Reducing the impact of taxes is one of the best ways to help clients keep more of their wealth. Indeed, high-net-worth clients continue to rank tax-management solutions as their top financial need. A separately managed account (SMA) using intelligent tax technology offers critical advantages to help advisors and investment managers tailor solutions to each client’s individual tax situation, investment objectives and risk tolerance.
Tax-Smart transition of a concentrated stock position
Concentrated stock positions can be a major consideration when clients are working with an advisor on optimizing their investment portfolio. Often times these positions may have deep embedded gains that will be realized if the stock is sold, forcing a choice for the advisor and client: How much in capital gains tax would the client be willing to pay to move toward the desired investment outcome?
An additional and important consideration is the risk that comes with holding onto a single stock position. A J.P. Morgan Asset Management analysis showed that more than 40% of companies ever in the Russell 3000 experienced a catastrophic loss — a 70% decline in price from peak levels that is not recovered — while over 60% underperformed the index.
Case study: Executive retiring with company stock
Consider, for example, a high-level executive at a large, publicly traded U.S. consumer products company who retires with all of their non-IRA net worth in company stock. After years of accumulating shares through grants and an employee stock purchase plan (ESPP) through 2022, their portfolio’s market value may increase to $9.16 million, with a cost basis of $5.06 million. Assuming they retire at the end of 2022, the client could liquidate everything and face a tax bill of $1.2 million or choose one of three options:
- Stay in the company stock, which has a low beta and may lag the broader market during strong rallies (such as in 2023)
- Sell a portion of the stock and invest the proceeds in an S&P 500 ETF to improve diversification
- Sell a portion of the stock, but use J.P. Morgan’s tax transition capabilities to invest in higher beta names to complement the legacy company exposure and manage risk holistically across the entire account
The difference in potential outcomes in 2023 is striking. J.P. Morgan’s Tax-Smart transition exhibited approximately 80% of the return improvement that would have been achieved by moving all the concentrated stock position into the S&P 500, but with only about 30% of the tax bill.
Tax-Smart SMAs provide you and your clients with the most flexibility to stay one step ahead of taxes and benefit from the risk-based portfolio construction approach. For clients with concentrated stock positions that have large unrealized gains, a Tax-Smart transition can reduce both the market risk of concentrated stock positions and the capital gains tax bill.