[Editor’s Note: Don’t forget to set your clock for tomorrow, Sept. 14, at 7pm MST when registration for the Physician Wellness and Financial Literacy Conference (WCICON22) opens. This CME eligible event will be held February 9-12, 2022 at the JW Marriott in Phoenix, AZ, and there will be both in-person and virtual packages. Click here for more details and remember to be ready to sign up tomorrow!]
By Dr. James M. Dahle, Emergency Physician, WCI Founder
I occasionally receive emailed questions such as:
“I have been aggressively saving and investing for several years, but have just recently started reading more about investing on your website. When I first started investing, I didn’t want to think or research too much about it, so I invested everything into Vanguard Target Retirement funds. My wife’s 401(k) and Roth IRA and my Simple IRA/Roth IRA and our taxable Vanguard account all have Target Retirement funds. Now, I want to spend a little more time on our investments and want to also make sure they are tax-efficient. I understand with the accounts I have that bonds should probably go into my wife’s 401(k). The problem I am having is that selling the Target Retirement funds in my taxable account will lead to a large tax bill of around $13,000. Right now the Target Retirement fund only has 10% in bonds, so it’s not terribly tax-inefficient. However, I understand that in the future, this fund will only become more and more tax-inefficient, especially since I also live in a high tax state. I wanted to know whether it is best to just bite the bullet and sell the target-date fund in the taxable account and pay the resulting tax or just let it be and not invest any more money into it.”
“I am a well-paid tech worker for Google who has received shares of Google (Alphabet) stock as part of my compensation package for years. It has obviously done well, but now composes about 50% of my portfolio which I think is probably too much. Should I sell a little bit each month for the next 12-18 months to reduce the tax bill?”
“I took a flyer on cryptocurrency and it obviously paid off really well. However, it has gone from 5% of my portfolio to 25% and I am not comfortable with that at all. I don’t want to pay the capital gains taxes on it though, especially since it has not even been a year since I bought it. What do you recommend?”
All of these situations have one thing in common—each investor owns something they do not actually want to own in a taxable account and is hesitant to sell it because of the capital gains taxes that would be due. These “somethings” are called “Legacy Holdings“.
5 Ways to Deal with Legacy Holdings
In this post, I will first discuss in general what to do with legacy holdings. Afterward, we’ll talk more specifically about each of the above situations. Remember this only applies to a taxable account. If you own a “legacy holding” in a 401(k), IRA, 529, or HSA, just sell it. There are no tax consequences.
The first step when you find yourself in a hole is to stop digging. If you realize you own something you don’t want to own, make sure you’re not buying more of it. Cancel any “automatic purchase” orders and make sure your dividends and other distributions are not set to automatically reinvest. Then consider your options.
#1 Sell It
You always have the option to just sell it. Sure, it will cost you some capital gains taxes, but it is pretty much always better to owe taxes than to not owe taxes. This is particularly important if the legacy holding is not particularly diversified. The worse the legacy holding is as a component of your portfolio, the more you should be willing to grit your teeth and just sell it.
The first thing to do with any legacy holding is to look at the basis of the holding (and while you’re at it, the basis of every other holding you have in taxable). Basis is what you paid for something. It is the part that you don’t pay taxes on if you sell it with a gain. You only pay capital gains taxes on gains, not the entire proceeds of the sale. If your basis is more than the current value, great! You have an unrealized loss. If you sell now, not only will there be no tax due, but you can actually use the loss to offset any other capital gains you might have (and up to $3,000 per year in ordinary income). Likewise, if your basis and the value are equal or the value is only a little more than the basis, go ahead and sell it and buy what you actually want to own in that taxable account.
If you discover that the value is much more than the basis and you don’t want to pay the big tax bill that would come from selling it, take a look at the other holdings in your taxable account. Are there any that are underwater? If so, exchange them for a similar (but not in the words of the IRS “substantially identical”) holding and book that tax loss. You can use that loss to offset the gains from the sale of the legacy holding. Likewise, if you did some tax-loss harvesting years ago, you’ve been carrying forward those losses for a time like this. Now you can use them! I’ve only ever owned one individual stock. I sold it for a significant gain after just two weeks, but I didn’t have to pay any capital gains taxes on it because I had some losses saved up from prior tax-loss harvesting.
#2 Plan to Sell It Later
Another option is to plan to sell the stock later. Perhaps you will have more money to pay the taxes later. Or perhaps you will be in a lower tax bracket later. Or maybe you will have the opportunity to tax-loss harvest another investment between now and when you sell, and you can use those losses to offset your gains.
#3 Give It to a Family Member or Friend with a Low Income
When you donate an appreciated asset to someone else while you are alive, they inherit your basis. When they sell it, they will have to pay capital gains on it as if they bought it on the same day you did. However, if they are in a much lower capital gains bracket than you are, this can dramatically lower the overall amount of taxes that are paid on the gains. In fact, there may be no taxes due at all if their income is low enough. Remember, though, that if you give away more than $15,000 per year, you will need to file a gift tax return, as you will be using up some of your estate tax exemption.
