Author: Rick Bryan
Looking back over this year, one theme coming up in conversations with some of our newer clients is that many of them are sitting on highly concentrated positions in their portfolios.
What is a Concentrated Position?
A concentrated position is simply an investment, most typically a stock, encompassing an outsized percentage allocation within the portfolio. It’s not uncommon for me to speak with prospective clients who have 50% or 75% of their financial assets in one stock. Unsurprisingly, here in the Puget Sound, there are a lot of folks working for well-recognized tech companies owning outsized stock positions. Most of the time, these stock positions are accumulated over the years through equity compensation and corporate stock purchase plans. Less frequently, non-employee investors may own concentrated stock positions through inheritance or simply by riding spectacular appreciation over a decade or more (see Amazon and Apple Computer).
Whatever the reason for building up a concentrated position, it is an issue that eventually should be acknowledged and managed. Depending on the size of the concentrated position within the portfolio, if its concentration is significant enough, it can certainly amplify the risk within your portfolio due to the reduction of overall diversification and the assumption of concentrated company risk. Unfortunately, many investors with concentrated positions tend to downplay the risks, especially if the concentrated position experienced stellar performance in the past.
Addressing Concentrated Portfolios and New Capital Gains Tax
When we address the concentrated position issue with clients, in addition to outlining the portfolio risk factors, we will often frame the conversation around future liquidity needs. This is typically identified through a financial planning exercise, where we develop a strategic approach to managing capital gains.
And if risk issues and liquidity needs weren’t enough of a motivator, proposed tax law changes should hasten your game plan. The Biden Administration has proposed increasing the Federal capital gain rates on high-income earners from 20% (really 23.8% with the net investment income tax (“NIIT”) to 39.6% (or 43.4% with NIIT applied). The goal here is to more align capital gain taxes with ordinary income tax rates on high-income earners.
And, remember, these are Federal tax rates. Once you include state income taxes on top of the Federal capital gains rates, (see California, Oregon or New York), you could be looking at a total Federal plus state capital gain bite in excess of 50%. Historically, here in Washington State, we were fortunate to not deal with any state income taxes until January 1st, 2022, when the state instituted a 7% capital gains tax on long-term capital gains above $250,000 (gains generated from real property are excluded.)
Another Tax Law Proposal — Step-Up in Basis at Death Change
There is another tax law proposal on the table that could modify or eliminate the at-death step-up to the fair market value on inherited appreciated assets. Proposed changes to the current at-death step-up range from eliminating the step-up at death altogether to creating an exemption amount that would essentially limit the amount of at-death step-up per person. It will be interesting to see how this plays out in the handful of community property states where the surviving spouse can receive a step-up in basis on all community property.
Planning for Tax Reform
Historically speaking, taxation on investment income, including capital gains, is currently relatively low. Given the political desire to increase Federal and State tax revenue, the degree to which investment income is preferential might be changing for the worse for high-income earners. Kicking the can down the road could end up hindering you with respect to heightened portfolio risk, subpar returns, and a much higher tax burden. Now is the perfect time to work with your investment advisor and tax counsel on building a strategy with respect to your concentrated portfolio positions.