Tax Advantages of Individual Stocks

In my post last week ETFs vs Mutual Funds: A Few Things You Need To Know I talked about the various tax advantages that ETFs have vs Mutual Funds. In today’s post I am going to discuss some of the key tax advantages related to owning individual stocks instead of ETFs.

Investments in individual stocks require more work than investing in ETFs. However, individual stock portfolios allow for a greater degree of customization. One benefit to a higher degree of customization is the fact that investors have more control over tax management. To better understand how this tax advantage works it is helpful to consider two hypothetical examples.

As a basis for each example strategy, let’s suppose an investor allocated 100% of their portfolio to equities one year ago.

Scenario 1

Under the first scenario, suppose the investor decided to purchase the SPDR S&P 500 Trust ETF (SPY). As of this writing, SPY has delivered a total return of ~15.7% over the past year (~14% from price appreciation and ~1.6% from dividends.)

At a minimum the investor would be subject to tax on the dividends. Additionally, If the investor needs to sell stock for any reason (to pay taxes, to pay living expenses, to change their asset allocation, etc..) the investor will be subject to capital gains tax with the highest rate being 20% on gains related to any sales. A 3.8% net investment income tax may also apply to high earners.

Scenario 2

Under a separate scenario lets assume an investor had made the below allocations to individual blue chip stocks:

Microsoft (21%)

Apple (20%)

Visa (20%)

Johnson & Johnson (20%)

Bank of American (19%)

*Note this portfolio is highly simplified and concentrated for ease of explanation. I generally believe a more diversified approach is better suited for most investors. 

This portfolio would have also generated a total return of ~15.7% over the past year. However, as shown by the chart below there was a lot of dispersion in the portfolio with the best performer Microsoft delivering a total return of 57%. The worst performer of the group, Bank of America delivered a total return of -18.6%.

While our investor would still be subject to taxes on dividends received, they would be able to avoid taxes in the event they need to sell stock to raise cash for any reason. Our investor could sell out of Bank of America or Johnson & Johnson stock without incurring any capital gains tax.

The tax advantages do not end there. Additionally most tax payers are able to use up to $3,000 each year in capital losses to reduce ordinary income. Under the scenario where our investor simply held SPY, he or she would be unable to take advantage of the $3,000 per year in potential ordinary income reduction due to capital losses. On the other hand, under the individual stock scenario our investor could sell out of either Bank of America or Johnson & Johnson, realize $3,000 of capital losses, and reinvest in other similar securities. One thing investors do need to be aware of is the wash-sale rule which does not allow investors to claim the loss if they purchase the same security or a substantially identical security within 30 days before or after the date of selling the loss generating investment.

Another potential tax advantage related to individual securities is the potential for individuals to gift highly appreciated stock. By gifting highly appreciated stock to charity, the investor would be able to give more than he or she would have been able to had the stock been sold to raise cash for the gift. The charity generally does not owe capital gains tax when selling the investment either. Additionally, individuals are typically eligible to deduct the full fair-market value of assets donated from income taxes. Similarly, in certain circumstances gifting highly appreciated stock can be a favorable estate planning strategy in cases when the recipient is in a lower tax bracket than the person who gives the gift.

The potential tax benefits due to tax strategy are generally greatest for individuals later in their life. The reason is that the step up basis (the tax rule which allows the price of inherited assets on the date of the decedent’s death to rise to the fair market value) has the potential to result in no tax paid on unrealized capital gains. Thus, from a tax efficiency standpoint individuals are generally best served by never selling stock which has significantly appreciated if at all possible while utilizing the full $3,000 of capital loss deductions against ordinary income each year.

While the example scenario discussed in this article is overly simplistic the general principal remains the same: investors who hold individual stocks generally have better control over tax strategy than investors who simply hold index ETFs or mutual funds.

A Consideration To Be Aware Of

A significant trade off as it relates to an individual stock strategy used to maximize tax efficiency is that initially small individual stocks have potential to result in highly concentrated portfolios later on. Take for example Warren Buffett’s Berkshire Hathaway, which now has ~50% of its equity portfolio in Apple. The reason for this is not that Berkshire invested 50% of its equity portfolio in Apple initially, rather Apple shares have appreciated so much faster than the rest of Berkshire’s portfolio which has resulted in high position concentration. Investors who go with index ETFs generally do not need to worry as much about over concentration though index funds have also become somewhat concentrated with Apple and Microsoft now accounting for a combined ~14% of the index.

Generally speaking, investors with a long time horizon (10 years+) should be more concerned about the risk of concentration as there is more time for stock dispersion to compound. On the other hand, investors with shorter time horizons may be better served by focusing on individual securities to take advantage of tax optimization.

Takeaway 

While ETFs are more tax efficient than Mutual Funds, they are not quite as tax efficient as individual stocks. The reason for this is the dispersion among individual stocks tends to be fairly high which creates opportunities for investors to harvest losses on losing investments. Moreover, investors may able to able to benefit from gifting highly appreciated stocks while retaining stocks that have experienced less appreciation.

An important consideration that investors should be aware of is that an individual stock strategy focused on maximum tax efficiency has potential to result in a highly concentrated portfolio.

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