If you are in a concentrated position (>10% of net work in a single stock), you should generally dump large amounts
of it to cut risk.
Unfortunately, selling is a taxable event. This
blog post explores strategies to raise your after-tax returns, by focusing on the “tax” part. It assumes you are
already utilizing the standard tax-advantaged
Before reading this section, please be familiar with:
Remember, there’s little you can do with ordinary income — but a lot you can do with the capital gains. Depending
on your own equity structure and company performance, you may or may not have substantial capital gains.
General Tax Minimization
Especially in a year with a windfall and high taxation, you should be sure to use all the standard tax
- Maximize your contributions to every tax-deferred
account (401k, HSA) to cut taxes today.
- Bonus for HSA: The last month rule - If you switch to a high deductable
plan mid-year and you keep it until December of the following year, your contribution maximum for
the opening year is as though you held the HSA the entire year. (no proration)
Reducing future taxes on investments
As you liquidate your stock, maximize contributions to every tax-free account (Roth, 529) to
minimize future taxes on your investments.
If you have children, “super-fund” a 529 plan with sufficient assets so the expected balance
(after appreciation) will be sufficient to pay for college entirely.
- Be wary of over-contributing as there are penalties for withdrawing for non-qualified educational
- How much should be there? I used a conservative formula of taking the current Univeristy
of California cost of attendance, discounting it 4% a year until my child attends college.
(7% nominal returns less 3% college budget inflation).
- Recent tax law changes allow using 529 plans to pay for K-12 private school, though some states (like
California) will tax these withdraws, making it not sensible to use 529s for these purposes in such states.
- You can make use of UTMA-529s to minimize capital gains. Discussed below
Capital Gains Tax minimization
Do the assets you wish to sell have a significant amount of their value in capital gains? Read below
Do you have over $5M?
If you meet the standard of qualified
purchaser, you can invest in an exchange
fund, diversifying without realizing capital gains taxes. You’ll need to keep your funds in the fund for
seven years, but with this much assets, that generally won’t be a concern. Contact your local investment bank.
If not, carry on. This section is targeted for people who cannot use exchange funds.
Recall there are tax
incentives to postpone selling, but holding increases
risks. There are some techniques that increase the risk-adjusted returns by either cutting risk or raising
Stock protection trusts — cutting risk without the tax
Stock Protection Trusts allow pooling
of risk, reducing the unsystemic risk associated with holding a single stock
- 20 holders of different (similar risk, but relatively non-correlated) stocks contribute a small amount of
cash, e.g. 5% of your stock value, into a fund (“the pool”)
- After some time period, the pool pays out in a way that offsets any stock loss (up to value of stock
- There are no adverse tax effects with using protection funds as there are with options, collars, etc.
See the following resources for more detail:
A stock protection trust can be a solid tool to hedge risk if you are optimistic about your own stock and
want to hold it and/or there are heavy costs (e.g. taxes) associated with disposing it in the short-term. Accredited investors (earn over $200k a year OR over $1M in assets) only.
I’m currently building up a pool; contact me for more information.
Collars — cutting risk
If you want to shift tax liability to next year while cutting risk, you can open a zero-collar against your
stock that expires in the subsequent year. If your stock sales will be taxed at a significantly lower rate the
following year (or the following year is only a few months away), this can make a lot of sense.
Please read the lock-up
hedging section to learn more about the strategies of using options and the tax complications associated
with doing so. Feel free to contact me if you wish to explore whether
using collars makes sense
in your particular situation.
Moving — increasing after-tax returns
If you are currently in a state that taxes capital gains (e.g. California), you can relocate to a state that
doesn’t (e.g. Washington) and sell in a year you don’t reside or work in the original state. You can use collars
or protection funds to reduce your risk until your tax jurisdiction has changed.
Note that this only applies to capital gains; ordinary income events such as NQSO option exercises and RSUs will
be taxed by the state in which you worked when you initially received the option or RSU (at least in CA).
Investing in Qualified Opportunity Zone funds
opportunity zone funds are special type of investment vehicles created by the 2017 Tax Cut & Jobs Act.
Effectively, investors receive tax benefits by investing in economically distressed communities.
These tax benefits are very relevant to investors with sizable capital gains. If you invest $X into an
opportunity zone fund, you can receive up to the following tax advantages:
- Defer taxes on $X of capital gains until 2027.
- That is you report/pay taxes on the capital gains in 2027, not this year.
- Reduce the taxable capital gains amount by up to 15%
- Capital gains in the opportunity zone fund will not be taxed.
Note that the above only applies federally; your state may or may not honor opportunity zone funds.
California for instance does not, meaning you still pay capital gains tax (to CA) this year and your investment
in the fund may be taxed.
In other words several tax incentives exist:
- No capital gains taxes on the opportunity zone investment (higher-after-tax returns)
- Deferred capital gains taxes on your sales for 10 years
- More investment capital = more returns
- Moves the taxable event to a different year (which could be more favorable to you.. or not)
- Capital gains reduced by 15%
- meaning 15% lower taxes if your tax bracket stays the same.
- Accredited investors only
- If you need to sell your stock anyway to diversify, investing in opportunity zone funds makes a lot of
sense, especially if you wish to increase your exposure to real estate.
