Investors with concentrated positions may be able to leverage a tax-aware strategy that seeks to reduce single-stock risk.
Maria has a great problem. As a result of working at a tech company for the last 15 years, she has amassed a multi-million-dollar position in her company’s publicly traded stock through a combination of buying shares using the employee stock purchase plan and stock option grants. Maria has now decided to retire from the company and meet with a CERTIFIED FINANCIAL PLANNER™ professional.
Although she has built significant wealth, her retirement plan has a major risk: over 80% of her net worth is in this one stock. And while she could sell some or all the shares, doing so would trigger capital gains taxes. Depending on her income, those capital gains taxes could range from 15 to 23.8% at the federal level and even more should she live in one of the 42 states that impose a state income tax. Due to significant appreciation in the shares, she would face significant tax costs.
Fortunately, there is a solution. When Maria meets with her CFP® professional, she learns about a unique approach that would make it possible for her to easily diversify from this one holding to a broad-based market exposure, without taking on an additional tax burden now. Exchange funds are private investment funds designed for long-term investors seeking to reduce their concentration in a particular stock without triggering a taxable event.
Not to be confused with an exchange traded fund – an exchange fund allows investors holding a concentrated, publicly traded stock position to exchange their stock into a fund and in return receive an ownership stake in a partnership that seeks to mimic the return of an index (e.g., the U.S. total market or S&P 500) while avoiding capital gains taxes. Essentially, this allows the investor to mitigate single-stock risk by exchanging low-cost basis concentrated positions for an investment in a more diversified portfolio.
|Investor Example: Maria|
|Obstacle: Concentrated Position||
Solution: Exchange Fund
How an Exchange Fund Works
To get started, Maria first has a conversation with her CFP® professional who needs to verify that she is an accredited investor (an individual who has a net worth over $1 million and an income over $200,000). Then the advisor needs to determine if there is an exchange fund with the capacity to accept shares of her company, as exchange funds use new stock additions to help rebalance to meet their objectives. These Exchange Funds do not always have capacity to take certain shares. This can vary from fund to fund as well as over time.
Once both conditions are met, Maria and her advisor walk through these additional details as part of an overall plan, which will include working with her tax professionals:
- As per IRS regulations, she will need to stay invested in the fund for 7 years to get the tax deferral benefit, after which time she can either remain in the fund or choose to receive a diversified pool of stocks, with her original basis spread out amongst these positions.
- Also, per the regulation, the fund must invest at least 20% in “qualifying assets,” which are neither publicly traded stocks or bonds (but could be real estate, for example).
- Funds have their own management fees that can reduce her overall return.
- The strategy is complex, often with lengthy subscription and prospectus documents.
Is an Exchange Fund Right for You?
So how can you know whether the exchange fund strategy makes sense for you? While this solution may work for some investors who have a concentration risk like Maria in the example above, each investor needs to weigh the advantages of instant diversification and capital gains tax deferral against the disadvantages such as liquidity restrictions, fees and complexity.
To find a CFP® professional with experience using the exchange fund strategy and determine if this strategy is a good fit for you, visit LetsMakeAPlan.org.
Disclosure: Anecdote is an example only and any similarity to real life situations is purely coincidental. Participation in an Exchange Fund involves risks and restrictions that would be disclosed within the specific fund participation documents.