Many investors face a difficult tradeoff at some point in their investing career. They have some stock that they want to sell, but it is at a large gain. They want to diversify or rebalance their portfolio but don’t want to pay the taxes associated with selling the position. Many of our clients face this dilemma either from stock positions they have accumulated from their employer over a career or old investment decisions that have lingered in individual stocks.

Unfortunately, there haven’t been good options to solve this issue. Historically, investors have tried using things like options or exchange funds, but these solutions are costly, tax-inefficient, and illiquid.

As wealth managers, we always look for that third door that can efficiently solve a client’s need. 351 conversions beautifully solve this issue. They are low-cost, have zero tax impact, and are liquid.

What is a 351 Conversion?

A 351 conversion or exchange refers to a section of the Internal Revenue Code that deals with corporate reorganizations. This code section allows for a tax-free exchange of securities into a newly created entity, such as an ETF, provided certain diversification rules are met. In other words, the Code allows individuals to exchange holdings of stocks or ETFs into a new ETF in a tax-free conversion with a carryover basis.

Why does this matter to me?

Any investor can seed (put money in at launch) an ETF with individual stock positions and immediately convert their investments from whatever they held to a fully diversified ETF tax-free. Your original cost basis carries over, but now, instead of holding a handful of individual stocks, you can hold a low-cost, diversified, transparent ETF that can rebalance itself and pursue higher returns without incurring capital gains.

What are the limitations?

“There must be a catch! This seems too good to be true. How do I get to go from concentrated stock positions to a diversified investment portfolio without paying taxes?” Yes, 351 conversions are highly effective tools for investors; however, there are several limitations as to when and how they are implemented.

First, the investments that an investor converts must be “diversified,” which means that investors cannot seed a new ETF solely with a single stock (e.g., Apple, Boeing, or Tesla). Specifically, the largest single position cannot exceed 25% of the contributed portfolio, and the five largest positions cannot exceed 50% of the contributed portfolio. While this may limit how much of an existing portfolio an investor can convert, an investor can combine individual stocks and additional ETFs to meet this criteria. Second, 351 conversions can only be done when an ETF first launches…not whenever an investor wants to.

Summary

A 351 conversion is a unique opportunity for investors to improve and diversify their investment portfolio without incurring current capital gains taxes. It allows investors to convert unwanted positions with significant capital gains into a diversified, tax-efficient, low-cost ETF in a non-taxable event.

Why should I care about 351 conversions? We want our clients and the investing community at large to benefit from a 351 conversion in the future, should it become available. Please stay tuned for more details as we prepare to do our own 351 conversion in the coming months!

If you have or know someone who has a low-basis stock portfolio or ETF that may benefit from better diversification but has hesitated to do so out of fear of incurring severe tax consequences, please reach out. A 351 conversion might be the right solution.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Investments involve risk, and past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser or tax professional before implementing any investment or tax strategy.

The future looks bright for younger investors. A 2024 analysis by the Investment Company Institute found that, adjusted for inflation, Gen Zers have nearly three times more retirement assets than Gen Xers did at the same age. That’s a seismic shift, and we would propose it’s largely due to improvements in the retirement system. For instance, defined contribution plans—think 401(k)s—and employee stock purchase plans are more common, providing a relatively easy way to start and build your savings.

Even so, if you’re new to investing, it can be tough to know where to get started. There’s so much information and advice out there, it’s hard to know which makes sense for you. The good news is that getting familiar with a few basic principles can help you see past the information overload and set you on the path toward a healthy financial future.

Let’s jump-start your efforts with six important concepts for young investors to know about.

Avoid the Vicious Cycle of Credit Card Debt

The debt you carry directly impacts every facet of your financial life. Put plainly, every dollar you put toward paying down a credit card bill or car loan is one less dollar that can grow to benefit Future You. That’s why minimizing bad debt is the first step toward building a strong financial future. 

Note that we said “bad debt.” The truth is, not all debts are bad. Low-interest student loans, for instance, can help you receive the education you need to follow a rewarding career path and earn income. And reasonable mortgages can help you buy a home and build equity. On the other hand, high-interest credit card debt can quickly become very expensive—and severely hamper your ability to make other, more important financial moves such as saving and investing.

Why is credit card debt so bad? Credit cards are a form of revolving credit; they allow you to carry a balance from month to month. If you can pay your balance off every month, you won’t owe interest. But if you carry a balance, you’ll pay interest on that balance—often to the tune of 20% or more. That interest will be tacked on to your total bill, which will then continue to accrue interest.

What’s more, credit cards allow you to make minimum payments equal to a percentage of your total balance. If you get in the habit of only paying the minimum every month, your debt load will only grow greater over time. Using this Bankrate calculator, let’s say you have $1,000 in debt on a credit card with a 20% interest rate. If you only make minimum payments of 2%, or $20, per month, it will take you 195 months—more than 16 years—just to pay off this single debt. And in that time, you will have paid $2,126.15 in interest—more than double the amount of your original debt.

