Down markets are not a time to ignore the risks and reality of maintaining concentrated positions in one or a few stocks. Instead, you have an opportunity to use these events to diversify and manage your holdings, especially company stock holdings earned as part of your compensation, as tax efficiently as possible.
In general, there are two strategies that can help you make the most of declining share prices. With the help of an experienced financial advisor, you can leverage these strategies to manage the tax implications of changes to what can be a significant portion of your overall wealth.
If you receive restricted stock units (RSUs) from your employer, those RSUs convert to shares of company stock on the day they vest. If the stock price declines after you gain ownership of those shares, you have an unrealized loss from those holdings. The loss is unrealized because you have not yet sold that stock. This situation can create opportunities to use some or all of those unrealized losses to offset unrealized gains from other investments in your portfolio.
RSUs tend to be granted over time with vesting schedules set by the company. Once RSUs vest, you take ownership of the underlying stock. The cost basis of the company stock you receive will depend on the share price on the date those RSUs vest.
If you are like many investors, you may have an aversion to selling appreciated assets and realizing taxable gains from those transactions. Taxes are an understandable concern in financial planning, which is why managing assets in a way that also manages taxes can be so important.
This is where you can turn market declines into tax planning opportunities. If some of the stock you have received via RSUs is worth less than it was on the day the RSUs vested, the amount of that loss is considered an unrealized loss because you have not yet sold the stock. If you have other holdings elsewhere in your portfolio that have increased in value, those holdings have unrealized gains.
Let’s say you need to diversify your portfolio to reduce the concentration in company stock or you need to liquidate assets for some planned future expense, like a home purchase. You can create a “tax-neutral” transaction by selling your company stock at a loss and using those losses to offset any taxable gains from the sale of any appreciated shares in your portfolio.
It is important to note that you can do this even if you do not want or need to sell appreciated stock holdings this year. You simply sell your company stock and carry forward those realized capital losses to offset future realized capital gains.
This type of loss harvesting can help you manage your current and future tax bills and gives you extra flexibility when considering future investment decisions.
Two other tools to consider for tax management are Net Unrealized Appreciation (NUA) and Net Unrealized Depreciation (NUD). NUA is a tax benefit available if you own appreciated company stock in your 401(k) plan account.
NUA allows you to withdraw that company stock from your 401(k) account when you leave the company with the cost basis of the stock taxed as ordinary income. Any company stock price appreciation is subject to long-term capital gains tax rates, which tend to be much lower than income tax rates.
This can yield significant savings in taxes and represents the real benefit of NUA. By contrast, 401(k) withdrawals made after age 59-1/2 that come from any non-company stock holdings are taxed in their entirety as ordinary income.
For example, let’s say you have 1,000 shares of company stock in your 401(k) plan that were awarded as a matching contribution at $10/share worth $10,000. By the time you retire, those shares have doubled in value to $20/share worth $20,000. Thanks to NUA, instead of paying ordinary income tax on the total amount when you sell those shares and withdraw the proceeds, you would pay income tax only on the original value of the shares ($10,000) with the appreciation (another $10,000) taxed as capital gains.
To take maximum advantage from NUA, you need to make use of NUD. NUD allows you to make moves to set the lowest possible cost basis for company stock in your 401(k) plan. This is important because achieving the lowest cost basis means that more of the dollar value of your company stock withdrawals from this account will be subject to the capital gains tax rate rather than your ordinary income tax rate, which is likely to be much higher.
Here is how to accomplish this. If you are holding any company stock that has declined in price since it was deposited in your 401(k) plan account, you can use NUD to “reset” the cost basis for those shares. NUD allows you to sell those shares at a loss when the stock price goes down far enough then repurchase those shares at a lower price.
You can complete this transaction over the course of two days, during which any price movements are likely, but not guaranteed, to be minimal. The result is a lower cost basis and a greater potential for favorable NUA tax treatment in the future.
These are just two situations where smart tax planning can take the sting out of investment losses and create opportunities for greater portfolio diversification. By taking action now, you can enjoy larger gains on your assets in the future. So don’t sit on the sideline wondering what you can do about falling stock prices, schedule a call with Blue Chip Partners to discuss how smart tax management fits into your overall financial plan.Disclaimer: