[Editor's Note: Today's WCI Network post is from The Physician on FIRE and addresses a common question that newly financially literate people often have, what to do with “suboptimal” or “legacy” investments. It can be difficult to decide whether to sell, keep, or give away these assets. In this post, POF walks us through his thinking on the topic.]
If you’ve got an ideal investment portfolio and you’re perfectly content with your asset allocation (the percentage of stocks and bonds), your asset location (where those funds are located, ideally in the most tax-efficient manner) and the choice of assets you hold, this post is not for you.
If, on the other hand, you are human and have made less than optimal choices in the past, or someone made them for you, I’d like to share some strategies you can employ to improve your portfolio’s positions without taking a big tax hit.
You may have purchased individual stocks when younger and are now ready to eliminate that uncompensated risk. If you’re like me, you might have chosen some random actively managed funds in a taxable account before realizing how tax-inefficient they can be.
You may have been gifted shares or inherited shares of assets that don’t align well with how your investor policy statement dictates you should be investing. Maybe you had a financial advisor who made investments that lined his pockets better than yours.
Whatever the situation, there are a number of ways you can choose to deal with it. Some will cost you nothing; others will cost you plenty but will benefit others. The good news is that you’ve got options and the sooner you take action, the quicker you’ll have a portfolio you’re happy to call your own. [My online course, Fire Your Financial Advisor! A Step By Step Guide to Creating Your Own Financial Plan is the quickest, least painful way to get a quality financial plan in place and to design a portfolio you're happy with for decades. – ed]
Suboptimal Assets in a Tax-Advantaged Account
Let’s start with an easy one. If the assets you no longer want in your portfolio reside in any kind of traditional or Roth IRA, 401(k), 403(b), 457(b), HSA, or similar account, you can sell what you like when you like without tax consequences, as long as the money stays in the account.
So if you’re holding funds with high expense ratios of a half-percent or more when there are index funds available to you that are 90% cheaper to own, you can simply sell the costly ones, buy the lower-cost ones, and there’s nothing to report or pay tax on.
If your retirement account only has lousy investment options, you can do the best you can with what you have available, and you can also lobby your HR department or whoever handles the retirement plan to switch to a better plan. I’ve heard of a number of people who have been successful in convincing their employers to offer a plan with better fund options.
Suboptimal Assets in a Taxable Brokerage Account
When holding assets outside of a tax-advantaged account, it gets trickier. When you simply purchase stocks, ETFs and mutual funds outside of a retirement account, you’ll typically hold them in what’s known as a non-qualified brokerage account, often referred to simply as a taxable account.
When you sell or exchange assets in a taxable account, if they have increased in value, you’ll owe taxes on the gains.
For review, what you paid for the asset is your cost basis. The difference between your cost basis and the price at which you sell represents capital gains, and capital gains are taxed in most situations.
If you owned the asset for more than a year, you’ll pay more favorable long-term capital gains rates. Capital gains from the sale of an asset held less than one year will be charged at the typically higher ordinary income tax rates.
If you have a taxable income of $80,000 or less in 2020 (as a married couple filing jointly — divide by 2 for individual filers), you’ll pay no federal income tax. If you earn more than that, you’ll pay at least 15% tax on the gains.
Above $250,000 in modified adjusted gross income, you’ll pay the additional 3.8% NIIT to help pay for the Affordable Care Act. If your taxable income puts you in the top federal income tax bracket, your 15% rate becomes 20%, and you’re actually paying 23.8% federal capital gains rates.
Don’t forget about state income tax. It’s rarely mentioned when capital gains taxes are discussed but states generally tax capital gains at the same rate as income. With state income tax in the 5% to 10% or higher range, many high-income professionals will have capital gains tax rates of 25% to 35% or so.
Do the Math!
Sometimes it makes sense to bite the bullet and pay those capital gains taxes. Calculate your total capital gains tax rate and look into the value of your unrealized capital gains.
Brokerage firms have been required to track this information since 2011 and may have tracked for quite a bit longer. If not, hopefully, you’ve got some paperwork that shows the price at which you bought.
Calculate how much it would cost you to sell the asset(s) you’re ready to part with.
Now, calculate how much it’s costing you annually to hold the asset(s). You should be able to look up the dividend yield and capital gains from the asset(s) in the year prior. Morningstar has a wealth of information, including the tax efficiency of thousands of funds.
How much did it cost you to own the fund? Would you be comfortable paying those taxes year in and year out, and presumably paying more annually as the asset continues to appreciate?
About five years ago, I was still sitting on some active mutual funds in a taxable account and I was hemming and hawing over what to do. I did the math and realized that the capital gains I would incur from selling them were equal to the tax implications of simply owning them for another 18 months or so.
My unrealized gains weren’t huge, and the fund had enough turnover and dividends that were costing me, anyway.