In short:

Use high-interest debt carefully, and if you can, only use your credit card when you know you’ll be able to pay off your balance in short order. That way, you’ll avoid getting trapped in a cycle of debt, and you’ll have more cash available to meet other goals, including investing for your future.

Stay Invested for the Long Haul

As a young investor, you may not have much money to invest. But what you may lack in resources, you more than make up for with time. With decades until retirement, the modest investments you make now can grow substantially over time.

This is thanks to the incredible power of compounding returns, or the return you earn on your returns. Indeed, the longer you can keep your money invested, the longer you can take advantage of compound growth to propel exponential growth in your investments. In tax-advantaged retirement accounts, these benefits are magnified as tax-deferred and tax-free growth allows even more money to compound over time.

You may be skeptical about just how important compounding can be. Consider this example: If you start with a humble penny and double its value every day in June, you’ll end up with a cool $5.37 million by the end of the month. If you started this one-month savings journey in July, which has one more day than June, you’d finish with more than $10.7 million. Of course, chances are slim to none that your investments are going to double every day. But the fact remains that compounding is one of the most powerful financial tools at your disposal. And when you pair compounding with time (remember that extra day in July?), the results can be even more impressive.

In short:

The longer you stay invested, the more your investments will have a chance to increase exponentially, thanks to compounding returns.

Make the Most of Tax-Advantaged Retirement Accounts

The government wants you to save for the future. To encourage you to do so, retirement savings plans, such as 401(k)s and individual retirement accounts (IRAs), offer big tax advantages that can save you money today and compound the growth of your savings for tomorrow.

Employer-sponsored plans such as 401(k)s allow you to contribute pretax income to your account. In 2024, you can contribute up to $23,000. Better still, your employer may offer matching funds. Contribute enough to receive these matches and avoid leaving extra money on the table.

Come tax time, your and your employer’s contributions aren’t reported as taxable income. Investments held inside the account grow tax deferred. You won’t have to pay any taxes until you start taking withdrawals from that account. The result? More money is available to work for you—and to benefit from the powers of compounding. Eventual withdrawals are taxed at ordinary income tax rates. But beware that making withdrawals before age 59½ can saddle you with an additional 10% early withdrawal penalty.

If you want to save even more, check out traditional IRAs. Like 401(k)s, traditional IRAs also allow pretax contributions—you can contribute up to $7,000 in 2024—and those contributions may be deductible on your taxes depending on your circumstances. Investments in the account grow tax-deferred, and withdrawals are taxed as ordinary income. Again, taking your money out early can trigger a penalty on top of your tax bill.

There’s one more account to get to know: Roth IRAs. Unlike traditional IRAs, you make Roth IRA contributions after tax. That means you can’t deduct those contributions on your tax return. But it also means you won’t owe taxes when you start taking withdrawals in retirement. In the meantime, just as with a traditional IRA, your Roth investments grow tax-free along the way. This can be a great trade-off if you’re a younger investor who hasn’t hit your peak earning years and you are still paying a relatively low-income tax rate.

Here’s another benefit of Roth IRAs: After your account has been open for five years, you can access your principal contributions penalty-free, though you will pay a penalty if you tap into your investment gains before age 59½. We’d add a caveat here: Tapping your retirement funds should typically be a choice of last resort. Since the point of any IRA is to save for retirement, your Future You will thank you if you avoid thinking of your Roth as a resource for pocket money along the way.

In short: 

If possible, max out your retirement plans to take full advantage of their powerful, tax-sheltered compound growth over time. Also, avoid leaving money on the table if your employer is offering to match your 401(k) contributions.

Get Diversified

In the short term, stock market swings can test even the strongest-willed investor. But over the long term, the market has historically shown a remarkable ability to smooth out performance and head in an upward direction. Holding a diversified basket of many different types of investments helps your portfolio weather short-terms bumps in the market and benefit from the market’s growth over time.

What is diversification? In a general sense, it’s about spreading your risks around. In investing, that means it’s more than just ensuring you have many holdings. It’s also about having many different kinds of holdings.

While this may make intuitive sense, many investors come to us believing they are well-diversified when they are not. They may own a large number of stocks or stock funds across numerous accounts. But upon closer analysis, we find most of their holdings are concentrated in large-company U.S. stocks, or similarly narrow market exposure. Diversification works because different types of investments react differently as market conditions change. When one investment falls on hard times, others might be performing well, and can buoy the overall performance of a portfolio. If all of your holdings are too similar in nature, diversification is unable to work its wonders over time.

So how do you get diversified without overcomplicating your life? Invest in one or a few basic index and index-like ETFs and mutual funds. Seek funds that track and hold a broadly diversified basket of stocks similar to those in broad market indexes, such as the S&P 500 or the Russell 2000. Favor those with relatively low expense ratios. (These days, your basic, well-diversified index ETF need not cost you more than a fraction of a basis point.) You can build a well-diversified portfolio with just a handful of these sorts of low-cost holdings.

