Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

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d41517
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Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by d41517 »

Hi, I am a longtime Boglehead and forum reader, but this is my first post!

I am starting to help manage my parents' finances. The majority of their marketable securities are held at 2 large brokerage firms. Taxable holdings are held within ~12 actively managed, high fee, high turnover, tax inefficient, and generally underperforming separately managed accounts. There are over 700 individual stock holdings with substantial unrealized capital gains (~$3 million).

I would like to help them transition these investments into a low-cost, diversified passively managed portfolio. I have spent the past few months reviewing the accounts and interviewing several advisors, including Vanguard PAS. My dilemma is how to most efficiently transition these individual stock holdings into passive index funds while minimizing the capital gains tax burden.

I would appreciate thoughts and suggestions on how to best make this transition. For simplicity, assume these specific funds will not be needed for living expenses for the foreseeable future. Additionally, assume at least one of my parents is likely to live another 20 years. Tax bracket 35-37% federal, no state income tax, married filing jointly.

Specific considerations include:
-The use of a DAF to offset some of the taxes (donating most appreciated shares and allowing a tax deduction). I am trying to get my parents to come up with an amount, as a longer contribution could significantly offset the tax liability.
-Rate of unwinding (sell everything this year vs. gradually transition portfolio over 2-3 years, potentially employing TLH during a future market downturn). Potential tax law changes and inherent market uncertainties obviously complicate this decision.
-Holding onto “bluechip” stocks with large CG burden until death to get step-up benefit. (Generally against this, because I don't want to pick inidividual stocks to keep, but would be curious to hear others' thoughts).
-Any other suggestions would be appreciated.

Thank you in advance for your input!
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retiredjg
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by retiredjg »

Welcome to the forum. :happy

No doubt your intentions are good, but this appears to be an exercise in futility to me.

With 700 different stock holdings, $3 million in capital gains, and in 35 - 37% tax bracket, I think the cure may be worse than the disease.

If they are already in the 35%+ tax bracket from other income, much or most of the long term capital gains will be taxed at 20% + 3.8% NITT. Short term gains would be taxed at 35% or 37%. If they don't need the money, why pay almost 24% (and more) to make the portfolio nicer and neater?

It makes me wonder if I'm misunderstanding what you posted.

What does seem to be a concern is "...~12 actively managed, high fee, high turnover, tax inefficient, and generally underperforming separately managed accounts". It seems like those problems could be easily fixed.

Individual stocks are not high fee or high turnover or tax-inefficient. So those qualities must be arising from the management of the individual stocks. Those things should be fixable unless I just don't understand the dynamics of "separately managed accounts" (which is definitely possible.) So maybe that is a good place to start.

Are the stocks locked into these accounts? Or some other thing that makes this different from just a plain ole taxable account?

It would be helpful to know approximate ages of your parents and whether either is still working. Are there other accounts from which RMDs must be withdrawn?
Prairiestorm
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by Prairiestorm »

I had a similar situation when I terminated my financial advisor who managed a portfolio of individual stocks in a % AUM fee relationship. Basically I just took over the portfolio (at Fidelity), saved the 1% fee drag, and sold all the smaller gain holdings and offset with any at loss positions so ended up with maybe 75 stocks all with high capital gains that I likely
never will sell. I set up dividends to be deposited to settlement account and monthly invest that in total stock index so over time that will help increase passive index mix.

Fortunately I had about another 50% of financial assets in low cost index funds that I self managed in a different brokerage account so individual stocks are just half my equity mix. I recommend Rick Ferri as a consultant (mentioned on this forum often) who helped me set up the transition plan.
bradpevans
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by bradpevans »

Is it organization/ simplicity or do they need the money? (It seems not). Step up basis and donations of appreciated stock come to mind
cryingshame
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by cryingshame »

I agree allot with what others have posted. When a portfolio is this out of wack from a boglehead perspective you have to widdle away.
Everything at once can be counter productive. I discovered bogleheads mid 50's or so . Sold everything with out a huge capital gain, stopped dividends set up a DAF fund. Slowly I have got my ER down to .18, not great but it feels so good. This year with the ACA hard cliff gone next two years were whittling some more.

