advisers might identify opportunities to add value by helping clients think strategically about managing capital gains.
Here are three reasons why now is a good time to start the conversation.
1. A Winner-Take-All Environment and Portfolio Concentration
The recent winner-take-all investing environment means that investors likely hold more concentrated portfolios than in the past. For example, consider the current individual security concentration levels in widely followed US stock market indexes. According to Goldman Sachs, the five largest stocks in the S&P 500 Index — AAPL, MSFT, AMZN, GOOG, and FB — now account for over 20% of its market cap. That exceeds the 18% concentration level reached in the tech bubble.
GOLDMAN: The 5 largest S&P 500 stocks “account for 20% of market cap, representing the highest concentration in more than 30 years… the further market concentration rises, the harder it will be for the S&P 500 index to keep rising without more broad-based participation”
— Carl Quintanilla (@carlquintanilla) April 27, 2020
Over the five years ending 20 May 2020, AAPL, MSFT, AMZN, GOOG, and FB were up about 145%, 290%, 489%, 161%, and 186%, respectively. If a taxable investor held any of these stocks over that period, they would have a large embedded capital gain, which might limit their willingness to reduce exposure. But as Michael Kitces points out, the value of waiting to realize a long-term capital gain is smaller than most investors think and easily trumped by the additional risk of holding an investment if it was otherwise desirable to make a change.
2. Potential for a One-Off Low-Income Year
Now could be a good time for certain investors to strategically realize long-term capital gains. Clients might consider this course of action when their current capital gains tax rate is lower than what they expect it to be in the future. Typically only a small cohort of investors stand to benefit from such strategies, specifically those who would need to have unrealized taxable gains on investments that are earmarked for sale in the next few years and have temporarily low income. Who would fit that bill? Maybe a recent retiree who expects to see their income jump in the future when Social Security payments and required minimum distributions begin, or an investor who experiences a one-off low income year due to temporary unemployment or business losses.
2020 Long-Term Federal Capital Gains Tax Rates
|Long-Term Capital Gains Tax Rate||Single Filers||Married Filing Jointly||Married Filing Separately||Head of Household|
|20%||Over $441,450||Over $496,600||Over $248,300||Over $469,050|
Note: There may be additional taxes on long-term capital gains that are not included in this table, such as an additional 3.8% Net Investment Income Tax and state and local income taxes. The Net Investment Income Tax modified AGI thresholds are as follows: Single Filers – $200,000, Married Filing Jointly – $250,000, Married Filing Separately – $125,000, and Head of Household – $200,000.
COVID-19–related business disruptions mean a substantial loss of income this year for many small business owners. Retirees may see lower income as well because the CARES Act allows them to bypass taking their required minimum distributions from IRAs and workplace retirement plans in 2020. Advisers should look for opportunities to help clients take advantage of temporarily being in a lower long-term capital gains tax bracket. For example, consider current federal tax rates on long-term capital gains and corresponding income levels in the United States.
If a small business owner is married filing jointly, and anticipates taxable income of $70,000 in 2020 but also plans to eventually sell a stock that would produce long-term capital gains of $10,000, they should consult their tax adviser about whether to sell it in 2020 when they are in the 0% federal long-term capital gains tax bracket, rather than waiting until 2021, when they anticipate their taxable income to jump back to the $100,000-plus range. The Internal Revenue Service (IRS)’s 30-day wash-sale rule does not apply when an investor sells a security at a gain. So if they wanted to keep the stock, they might consider selling it and immediately buying it back, booking the embedded gain at a favorable tax rate and resetting their cost basis higher for future sales.
3. An Opportunity to Offer Personalized Solutions
But here’s the caveat: While long-term capital gains are eligible for lower federal tax rates, they are still considered income for tax purposes. Capital gains can push an investor into a higher tax bracket, eliminate certain deductions or tax credits, reduce or eliminate Affordable Care Act subsidies, impact Medicare premiums, and affect the taxation of Social Security. Also there may be additional taxes on long-term capital gains, such as an additional 3.8% net investment income tax and state and local income taxes. Managing capital gains should be coordinated with a client’s tax professional and requires personalized advice, which will be a key theme for the wealth management industry going forward.
The recent “Earning Investors’ Trust” survey from CFA Institute found that 77% of retail investors are interested in more personalized products and services. Almost half said they would be willing to pay more for such solutions. The individualized planning required to successfully manage capital gains creates an opportunity for advisers to offer a personalized service to clients. It also helps advisers deliver value by coordinating with tax and estate planning professionals. That is something an investing algorithm can’t do.
A conversation about large unrealized capital gains could lead to discussions about portfolio risk and help advisers add value through the development of personalized tax management strategies, such as donate-and-replace or gift-and-replace strategies, offsetting gains with losses, and capital gains budgeting strategies.
So start a conversation about managing capital gains today.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / John Coletti
Professional Learning for CFA Institute Members
David L. Allison, CFA, CIPM, is vice president and founding partner at Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and investment performance measuring techniques. He has extensive experience managing investment portfolios for high net-worth investors. Allison is an active member of CFA Institute and the CFA Society of South Carolina, where he is a former president and currently serves on the board of directors. He holds a degree in finance from the University of North Carolina at Wilmington. Advisory services offered through Allison Investment Management, LLC. Securities offered through Triad Advisors, LLC. Member FINRA & SIPC. Allison Investment Management, LLC is a Registered Investment Advisor and is not affiliated with Triad Advisors, LLC.