As your wealth grows, you may decide to add an exposure to systemic market factors that have been shown to enhance portfolios over time. For example, as described in this Dimensional Fund Advisors piece, “value” companies have “low relative prices (stock price divided by an accounting metric such as book value).” Over time and in aggregate, such companies have delivered a built-in premium return compared to growth companies. By adding a value fund or ETF—and, importantly, holding it over the long run—you can increase the odds of experiencing higher returns over time, if you’re also willing to accept a likely wilder ride along the way.

In short:

Investing broadly across assets of various sector, size and geographies can help you build a resilient portfolio that can better weather the ups and down of the market over time.

Avoid Speculating

Focusing attention on broad market indices can also help you avoid speculative behaviors that tend to have a negative impact on your long-term returns. These include market timing and stock picking.

Attempts at timing the market—buying and selling stocks based on breaking news and short-term market movements—often turn out poorly. Because you’re typically buying into hot trends and selling when conditions are scary, you end up buying when prices are high or selling when prices are low. In both cases, that behavior can take a big bite out of your savings, causing major setbacks as you work toward your long-term financial goals.

In fact, investors’ poor track record around market timing is well known to researchers. A long-running annual survey of investor behavior by DALBAR found that the average equity fund investor trailed the S&P 500 by roughly 5.5% in 2023 due in large part to poor decisions surrounding when to buy and sell.

Meanwhile, stock picking can overload your portfolio with too-few individual securities. This reduces your diversification and introduces something known as concentration risk. Investors are typically rewarded for taking on systematic risk, or risk inherent to the entire market. Concentration risk is not systematic. Rather, it’s particular to the stock you hold, and as such, you cannot expect to be consistently rewarded for taking it on.

If you hold a large portion of your portfolio in just a few stocks, each holding can have an outsized effect on your portfolio. Should something happen to just one of the companies you happen to hold—bankruptcy, for instance—you could lose a big chunk of your savings. 

It’s also exceedingly difficult to pick stocks that will outperform the broader market over time. Consider that in 2023, more than 70% of companies in the S&P 500 Index underperformed the index. These results vary from year to year. But since a handful of companies often drives most of the stock market’s returns, choosing just when to sell the future losers and buy the next big winners can end up becoming an impossible—and often losing—game.

In short:

Timing the market can lead you to buy stocks when they’re expensive and lock in losses by selling during downturns. When it comes to stock picking, it’s exceedingly difficult to pick single stocks that will be winners, and holding concentrated stock positions can introduce uncompensated risk to your portfolio. Instead, build a diversified portfolio as part of your long-term financial plan.

Follow a Plan That Fits Your Goals

So how should you divvy up your diversified investments? Start with your asset allocation, which is how your portfolio is spread among asset classes including stocks, bonds and cash. Then base your asset allocation on your personal goals, tolerance for risk and the length of time you have to invest.

If you search the internet, you’re likely to instead come across various rules of thumb to help you choose how to allocate your funds, such as the “your-age-in-bonds” rule. This rule suggests you hold a percentage of bonds equal to your age. A 30-year-old would supposedly hold 30% of their portfolio in bonds and 70% in stocks, for example.

Be wary of rules of thumb like these. They depend on broad averages, not your individual circumstances. Also, it can be ill-advised to reconfigure your portfolio too frequently or based on something as distracting as whether you’re 29 or 31 years old. With years ahead of you, if you’re able to remain calm and invested during the market’s inevitable rough patches, a healthy dose of stock market returns can take you far. 

In short:

Build your portfolio based on your personal goals, risk tolerance and time horizon rather than chasing or fleeing hot or cold investments or focusing on generalized rules of thumb.

Interested in learning more about how to take the first steps toward meeting your personal financial goals? Reach out to set up a time, and let’s talk.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Investments involve risk, and past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser or tax professional before implementing any investment or tax strategy.

Dear Friends and Clients, 

I know it’s obnoxious to put a big ad of yourself in the introductory comments, but I’m hoping it captured your attention. I’m sharing it because it’s a new print advertisement in which I am featured, along with a sentiment that speaks to the core of our firm. This month, we celebrated our 19th birthday as an organization, a milestone that has been possible because of your unwavering support and trust. It’s a journey that got me thinking about our shared growth and success.

When we contemplated starting Hill Investment Group 20 years ago, our primary question was: What would it be like if we went back to the basics and focused on fewer clients and deeper relationships? Tom Cruise asked the same question in his Academy-nominated performance as Jerry McGuire (here is Jerry’s Mission Statement).

I’m unsure how Jerry’s next twenty years worked out, but the answer has been a steady path of progress and prosperity for us. We’ve built lasting relationships and guided our clients through various market cycles by prioritizing personalized service and evidence-based investing. This is what started us and is who we are today. Your trust and support in taking the long view have been integral to our success.

Here’s to many more years of focusing on what matters most!

Matt