Turn Your Concentrated Stock Into Stable Retirement Income

If you’re retiring after a long career at Microsoft, Amazon, or any other big company, you’ve likely been given company stock as part of your compensation for years. Along the way, you’ve also watched it skyrocket and it now represents a much bigger percentage of your portfolio than you’re comfortable with. As retirement draws nearer, the dramatic day to day swings cause increasing anxiety and you’re thinking about taking some risk off the table.

But what about taxes?

If you have $2 million in company stock with a cost basis of $600,000, your $1.4 million in gain could be taxed at up to 23.8% in capital gain tax, more than $333,000, if you sold it all today. And it only gets worse if your state adds additional capital gain tax, like our home state of Washington.

Are you stuck choosing between too much risk or a massive tax bill? Fortunately, if you find yourself in this situation, the answer is no! If this sounds like you, here are a few principles to follow.

1. Start with your ideal target.

How much of the company stock do you want to keep? It’s common to feel a tie to a company that has helped you build wealth and given you a great career. It can be hard to part with these stocks. We find it helpful to ask yourself one question:

If I had $2 million in cash, how much of this stock would I buy?

Your answer can help set your ideal target for how much stock to keep. Then, discuss this target with your advising team to see if it fits with your retirement goals. If your initial target is 10%, they might say “Great, let’s work toward that!” But if your initial target is 50% and you need these funds for retirement income, don’t be surprised if they say this feels like a bit too much to keep in a single company. Generally, more than 10% or so of your retirement nest egg in a single company will make it much harder to manage volatility.

2. Commit to a plan for diversification.

Once you have a target, committing to a plan is the next important step. Decide in advance how much and when you’ll sell each year. This helps prevent decision fatigue from setting in when you must make a new decision every single year about how much stock to sell. This plan can be based on one or a combination of factors:

• Retirement date. If you’re planning to retire in five years and have 1,000 shares to diversify, you might sell 200 at the start of each year.
• Capital gain tax budget. You might decide to set a limit on annual capital gain tax you’re comfortable paying. In our home state of Washington, we have a capital gain tax on gains over $250,000, so it’s common not to take more than this unless absolutely necessary.
• Number of shares or fixed dollar amount. If neither of the first two is comfortable to you, pick a target that is, whether that’s number of shares, dollar amount, or percentage of your stock. While this is less common, if it works better for you (and it meets your retirement goal!), committing to any viable plan is better than not having one.

The most common strategy we see is a plan based on retirement date with consideration for capital gain tax. But the important thing is committing to a plan that works! With a plan in place, your only question each year is “Is there any reason I should change this plan this year?” It’s a great discussion with your advising team. If the stock recently dropped by 50%, you might consider holding for a bit, for example.

3. Be tax smart.

Start by selling any company stock you own inside a 401(k) or other qualified retirement plan. You can generally diversify these shares with no tax cost, since these accounts are tax-deferred, meaning no taxes are due until you withdraw funds from the account.

With your ideal target and plan in place, look at ways to reduce the impact of taxes on your plan. Tax-loss harvesting is a great way to offset gains you’ve taken that year, allowing you to pay less tax or diversify faster. While this can be done any time, it’s common to take a look for these opportunities toward the end of the year or when there’s a significant market downturn.

Direct Indexing is a portfolio management strategy that automates the tax-loss harvesting process by investing in many of the individual stocks in an index, then looking for opportunities to sell companies at a tax loss so you can offset other gains, and replace them with similar companies to keep you invested.

4. Create an income plan.

How will you create income from the proceeds you’ve generated? There are a few ways to do this:

• Dividend paying stocks. These tend to be established companies that pay a portion of their profits to you through a dividend throughout the year.
• Bonds. A mix of corporate, high-yield, and municipal bonds (if income taxes will still be a concern) can offset stock risk and send you regular interest payments.
• Annuities. Insurance companies offer a guaranteed income. Fixed annuities function like a pension with high income and little to no liquidity, while indexed or variable annuities function more like an investment account with a guaranteed minimum income percentage. Annuities can be confusing and often come with higher costs and surrender periods, so working with an independent planning team who can explain these pros and cons is essential.
• Real estate. You might like the idea of investing in a rental property, though of course you’ll want to realistically consider the time and cost needed to maximize a property like this.

You can work through Get Ready to Retire in 8 Steps to determine how much income you need. From there, evaluate the options, and choose the right mix for you, usually a blend of some of the strategies above.

Need access to your stock before you sell it?

You can use options to create income from your stock while you divest. If you need short-term access to funds held in concentrated stock, selling isn’t your only option. While you execute your diversification plan, a Securities Backed Line of Credit (SBLOC) can borrow against the value of your stock without requiring you to sell it. This requires very careful consideration and shouldn’t be done hastily but, for the right situation, an SBLOC can help you reduce taxes and access the funds you need.

Take the first step!

Now that you have a better understanding of how to create income from your concentrated stock, commit to the first step! You don’t have to go it alone. Let’s have a conversation to see if we’re the right fit to bring the clarity and confidence you need.

The opinions / strategies above are for general information only, are not intended to provide specific advice or recommendations for any individual. Diversification and past performance do not guarantee future results. Alterra and LSF LLC do not offer tax advice. Fixed income securities are subject to increased loss of principal when interest rates rise and various other risks, including changes in credit quality, liquidity, prepayments, and other factors. Fixed Annuities are long term insurance contracts, generally with surrender charges during the first 5 to 7 years, withdrawals prior to age 59-1/2 may result in a 10% IRS tax penalty plus ordinary income tax, and guarantees are backed by the financial strength of the insurance company. Investment return and principal value of variable annuity investment options are not guaranteed and fluctuate with changes in market conditions. The principal may be worth more or less than the original amount invested when the annuity is surrendered. Real estate may be considered a riskier investment for some clients. Real estate risks, including REITs, include changes in real estate values and property taxes, interest rates, cash flow, supply and demand, and the management skill.