I decided to sell the old active funds and I bought a pile of Vanguard index funds with the proceeds. I also donated some of the most highly appreciated funds to start my first donor-advised fund in 2013.
When Recently Inherited
This is not something I’ve experienced personally, but it’s important to understand that assets inherited outside of a retirement account undergo a “step-up” in cost basis when transferred to heirs.
For example, if your parents had invested in Apple in the 1980s, Google in the 1990s, Netflix in the 2000s, Tesla in the 2010s, and left you with $20 million dollars in highly-appreciated stock upon their passing, I would love to hang out with you on your yacht.
While we sail the oceans blue, I would tell you that if you’re not interested in having so much of your net worth tied up in a few companies, the cost basis of those stocks was reset to the current value when inherited, so there would not be much owed in terms of capital gains taxes if the stocks were to be sold, at least not in terms of percentages.
While there will be more pressing issues and a grieving period when a loved one passes away, inherited stocks, bonds, and funds should probably be sold sooner than later unless they align perfectly with the portfolio you currently have.
Note that a jointly held account will only experience a 50% step-up in cost basis when one spouse passes away.
There can be asset protection benefits to joint ownership, but it can actually be a disadvantage when one spouse passes away. The surviving spouse would get a 100% step-up in cost basis if the assets had been fully owned by the deceased.
When Opportunity Zones Knock
The passage of the Tax Cut and Jobs Act created a new way for people to dispose of potential capital gains taxes.
Opportunity zones are areas on the map that the government has determined would benefit from private investment, and they’ve incentivized investors to do so.
When you sell an asset for a gain and take that money and invest it in an opportunity zone within 6 months, you can benefit from tax incentives.
The capital gains taxes are deferred and 10% or 15% of the tax will be forgiven if you remain invested for five or seven years. If you hold the investment for a full ten years, the capital gains taxes are permanently forgiven.
You shouldn’t let the tax tail wag the dog and make an investment solely for the tax benefit. It should make sense on its own.
While you can invest in an opportunity zone on your own by opening a small business or building apartments, crowdfunding platforms have made opportunity zone investing more accessible.
Give it Away. Give it Away. Give it Away. Give it Away Now.
Finally, if you’re feeling generous, giving can be a way to part with suboptimal assets in a tax-advantaged way. There are two ways you can do this; give to an individual or give to charity.
Gifting Appreciated Assets to an Individual
If you’re still alive after giving some stocks or funds to someone, and I hope you are, there will be no step-up in cost basis. You’re simply transferring the potential capital gains tax burden to someone else.
However, if that person needs the money and you’re in a position to give it, they’re probably in a lower tax bracket than you. Remember, the 0% capital gains bracket goes up to $80,000 for married couples and $40,000 for single filers in 2020.
Let’s say your 25-year old son in graduate school needs a reliable vehicle and you want to get him a $20,000 car. You could buy the car yourself and give it to him, but there’s a better way.
Take $20,000 worth of stock that has a low cost basis (it’s mostly unrealized capital gains) and gift that to your son. He can sell it using your cost basis and total holding period, collect the funds, and buy the car himself.
He’ll be responsible for the capital gains taxes, but without much earned income, he’ll easily be in the 0% capital gains bracket. At most, he’ll owe a little bit state income tax, depending on where he lives, and you will have flushed out some unrealized capital gains from your portfolio.
One does need to be careful gifting to one’s children aged 18 or younger or college students 24 and under. Trust tax rates apply, which can be much higher than capital gains rates.
Gifting Appreciated Assets to Charity
Capital gains disappear more easily when you donate appreciated assets to bona fide charities. You don’t pay them, and neither does the recipient. That’s all there is to it.
It’s important that you donate the actual asset and not the proceeds from the sale of an asset. This doesn’t work like opportunity zone fund investing, where you can sell and have a grace period before reinvesting the money.
When donating to charity, if you sell prior to donating, you’ll realize the capital gains and owe tax on them. Some charities — typically larger ones — are set up to readily accept donated assets. Smaller charities may have a more difficult time with it, but there’s a way to make it easy to give to any 501(c)(3) charity.
What I do is donate my appreciated funds with the highest percentage of unrealized capital gains to a donor-advised fund. From there, I can grant as little as $50 at a time to any of well over a million different charities in the U.S. that do good work both domestically and internationally.
It can be difficult to keep track of your various investments across numerous accounts, and it’s hard to know if you’re holding assets that are suboptimal if you don’t have a complete picture.
I use a combination of Personal Capital’s free portfolio tracking software that logs into all of my accounts simultaneously, and a customizable spreadsheet that helps me rebalance as needed.
You can download the spreadsheet by entering your email address below and sign up to use Personal Capital’s free service here.
What have you done to optimize your portfolio? Any tips or tricks I missed?