Total Tax 365: Tax-Smart Investing. All Year Long.

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One of the first things every investor learns is that diversification can help mitigate risk. As the saying goes, Don’t put all your eggs in one basket.

But the reality of investing is that despite your best efforts you may still find yourself with highly concentrated positions. Meaning too much of a single stock.

This can happen through an inheritance, a buildup of employee stock in an equity compensation plan or simply by holding assets that have grown over time.

Of course, it's possible to sell most of a concentrated position and diversify into other investments. But without the right planning, that could easily lead to a big capital gains tax bill.

Your Morgan Stanley Financial Advisor can help you, and other investors with the same issue, manage concentrated positions and re-diversify in a tax-efficient way by potentially taking advantage of exchange funds.

If you quality, an exchange fund lets you swap your concentrated shares in one security for the equivalent value of shares in a diversified fund.

Because this is not a taxable transaction for US federal income tax purposes, you can potentially defer capital gains taxes until you sell the fund shares down the road.

It’s part of our Total Tax 365 approach which lets you incorporate a full range of tax-smart strategies into your investment planning, all year round.

Taken together, the solutions that make up Total Tax 365 may potentially add up to 2 percent to your annual returns, on average, depending on your specific portfolios and approaches.

Let’s take a closer look at what it means to have a concentrated portfolio. A stock position is typically considered concentrated when it represents 10 percent to 20 percent or more of your portfolio value.

There are many ways investors end up with concentrated positions and many factors that inhibit investors from selling including taxes, bullish expectations, psychological barriers, regulations or public perceptions.

But if you have an outsized position in your portfolio, you may be taking on outsized investment risks.

Let’s look at a recent example. Consider what happened to the S and P 500 Index in 2020.  While the index finished the year up 18 percent, just five high-performing stocks Apple, Amazon, Microsoft, Nvidia, and Meta accounted for nearly half of the index’s return. In fact, over 24 percent of the stocks in the index were actually down by 10 percent or more by year end 2020.

Even longer-term, the story is similar. Over the 25 years ended in 2021, the S and P 500 has only declined by more than 10 percent in three calendar years. By comparison, a quarter of the stocks in the index declined by more than 10 percent in each year on average.

All said, the odds of a concentrated position being one of the underperformers in any given year, may be higher than you realize.

That’s where exchange funds come in. They allow qualified investors to move into a diversified fund in a tax-smart way.

Because you and other investors may run into the same issue, exchange funds are an aggregate of many investors’ concentrated stock enabling investors to exchange their concentrated shares for the equivalent value of shares in a diversified fund. 

Since many Exchange Funds seek to track the performance of a broad index, like the S and P 500, despite some tracking error, you can gain exposure to hundreds of varied securities.

Let’s look at what tax-deferred growth can mean in the real world. Since taxes vary by state, let’s say you’re a California resident whose assets are all in Stock A. 

Concerned about the increased risks of a concentrated portfolio, you sell 1 million worth of your stock A shares. Assuming a zero cost-basis and an effective tax of 37.1 percent, you would have 629,000 dollars left to invest in a diversified portfolio. That means you’d need a return of over 58.9 percent just to get back what you paid in taxes.

Swapping into an exchange fund, on the other hand, means you could invest the full million into a professionally managed, diversified fund.

Let’s see that in action assuming an 8 percent annual growth rate over 20 years for both hypothetical portfolios.

For the sell and buy approach you pay taxes up front but you sacrifice the power of investment exposure over time.

On the other hand, with the Exchange Fund you got to keep the full value of your investment power but at the expense of a larger tax bill at the end.

However, when all is said and done, the sell and buy portfolio would be worth roughly 2 million dollars, while the exchange fund would be worth roughly 3 million dollars. That’s a big difference in final value on a post liquidation, after tax basis.

Exchange funds may not be for everyone. They’re designed for long-term, qualified investors. While many offer early redemptions, some may charge fees for early withdrawals, or they may have other liquidity constraints.

But all things considered, exchange funds can offer an efficient way to diversify holdings while benefiting from potential growth.

In practice, decisions like whether to realize gains today, defer recognizing them by continuing to hold your portfolio or consider an exchange fund strategy, are often more complex than they look. And their solutions like all our Total Tax 365 strategies work best when factoring in all your accounts and holdings.

Many of us keep accounts at different firms for different reasons. But if some of your assets are not visible, you may not reach full potential.

That’s why consolidation may itself be a tax-smart move. By bringing all your accounts together, we can take a holistic view of your portfolio, understand what changes could help you seek the most tax-efficient outcome.

With Total Tax 365, your Morgan Stanley Financial Advisor can help bring innovative technology to the old wisdom about eggs and baskets.

Diversification has typically played a key role in managing risk and if you qualify, you can do it in a tax-smart way that’s integrated into your investment plan and financial goals.

Contact your Financial Advisor to see how Total Tax 365 can help.

Capital gains taxes are a fact of life, especially in volatile markets. But working with your Financial Advisor you can work toward lowering your tax burden using Total Tax 365 strategies, like Direct Indexing. 

Liquidating assets to meet a goal can be a land mine of tax risk. Your Financial Advisor can help you navigate the complexities with Total Tax 365 and Intelligent Withdrawals.