Ah, the traditional pleasures of September. Summer's heat starts to recede. Pumpkin spice–flavored everything starts to appear on menus. People get in their first complaints of the year at seeing retailers roll out the Christmas marketing before they've even picked out their Halloween costumes. And, of course, here at Fool HQ, the month would not be complete without a mailbag show from Motley Fool Answers podcast hosts Alison Southwick and Robert Brokamp. To help them address all your autumnal financial conundrums, Sean Gates, a financial planner with Motley Fool Wealth Management (a sister company of The Motley Fool), returns to the studio.
In this segment, they weigh in on a portfolio that isn't allocated the way its owner would like, because much of it came to him through inheritance. His fear is that selling stock holdings purchased many years ago would leave him with an unpalatable capital gains tax bill. It's possible his fears are overblown. And even if they aren't, say the Fools, he probably shouldn't let that stop him from reallocating.
A full transcript follows the video.
This video was recorded on Sept 25, 2018.
Alison Southwick: The next question comes from Rob. "What is the best way to handle inherited stocks with extremely low cost bases?"
Robert Brokamp: Ba-see-see-sees.
Sean Gates: Indices.
Southwick: Thank you!
Brokamp: Indices of bases.
Rick Engdahl: Basics-ses.
Southwick: Basically inheriting stocks that your grandparents bought for a very low price.
Brokamp: There you go!
Southwick: "Selling the stock would create a significant tax event, but I'm worried that continuing to hold the positions leaves me overexposed to just a handful of stocks; specifically ExxonMobil, Wells Fargo, and General Electric. GE, in particular in recent years, has wiped out a large portion of my net worth." Aw! "At the moment I have dividend reinvestment turned off to funnel those dividends to purchasing low-cost funds in an attempt to slowly rebalance the portfolio, but it's not moving as quickly as I'd like."
Brokamp: I'll start by saying it's generally not a good idea to let taxes determine your asset allocation. It's fine to consider them as a factor, but they should never be the primary factor. If you have a very concentrated portfolio that you think you should diversify and you're afraid of the tax consequences, go ahead and do it.
The important thing to know is that when you inherit a stock that isn't in a retirement account, like an IRA, your cost basis is the value of the stock as of the date of death. If the original owner bought the stock for $10 and it was worth $100 as of the date of death, your new cost basis is $100. That's known as a "step up in cost basis."
That said, you could have a "step down," too. It works the other way around. If your grandmother bought it for $100 and it was $10 on the day she died, your new cost basis is $10. There are some cases in which the value is actually six months after the date of death depending on how the estate was settled, but for most people it's as of the date of death.
It could be that that cost basis is actually higher than you think given that, especially with these three stocks. They've had a lot of ups and downs over the last decade or two. So in this situation, it actually could be possible where you sell some of it at a capital loss to offset the gains of selling some of the others. You actually might have more flexibility taxwise with this situation than you think.
That said, I still think even if you ended up having to pay capital gains to rebalance the portfolio, I think it's the smart thing to do, especially if you have a large portion of your net worth in these three companies.
Gates: And I would say just in dealing with these situations on a day-to-day basis and to Bro's point, one of the reasons that you might consider enlisting some help is there's this common wisdom that you shouldn't let taxes wag the investment dog; but, let's just say for the sake of argument you have $1 million worth of capital gains exposure in these stocks. If you shift your portfolio and recognize that all at once, your tax bill is enormous. So maybe you decide that you have the risk capacity to distribute it over a year, two, or three. The ultimate goal is still to diversify the portfolio but strategically recognize the taxes over time.
Then another reason why you might want to consider getting help is because your situation raises the opportunity to look at a more complicated investment where you might want to consider utilizing options, which can get complicated, but in your case, because you own the underlying investments like GE, you could implement an option that gives you the ability to participate in the deterioration of the stock and/ or strategically dole out those shares to other investors who the think the prospects are brighter and reduce your position over time. That can be a really smart strategy for these highly concentrated portfolios.
Brokamp: I would say that I think Rob is being smart in that he's not reinvesting the dividends.
Brokamp: That's a great way to build up a cash cushion or to invest in something else. But as he points out, it can take a while for that to have a meaningful impact on the asset allocation.