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Tax-Loss Harvesting via Direct Indexing

Taxes are one of the most significant costs you’ll pay in your investing life. Fortunately, the U.S. Tax Code provides ample opportunities to reduce your lifelong tax liability – you just have to know HOW to use those opportunities. One of the more clever techniques in overall tax reduction is tax-loss harvesting via Direct Indexing within a Separately Managed Account.
Ok, we’re throwing around some technical words that many people don’t understand right off the bat, so let’s break them down first before we get into the unique complexities of tax-loss harvesting via Direct Indexing.

What is Tax-Loss Harvesting?

In the realm of investing, you’re taxed only on your net earnings, not your losses. Let’s consider a scenario where you buy three shares of Company A at $100 apiece, as well as one share of Company B for $100. Six months later, Company A’s stock skyrockets to $200 per share, yielding a tidy $300 profit when you sell. Meanwhile, Company B’s stock falters, dropping to $50, leading to a $50 loss when you sell it.
So, what’s your tax obligation? If you’re assuming it’s on the $300 profit, think again. Your actual taxable gain is $250, as the $50 loss on Company B offsets some of your earnings. Remember, this scenario is only applicable if you actually sell all of the assets just described. Unrealized gains and unrealized losses don’t count toward your yearly tax situation – though this may change in the future.
Tax-loss harvesting is more deliberate than just adding and subtracting your gains and losses to figure out your net earnings. Instead, you purposefully sell off a losing asset and immediately repurchase a similar asset (not the same asset) at around the same price to maintain your asset allocation and earnings potential. Even if that new asset rises in value before the year’s end, as long as you don’t sell it, you’ve still suffered a loss from the sale of the initial asset, letting you offset your capital gains. However, there are some nuances to consider.

The Wash-Sale Rule

The IRS has a 30-day wash-sale rule which means if you buy a “substantially identical” asset within 30 days before or after selling an asset at a loss, you cannot claim that loss on your taxes. Fortunately, the stocks of two companies are considered ‘different’ enough to execute this strategy.
Apple stock = Apple stock (substantially identical)
Apple stock ⧣ Microsoft stock (substantially different)
The wash-sale rule may inadvertently come into play if you receive company shares as part of a stock purchase plan, bonus, or options contract, so be aware of this possibility when selling shares as part of a tax-loss harvesting strategy.

Capital Gains Rate

Here in the U.S., capital gains are subject to two different tax rates depending on the holding period of the asset. Long-term gains, which apply to assets held for more than a year, are taxed at a lower rate. On the other hand, short-term gains, which apply to assets held for a year or less, are taxed at your generally-higher regular income tax rate.
Considering that each kind of gain has it’s own tax rate, there is an order of operations to prevent investors from taking unfair advantage of the system, such as using capital gains losses to neutralize short-term capital gains.
First, you must use long-term capital losses to offset any long-term capital gains. Only after neutralizing all long-term gains can you apply any leftover long-term losses to offset short-term gains. The same rule applies in reverse: you must first use short-term losses to neutralize short-term gains before applying them to long-term gains.
Additionally, if you end up with more capital losses than gains in a tax year, you can carry forward the remaining losses into future tax years. This feature allows you to offset future capital gains, providing even further tax-saving opportunities.

What is Direct Indexing?

Direct indexing involves purchasing all of the assets of an index, such as the S&P 500, and maintaining its composition as closely as possible. This is in stark contrast to purchasing an Index Fund that mirrors its underlying index, such as SPY for the S&P 500.
Indexing is, in essence, a passive investment strategy. However, direct indexing allows for more customization and control than an ETF index fund provides. The benefits are multiple – more tax-loss harvesting opportunities (we’ll get into that later), the option to replace companies according to your beliefs or values, and the opportunity to target specific industries within the personalized index more than the standard index does.
If it all sounds prohibitively expensive, modern technology allows for the purchase of partial shares of a company stock, drastically lowering the overal costs previously associated with Direct Indexing. To answer the question you haven’t asked, no – you don’t need the millions of dollars necessary to replicate the S&P 500!

Tax-Loss Harvesting via Direct Indexing

Finally, we can get to the reason we’re writing this article. One of the main drawbacks of an ETF is that we can’t take advantage of the losses of any of the individual stocks that comprise the ETF. When we have an ETF, we don’t actually own any of the stocks that make up the ETF – rather, we just own an interest in it.
We can harvest the losses of an individual ETF, but given the very nature of ETFs, we will certainly have fewer overall kinds of them in our portfolio. Using the 3-Fund Portfolio popular among DIYers as an example, how many possible tax-loss harvesting possibilities will you ever have?
However, inside each of the two stock-based funds within the 3-Fund Portfolio, there are potentially hundreds of companies losing value throughout the year, whose losses are completely out of your reach.
Instead, by physically owning all of the stocks within the index, we can take advantage of each and every possible tax-loss harvesting possibility year-round while maintaining robust diversification of our assets.
Here’s how it works:

Step 1: You realize that a stock has lost significant value since you first purchased it. You sell it.

Step 2: You immediately purchase a similar stock at the same value so you don’t lose future earnings potential.

Step 3: You claim that loss on your tax return.

Now, one of the disadvantages you may have already noticed is that by selling a stock and purchasing another, you’re drifting from the index’s composition. However, the other benefits should more than make up for it (if executed correctly), and you can gradually realign your portfolio to match the chosen index as other tax-loss harvesting or rebalancing opportunities appear.
Here are some more benefits you get with tax-loss harvesting via Direct Indexing:

Tax Bracket Management

Understanding your tax bracket and applicable capital gains rates can make your tax-loss harvesting more effective. With Direct Indexing, you can be more nuanced in your tax planning, deciding when to realize a loss based on your specific tax situation.

Rebalancing Opportunities

When you’re conducting tax-loss harvesting via Direct Indexing, the act of selling off underperforming assets also gives you a natural chance to rebalance your portfolio back to its target allocations. This not only helps in managing risk but also ensures that your portfolio remains aligned with your long-term goals and the goals of the index.

Matching Losses and Gains

Owning individual stocks through Direct Indexing enables you to match short-term losses with short-term gains and long-term losses with long-term gains. This ensures that you receive the most favorable tax treatment for both gains and losses.
By taking advantage of these unique benefits, Direct Indexing stands as a super-charged variant of the time-tested passive indexing strategy, equipping investors with a level of control and optimization that’s simply unavailable in traditional ETFs.

The Reality of Tax-Loss Harvesting via Direct Indexing

So, this all sounds quite enticing, right? You get the benefit of year-round tax-loss harvesting combined with the simplicity of passive index investing. However, there is still one more issue to consider – time and knowledge.
Think about how much time it already takes to rebalance your portfolio or work out your tax strategy and all the different nuances you have to keep in mind. Now imagine trying to do that with 500+ stocks while trying hard to not drift too far away from the index, which would nullify the point of passive indexing.
Fortunately, Walters Strategic Advisors has the time, knowledge, and expertise to develop a Direct Indexing strategy for you. As both CPAs and Fiduciary Financial Advisors, we’re in a unique position to make your money work as hard as possible.
Do you think tax-loss harvesting via Direct Indexing has a place within your financial plan? We’d be happy to meet with you over the phone or in person at our office to discuss the possibilities. Just click the button below!

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

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  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.

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