When I retire will sell the high er funds first when our income is lower. This is an example of your parents at least having an investment mindset, it's still a wonderful problem to have versus someone who never thought this way....At least this is what I tell myself :sharebeer
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cchrissyy
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by cchrissyy »

Do you know the 12 account types? It would be unusual to have that many brokerage accounts so I'm wondering if some of what you are seeing is expensive and tax inefficient funds placed in non-taxable accounts. That that's the case then you can suggest they radically simplify those and/or move to a better firm away from expensive advisors, and it won't have tax consequences.

But if this is truly the way it sounds, I agree maybe the cure is worse than the disease.
60-20-20 us-intl-bond
Topic Author
d41517
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by d41517 »

Thanks for the responses! For clarification, the separately managed accounts are sub-accounts held at 2 brokerage firms (Morgan Stanley, Merrill Lynch). Each separately managed account (SMA) has a manager with a specific strategy (LCG, SCG, LCV, REIT, etc). As best I can tell from the statements, the ER is 1.2-1.5% per account. Individual stocks within these accounts are actively managed with significant turnover (each of the last 3 years, these accounts have realized ~ $500,000 in CG through active management). Looking at the performance reports provided by the brokerage firms, these accounts have lagged their stated benchmarks by 2-4% per year over 10-20 year periods (length of time depends on when each account was funded). None of them has matched or beaten their benchmark net of fees for more than a 3-5 year period.

As someone committed to indexing and matching the market return, this situation is very hard for me to stomach. I do not want to see this tax inefficiency and underperformance continue, even if my parents are fortunate enough to not need this money for living expenses. They have already decided to pull the money out of these brokerage firms and active management, but now I am trying to decide what to do with all of these individual holdings. They will be transferred in-kind to another custodian (Vanguard or Schwab). I agree with selling the lowest cost basis shares and gradually increasing the indexed portion of their portfolio. But I worry that they will be left with a poorly diversified mixture of stocks in various quantities that over the long term will underperform the broader market.
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by placeholder »

With that many stocks if you can get away from the fees and churning the portfolio might end up approximating indexes.
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Watty
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by Watty »

d41517 wrote: Wed Jul 28, 2021 4:51 pm My dilemma is how to most efficiently transition these individual stock holdings into passive index funds while minimizing the capital gains tax burden.
These would not be a solution but they would be some steps in the right direction.

1) Set any mutual funds to not automatically reinvest dividends and capital gains distributions. This will stop buying more things you do not want to keep for the long term. After a year all the gains will also be long term.

2) Look through the 700 investments and sell any that have a capital loss or a trivial capital gain.

3) Look through the investments and find any that are more than 5% of the portfolio. You do not want too much in one stock. Look at each of these individually to see how much long and short term capital gains there are and figure out which ones you can sell down to be just 5% of the portfolio. If one of them has short term capital gains that become long term soon it may make sense to keep it for a short time to make the gains long term.
d41517 wrote: Wed Jul 28, 2021 4:51 pm I would like to help them transition these investments into a low-cost, diversified passively managed portfolio. I have spent the past few months reviewing the accounts and interviewing several advisors, including Vanguard PAS. My dilemma is how to most efficiently transition these individual stock holdings into passive index funds while minimizing the capital gains tax burden.
Using a a carefully selected fee only financial advisor would make a lot of sense at least for a few years to get this cleaned up. When talking to the Vanguard PAS be sure to find out how much they will take your parents tax issues into account, they may need someone who will be more concerned about that.

There is a quote you will sometimes see here, “The greatest enemy of a good plan is the dream of a perfect plan.” .

It will likely make sense to keep many of the investments at least for now so do not get hung up on trying to get them into a perfect set of low cost index funds.
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retiredjg
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by retiredjg »

d41517 wrote: Wed Jul 28, 2021 11:39 pm As someone committed to indexing and matching the market return, this situation is very hard for me to stomach.
Since these are all in a taxable account, the tax cost of moving this portfolio to an index fund portfolio could be significant. There is no indication it is worth it. However, I believe you can do some improvement.

