Morgan Stanley
  • Wealth Management
  • Jan 12, 2023

4 Tax-Smart Ways to Diversify Your Portfolio

Investment portfolios concentrated in a single stock can be risky. Learn to diversify without boosting your tax bill.

Daniel Hunt Senior Investment Strategist, Morgan Stanley Wealth Management

Many investors find that their portfolio has an outsized amount of a single stock. They may have received shares as compensation through work, inherited the shares or simply made a fortunate early investment in a successful company. While such concentrated holdings have the potential to generate a great deal of wealth, they can also pose significant risks. 

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Take, for example, an investor who rises to a senior management role at a major retail chain and builds a sizable equity position in the company. She retires at 65, when the stock price is $50 per share. However, the company’s failure to adapt to the shift to e-commerce and the sudden departure of a longtime CEO causes the share price to plummet to $10 several years later. Because she has large amounts of her net worth concentrated in the stock, this disruptive change threatens to wipe out much of her wealth and put her financial goals in jeopardy. 

While such concentrated holdings have the potential to generate a great deal of wealth, they can also pose significant risks.

While this fictitious example may seem extreme, the risks of concentrated stock positions are quite real, and they are not limited to losses. If the stock performs well, investors can trigger big income tax liabilities when they sell, because they will likely owe income taxes on the difference between the price at which the shares were acquired and at which they are sold.

Fortunately, there are strategies that can help you successfully diversify out of a concentrated position in a tax-smart way. Here are four:

1. Equity exchange funds, for example, offer qualified investors1 a tax-deferred option, allowing them to place a stock that has gained significant value into a pooled vehicle with other investors in similar situations. Each investor can receive interests in the exchange fund, representing a proportional share of the newly created diversified basket of securities. The aim is to provide immediate diversification without incurring immediate capital gains taxes. 

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The downside to exchange funds is limited liquidity. If you hold the interests for seven years, you can withdraw your share of the pool, with realized gains calculated pro-rata over the entire portfolio. However, if you withdraw early, you’ll likely face hefty fees. 

2.   Tax-loss harvesting with separately managed accounts allow investors to employ a staged diversification strategy that may reduce the net capital gains of a concentrated stock or security position over time for federal income tax purposes. The investor can “harvest” unrealized investment losses in one account to offset net capital gains from the sale of concentrated stock or securities in another account, potentially reducing the federal income tax liability.

3.   Giving shares to family members using annual federal exclusions and lifetime gift tax exemptions, offers diversification and an opportunity to support loved ones. For 2023, the annual federal gift tax exclusion is $17,000 per individual or $34,000 per married couple who elect to split gifts, and the lifetime estate and gift tax exemption is $12.92 million per individual or $25.84 million per couple.2,3

Donating shares to charity is an option for investors looking to combine their philanthropic intentions with opportunities to minimize taxes.

4.   Donating shares to charity is an option for investors looking to combine their philanthropic intentions with opportunities to minimize taxes.

  • Donor-advised funds (DAFs) are accounts held by public charities to which you can donate and receive an immediate federal income tax deduction, and which hold the donated assets until they are distributed to the ultimate charitable recipients. You can recommend how the DAF invests the donated assets, and those assets can stay invested and potentially grow, tax-free, until you recommend which charities you want to receive a cash donation. You can name a successor to recommend investments and grants after your death.
  • Charitable gift annuities are annuities offered by some public charities. You transfer assets to the charity in exchange for an annuity interest for yourself or someone else. The charity invests the assets and retains anything not used to satisfy the required annuity payments. You may receive an immediate federal income tax deduction for the value of the property donated, less the value of the annuity interest.4
  • Charitable remainder trusts are irrevocable trusts in which you retain an income interest (or give the income interest to someone else) for life or for a term of up to 20 years. At the end of the trust term, the remaining property goes to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.5
  • Pooled income funds invest your donation alongside those of other donors. You (or someone you designate) will receive an income stream for life, after which the remainder of your donation will be transferred to charity. You may receive an immediate federal income tax deduction for the present value of the charitable remainder interest.

Taking steps to manage a concentrated position can help you avoid additional risks in your portfolio. A Morgan Stanley Financial Advisor can help you determine which strategies may be most beneficial for you. Your Financial Advisor or Private Wealth Advisor has access to Morgan Stanley’s Total Tax 365 solutions to help you implement a tax-smart strategy that’s tailored to your unique financial goals. To learn more, request a copy of the Global Investment Office primer, Managing a Concentrated Stock Position.

Questions to Ask Your Morgan Stanley Financial Advisor:

  1. What are the implications if I sell my concentrated position outright?
  2. How can I diversify my concentrated position in a tax-smart way that aligns with my investment and financial goals? 

Footnotes

1Funds that rely on a Qualified Investor require a net worth of $1 million, exclusive of primary residence.

2 IRS, What’s New – Estate and Gift Tax,  https://www.irs.gov/businesses/small-businesses-self-employed/whats-new-estate-and-gift-tax

3 While gifting securities does not incur federal income tax at the time of the transfer, the recipient would still be subject to any relevant capital gains taxes (generally based on the donor’s original purchase price) when the shares are sold in the future. This may reduce the capital gains tax ultimately owed if the recipient is subject to a lower federal income tax rate than the donor. Consequently, it’s important to make sure both the donor and recipient understands the potential federal income tax consequences associated with the transfer and the potential future sale of the shares by the recipient.

4 Some or all of each annuity payment will be subject to federal income tax.

5 Income and capital gains realized in the trust are not subject to federal income taxes at the trust level, but the federal income tax liability will pass to the income beneficiaries when income is distributed from the trust. 

Disclosures

This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. It has been prepared for informational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies and encourages investors to seek the advice of a Morgan Stanley Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Exchange funds are private placement vehicles that enable holders of concentrated single-stock positions to exchange those stocks for a diversified portfolio. Investors may benefit from greater diversification by exchanging a concentrated stock position for fund shares without triggering a taxable event. These funds are available only to qualified investors and may only be offered by Financial Advisors who are qualified to sell alternative investments. • Before investing, investors should consider the following: • Dividends are pooled • Investors may forfeit their stock voting rights • Investment may be illiquid for several years • Investments may be leveraged or contain derivatives • Significant early redemption fees may apply • Changes to the U.S. tax code, which could be retroactive (potentially disallowing the favorable tax treatment of exchange funds) • Investment risk and potential loss of principal

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Asset Allocation and diversification do not assure a profit or protect against loss in declining financial markets.

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