Tax Loss Harvesting with Direct Indexing
Contributed by Rory Henry
Director, Arrowroot Family Office
You can help clients prosper in today’s challenging times by harvesting losses all year round, not just at year-end. So, what is tax loss harvesting with direct indexing?
Key Takeaways
- Direct indexing offers ample opportunity to harvest losses and strategically rebalance without running afoul of wash sale rules.
- Loss harvesting should be a year-round strategy, not a year-end hope.
- You no longer have to be an ultra-high-net-worth individual to take advantage of direct indexing.
A bear market is clearly upon us as we head into the final months of 2022. Clients are likely asking you for advice about selling their losing stock positions to reduce taxes, raise cash, or sever ties to a company they no longer love. One silver lining to the current market slump is that many investors have many unrealized losses to choose from. But not all losses are created equal. For instance
- Positions may have been held for many, many years, and the basis is still way too low to be viable for loss harvesting.
- Losing positions have been held for less than one year, meaning a higher short-term capital gains rate (ordinary income rate).
- The wash sale rule states that if you sell an investment to recognize and deduct that loss for tax purposes, you cannot buy back that same asset—or another investment asset “substantially identical”—for 30 days. This can affect your client’s portfolio balance.
- The tax savings today can cause higher taxes later on. However, by selling some investments and using the proceeds to buy similar investments at lower prices, the investor lowers the overall tax basis of their portfolio.
- A client may have more losses already than they will ever use.
Enter direct indexing, aka personal indexing
Direct indexing is an investment strategy that enables investors to hold a large number of individual stocks that make up an index without having to own every single stock in the desired index. As with an index fund, the goal of direct indexing is to track the performance of a target benchmark index. But when the investor holds the individual securities directly in their account – rather than shares of a mutual fund or ETF – they can control exactly when each holding is purchased or sold (not the fund manager). That means no more surprise capital gains notices in January. Direct indexing also allows for more personalization of the portfolio and often greater tax benefits.
By using this approach, your clients can avoid owning stocks in certain companies or industries that don’t align with their values. They can also tilt their portfolio to increase exposure to certain stocks or industries on which they’re bullish. Finally, holding individual stocks rather than fund shares allows the investor to participate directly in proxy voting for companies they own.
Which clients are best suited for direct indexing?
Direct indexing has long been used by high-net-worth (HNW) clients and institutional investors. Still, thanks to technological advances, low-commission trading, lower account minimums, and the ease of buying fractional shares, direct indexing is becoming more widely adopted by clients with portfolios in the $100,000 to $250,000 range. In fact, direct indexing is expected to grow by more than 12% per year, faster than estimates for mutual funds and ETFs, according to Cerulli Associates.
Personal indexing works best for the following client situations:
- Your client has large enough capital gains regularly arising from assets held outside of their taxable equity account (i.e., realized capital gains are at least 3% to 4% of taxable equity holdings per year).
- Your client has a meaningful share of wealth invested in their taxable equity accounts (i.e., at least 20% to 30% of their financial wealth is in taxable equities).
For clients that meet the conditions above, direct indexing can provide additional tax savings on a regular basis and enhanced “tax alpha,” especially when there is a volatile market environment, a large difference between the harvesting tax rate and the liquidation rate, and regular contributions to the account.
Here’s how it works
After determining a client’s risk tolerance and time horizon, you can help them find an appropriate index to replicate. This approach is sometimes called personal indexing because investors can cleanse their portfolios of companies or industries that don’t align with their values, or which overexpose them to certain companies/industries as a result of their employment (and options). “Here in Silicon Valley, we have lots of clients working in the tech industry, say a dual-income couple both working in semiconductors,” shared Jonathan Hudacko, Principal of Personalized Indexing at Vanguard, on a recent podcast we did together. “If they own the S&P 500, that’s way too much more tech exposure, so let’s take that out of what we’re buying for you.”
Hudacko said the key to making direct indexing work is to own a “statistical representation” of the market – say 200 to 350 of the U.S. Total Market Index, for instance — that closely tracks the index without the hassle and expense of owning all 4,000 names.
“So now I’m directly owning the stocks. I can loss harvest because I don’t own all the index as I loss harvest, I can buy replacement stocks, put them into the client’s account, maintain my exposure to the market, so I capture market return,” related Hudacko. “And along the way, harvest losses, harvest losses, harvest losses. It’s a tremendous engine, and it’s really shocking that every investor doesn’t have some part of their invest taxable investments in one of these,” Hudacko added.
Tax efficiency
With hundreds of individual stocks held in a direct indexing portfolio, there are extensive opportunities for tax loss harvesting. While there are plenty of opportunities for tax loss harvesting in today’s volatile investment climate, individual stocks can have periods of poor performance even in bull markets. Direct indexing portfolios can take full advantage, harvesting losses in underperforming stocks even as the overall market is up. This can mean “tax alpha” of 1% to 2%, according to recent research from Vanguard. Meanwhile, a 2020 study published in the Financial Analysts Journal found that from 1926 to 2018, an investor using an approach similar to direct indexing on a portfolio of the 500 largest U.S. stocks would have improved their after-tax returns by 1.08 percentage points per year compared to a portfolio that didn’t use tax-loss harvesting.
“Having looked around the world, there’s one aspect of the U.S. tax code that’s amazing,” said Hudacko. “We have the freedom to decide which lots to sell, and if they’re at a loss, we can harvest those losses and use them as a tax shield against other gains in our life,” he added.
Hudacko said tax-loss harvesting is also beneficial for clients who are downsizing or otherwise selling their properties for large gains. With the recent run-up in real estate prices, more homeowners than you think are looking at substantial capital gains above the $500,000 exemption. “Wouldn’t you like to take $100,000 of that excess gain and not be taxed on it?” Hudacko added. “That’s where accountants can add great value for their clients.”
Can clients build their own personalized index?
In theory, yes, if they have lots of time on their hands and access to powerful software. But doing so is a time-consuming process, and they’ll need to manage the complexity of building a portfolio and managing the positions for size and tax purposes. They’ll also need to stay up to date on changes to the index they’re tracking and adjust their portfolio accordingly while also paying attention to the tax implications. Tax-loss harvesting can also be difficult to manage on one’s own because you’ll need to know your cost basis in each security and decide when to realize gains and losses.
That’s where you and a powerful platform come in.
Conclusion
Today’s market volatility is unnerving for many of your clients, but that’s when Hudacko said is when you want to be most active in harvesting losses. “When you get back to a calmer, up-trending, less volatile market, you’ve already banked those losses and have them available for the investor to use.” So, you can see why tax loss harvesting with direct indexing is beneficial to clients. What’s not to like?
Contact me any time if you’re interested in learning more about the direct indexing platform or our CPA partnership program that helps accountants integrate holistic wealth management services into their practices.
Rory Henry is a Director at Arrowroot Family Office and host of the Wealth Management Forward podcast. He can be reached at (310) 566-5865 rory@arrowrootfamilyoffice.com