I do not want to see this tax inefficiency and underperformance continue, even if my parents are fortunate enough to not need this money for living expenses.
It appears the tax-inefficiency is the result of the stocks being in the SMAs. That can be fixed. Individual stocks can be very tax efficient unless there is a heavy slant toward dividend producing stocks. This is something they do not need a lot of.

They have already decided to pull the money out of these brokerage firms and active management, but now I am trying to decide what to do with all of these individual holdings. They will be transferred in-kind to another custodian (Vanguard or Schwab).
This is a good plan.

I agree with selling the lowest cost basis shares and gradually increasing the indexed portion of their portfolio.
This could be an approach, but you might also want to reduce the dividend producing stocks if there is an overbalance in that direction.

But I worry that they will be left with a poorly diversified mixture of stocks in various quantities that over the long term will underperform the broader market.
This is possible. It is also possible they have a well diversified mix. You don't know yet.


It would be helpful to know if there are other accounts or if these are their only accounts. If there are other accounts, are there any bond allocations? Where does their income come from right now? Are they in such a high tax bracket because of current jobs or is all of the income from their portfolio?

One thing you/they will need to watch closely is that the cost basis of these shares is transferred to the new custodian. You might even consider transferring out of the SMAs but leaving the investments at MS and ML while you work out the details.
Topic Author
d41517
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by d41517 »

Some final clarifications:
Parents age 69 and 74. Bond portfolio is individual bonds (corporate and Muni). Intermediate duration, acceptable credit risk. Plan is to hold these until maturity and invest interest and principal back into index portfolio, which will be 60% equity index funds and 40% bond funds.

There is some trad IRAs (20% of investment space) which will be easier to transition.

Most of their AGI is coming from capital gains being realized through active management. I would anticipate AGI dropping 50% once this stops

Current income from other sources exceeds living expenses and comes from SS, disability policy paying until fathers death, rental property, 2 variable annuities (not a fan of these but policies sold to parents by family member so unlikely to dump these).

Thanks again for previous advice which has been helpful!
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retiredjg
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Re: Seek advice on transitioning individual stock portfolio with embedded gains to index portfolio

Post by retiredjg »

The parent who is 74 can start using (if desired) qualified charitable donations (QCDs). In case you are not familiar, s/he can donate the RMD from the IRA each year directly to a charity...up to $100k if I recall correctly. This is a benefit because it will reduce taxable income. Of course, if their goal is to pass everything to the kids, that option may not be attractive to them.

Just as a clarification on their tax bracket. Ordinary income has separate brackets from long term capital gains/qualified dividends brackets.

The $500k in capital gains probably is a combination of short term capital gains and long term capital gains. The short term gains are taxed at ordinary rates as ordinary income. The long term gains are taxed at the special (lower) rates.

The point being that their ordinary income may not be in the 35% to 37% tax brackets at all. It could be significantly lower. It all depends on how much of the gains are short term vs long term.

I'm just pointing this out because using QCDs mentioned above may not take money off at a 35% or 37% rate. It might be lower.

This SMA thing is something I'm not very familiar with, but if there are a lot of short term gains coming out of those accounts, that is just a complete travesty, causing huge amounts of unnecessary tax. This is made even worse by paying the AUMs of 1.2% to 1.5% that you mentioned. Imagine paying someone more than 1% of your vast fortune each year so they can generate extra taxes for you. It makes me wonder if there is an upside to SMAs that I don't know about yet.

I realize that just consolidating, rather than eliminating, their individual stocks in an ordinary brokerage account is contrary to your Bogleheaded self. However, it appears just doing that will create a vast improvement over what you are describing as their current situation.

They don't need the money in those stocks and they are not going to run out of money even if some of the stocks fail. I do not think your concerns about the individual stocks not being diversified enough is warranted in this particular situation. I really do think you can just lay all that to rest.
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