It’s out of scope of this page to talk about how to invest in real estate funds (and you want to invest in
reputable funds!); you may want to start with CrowdDD.
Are you charitable?
- If you donate shares that are eligible for long-term gains, you gain donation leverage
(where-in the government effectively matches your donation with lower taxes) because you:
- a. Don’t pay capital gains tax on them
- b. Can take an itemized deduction equal to the current market value of your stock
- e.g. you might find that donating $1000 of stock with a basis of $300 does the following:
35%*$700 = $245 in long term gains tax
- additionally lowers income tax by
50%*$1000 = $500 via the $1000
additional itemized deduction.
- So you “pay” only $255 (reduce your post-tax earnings by $255) and your charity of choice receives
- That’s nearly 4x donation leverage, or put another way, the government matching you
- Outcomes depend on your basis, your tax bracket, other itemized deductions, deduction phase outs,
reality, you are unlikely to get this high leverage.
- Strategically, use the lowest basis stock you have to donate.
- You can also donate shares eligible for only short-term gain:
- Still don’t pay capital gains tax
- But itemized deduction is limited to the cost basis.
Donor Advised Funds
A Donor Advised Fund
(DAF) is a vehicle to conduct the taxable donation now and worry about what charities to donate
to later. Commonly used ones are Fidelity’s or Vanguard’s.
Example: dump 10 years worth of donations into a DAF with your appreciated stock. You avoid all the capital
de-risk your charitable giving, and might get a large tax reduction when you are in an abnormally high bracket
(due to IPO related releases and sales)
- Federal taxes are not reduced by itemized deductions until itemized deductions exceed standard deductions.
For a married couple that only deducts state taxes, this could mean first $14k of donations result in no tax
- California has similar standard deductions and itemized deductions rules. Additionally, itemized deductions
are phased out at high incomes, reducing tax benefits.
- There are deduction limits. e.g. long-term stock donation itemized
deduction is limited to 30% of adjusted gross income (AGI) in contribution year.
- Excess donations will carry-forward to subsequent years.
Giving to Natural persons
(other than your
minor/college student children)
If you gift appreciated stock to a person, they only pay taxes (at their tax rate in their jurisdiction) when
they sell. So if you have relatives and friends you’ve been meaning to gift, consider gifting your appreciated
stock rather than cash.
Note for savvy readers: This is part of why stock transfers are great to give to charity - charities don’t
pay taxes on capital gains they realize!
Warning: Even if your company allows it, do not transfer stock options. As ordinary income cannot be
transferred, you’ll be taxed when the recipient exercises the option!
Warning 2: If you gift more than $15k (or $30k as a married couple in a community property state [e.g.
California]) to a single person, you run into gift tax issues that are out of scope of this document.
Giving to your Kids
As children pay different tax rates on their income than parents, you can “move” capital gains from yourself to
your minor children by transferring stock into a UTMA custodial
account and selling it there. Note that this is an irreconcilable decision; once you transfer the
stock, the money is your kids property — though you can choose how the kid uses it though until they are 25.
you can chose to spend it on their college education)
- First $1,100 of capital gains is tax-free (standard deduction for child)
- Next $1,100 is taxed at child’s tax rate if they were an independent filer (10% short-term; 0% long-term)
- Remaining is taxed at trust
- Next $2,600 of long-term capital gains is tax free ($4,800 total).
- Likely $9,300 more of capital gain ($11,500 total) will be taxed at less than your federal rate.
California state Tax
- About $2,000 or so capital gains is tax-free.
- Rest will be taxed as though it is parent’s income (i.e. same taxes whether you sell or kid sells).
- Open UTMA account (every broker offers them for no charge)
- Transfer desired amount of stock to UTMA account
- Sell stock in account
- File taxes for kid at tax time (kid will need their own return)
Beware of gift tax issues described above. However, for highly appreciated equity, tax rates will limit the
effectiveness of the transfers, not the $30k gift tax exclusion limit.
- Any investment income (e.g. dividends) over $2,000/year might be taxed.
- If the child sells when they are no longer subject to the kiddie tax (not a minor or full-time college
student), standard tax rates on long term gains apply.
- If a minor or college student funds over 50% of their expenses in a year with the UTMA,
they’ll be independent for that tax year (but still subject to kiddie tax), giving a much
higher threshold of tax-free gains they can realize.
Converting to a 529
To completely avoid any investment taxes, you can convert the UTMA into a 529. In addition to the usual 529 restrictions that
withdrawals must be used for education, this 529 will be restricted to the beneficiary (you can’t change
beneficiaries as you can with a normal 529).
An additional benefit of this transfer is that financial aid treats UTMA-sourced 529 accounts as a parent asset
and UTMA accounts as a student asset; i.e. moving assets to a 529 may reduce future impacts to need-based financial aid.
Comparing UTMAs to 529s
- 529 beneficiaries can be swapped between siblings (and sometimes other beneficiaries) so are a bit safer
from an “overfunding” perspective (if you have multiple children!)
- But 529s must be funded with cash; you can’t contribute appreciated stock, meaning more capital gains tax.