#4 Donate It to Charity
Do you donate regularly to charity? Why not donate appreciated shares you have owned for at least one year instead of cash? You can even use a Donor Advised Fund to make it even slicker and more anonymous. This is a wonderful use of a legacy holding. Everybody wins. You get it out of your portfolio, you probably get an itemized deduction for it, and neither you nor the charity pays any capital gains taxes on the sale.
#5 Build Around It
Finally, here is an option many people choose, especially elderly people. You can simply build around the legacy holding. Let’s say the legacy holding is some old actively managed growth stock fund. It probably has reasonable correlation to your Total Stock Market Index Fund (TSM), so just hold a little less TSM to make up for the legacy holding. Or perhaps you hold a value index fund in another account to offset it since Growth + Value = Total Market. You can do the same thing with a few individual stocks.
But what if the legacy holding is an individual stock and comprises a large percentage of the portfolio? There is plenty of risk of it going down in value. Well, you can hedge against that risk. You could put in stop-loss orders such that if it fell in value, you would automatically sell it. You could also short the stock. That way, if it goes down in value, your short will become more valuable to offset the loss in the shares you own. Buying puts on that stock would work similarly.
As your portfolio grows, theoretically the legacy holding becomes a smaller and smaller part and eventually gets left to your heirs, where it benefits from a step-up in basis at death and they can finally sell it, tax-free, as soon as you pass. In the meantime, you can live off the income (if any) from the investment.
Lesson from the Target Retirement Fund Debacle
The first question above provides a few learning points. The first is that if you want to keep things simple and easy, Vanguard Retirement Funds (and similar funds from other providers) are a great option. You get a diversified investment at a reasonably low cost that automatically rebalances, requires little knowledge of investing to implement, and lets you avoid the temptation to tinker. There are far worse ways to invest. We should not necessarily denigrate “the easy way” as being dumb. One reason I don’t use Target Retirement Funds, however, is because they introduce some asset location issues that the emailer above either just realized or just started caring about.
But a Target Retirement Fund isn’t a bad thing to hold long term. It’s just slightly less than ideal. So if the reader above doesn’t want to cough up $13,000 for taxes and doesn’t give to charity, I think it’s perfectly fine to just build the portfolio around it. Maybe the opportunity to tax-loss harvest and reduce the taxes will arise in the future, but if not, that’s just fine. A later date Target Retirement Fund is mostly just Total Stock Market and Total International Stock Market Funds anyway, so he can just hold a little less of each of those to make up for it. Yes, it will become less tax-efficient as time goes on, but by the time it becomes really tax-inefficient, he’ll likely be retired and not mind spending that income he’s paying taxes on anyway.
Lessons from the Google Debacle
50 percent of your portfolio in a single stock is way too much, especially if it is the stock of the company that also provides your paycheck. This reader thought he could reduce the tax bill by selling gradually over the next year or two. However, barring a crash in the price of Google stock, the tax bill is the same whether he sells in February or December. Splitting it over a few years might help, but the longer he drags it out, the longer he runs the same risk the Enron employees did. And if Google stock craters, then he will be really glad he sold now while he still had gains. All this strategy really does is hedge against the overperformance of Google against the overall market over the next 12-18 months. That seems like a silly reason to wait to sell. So I suggested he at least sell enough stock now that Google makes up no more than 5% of his portfolio and pay the taxes.
Lesson from the Cryptocurrency Debacle
Whether you gained through luck or skill, it’s time to take the money and run. If you are comfortable with 25% of your portfolio in cryptocurrency, your risk tolerance has gone beyond “iron-clad stomach” and into “foolhardy” territory. The temptation is to wait until you have owned it for at least one year so you will only have to pay long-term capital gains tax rates on it instead of short-term capital gains/ordinary income tax rates. Just be glad that, unlike gold, cryptocurrency qualifies for long-term capital gains rates (gold is taxed as a collectible at 28%).
But I think it’s too risky to wait. Either sell now (at least down to a reasonable level, like 5% of the portfolio) and just pay off the taxes, or figure out a way to hedge your bet until you hit the one-year mark. Perhaps you could short the cryptocurrency itself or an ETF that invests in it. Or perhaps buy some puts. Then sell it as soon as you hit the one-year mark.
The Bottom Line
Legacy holdings are a common phenomenon among many investors, especially the less-charitable ones. Deal with them the best you can by weighing the investment considerations against the tax considerations. While you don’t want to let the tax tail wag the investment dog, with careful planning you can sometimes get your cake and eat it, too. It is best to avoid these issues completely by carefully planning your taxable account investments.
What do you think? How would recommend each of these investors deal with their legacy holding? Comment below!