Executive summary:
- Tax-loss harvesting all year allows investors to accumulate a greater amount of tax losses to use to offset gains
- When tax-loss harvesting is conducted in a direct indexing portfolio, the investor has greater control over when and how tax losses are taken
- Direct indexing can help reduce taxes on a future financial windfall or help efficiently wind down a concentrated stock position
There are a few things it makes sense to get a start on when a new year begins. Adopting a healthier lifestyle for one. Making a list of your goals for the year. And tax-loss harvesting.
Many investors wait until the end of the year to harvest tax losses.
But the advantage of beginning the process as early as possible in the year is that an investor can realize losses the course of the year potentially creating a substantial amount of them that they then can use to offset taxable gains from the sale of a security or securities. For example, if an investor sells a stock position in January for a gain and transfers the assets to a direct indexing portfolio, they have the remainder of the year to harvest losses they can use to offset the gain. By waiting to harvest losses until later in the year, they not only have less time to conduct the harvesting, they may also face the possibility of a broad market rally that makes it harder to find losing stocks to sell.
For example, the chart below shows that the last two months of the year are often among the best in terms of index returns, which makes them among the worst for tax-loss harvesting.
While tax-loss harvesting is a useful strategy to manage tax liabilities on investments, when used in a direct indexing portfolio, it can be a powerful tax-planning tool with broader implications.
Investors who plan on selling a business or property in the future may want to consider investing in a direct indexing portfolio now and begin the tax-loss harvesting process as soon as possible, thus increasing the potential tax offset when they eventually realize their taxable gain.
With Direct Indexing, the investor owns a basket of individual securities, each with their own cost basis, that essentially mimics a chosen index. The basket is generally held in a Separately Managed Account which gives the investor the ability to buy and sell those individual securities at the time and in the amount that they determine. A simple way of describing the process is that the investor can sell the stocks that have fallen and replace them with similar names to maintain a profile as close to the benchmark index as possible. The losses that are booked in this process are essentially tax “assets” to use in the future. These losses can then be carried forward indefinitely and used when appropriate to offset capital gains produced from a financial windfall such as the sale of a business or property.
Other investors may use these tax losses to help diversify a concentrated position.
How does direct indexing help reduce a concentrated stock position?
Divesting part or all of a concentrated stock position in a tax-efficient manner can be challenging. In some cases, the original cost of the shares could be a small fraction of the current price, which would trigger a significant capital gain and a massive tax bill.
As noted earlier, direct indexing allows the investor to directly hold a basket of stocks that replicates an index. That means the investor can offset the capital gains from selling a concentrated stock position with capital losses generated from selling other securities in the direct indexing portfolio. When the transition is done through a program such as our Personalized Managed Accounts (PMA), using a direct indexing strategy, investors can determine how much they want to take in capital gains annually until the position is whittled down to a more manageable percentage of the portfolio. Alternatively, the exposure to the concentrated stock position can be pared down by taking gains over a period anywhere from three to five years. And with a PMA strategy, those capital gains will be offset with tax-loss harvesting, keeping any related taxes as low as possible.
How can Russell Investments help you implement direct indexing for your clients?
When you partner with us for non-IRA accounts, you get access to a time-tested process that conducts tax-loss harvesting from the start to the end of the year. Our trading desk is staffed 24 hours a day by traders averaging more than 15 years of experience across the investment spectrum. Our team is systematically looking for opportunities to harvest losses all year long, while balancing risk and index tracking. These losses can then be carried forward and used to offset any future gains in that portfolio, elsewhere in the investor’s account or even in another part of the household’s portfolio—such as the sale of a property or business.
As you can see, direct indexing can be a beneficial tax-planning tool. Whether to harvest losses today to offset a future gain or to reduce a concentrated stock position, direct indexing through our Personalized Managed Account program can provide you with options to help your clients reach their financial goals.
Disclosures
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
This material is not an offer, solicitation or recommendation to purchase any security.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.
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Personalized Managed Accounts (“PMA”) is a program of Russell Investment Management, LLC (“RIM”) and offers customized portfolio management services.
Each Personalized Separately Managed Account is a product of Russell Investment Management, LLC (”RIM”) and is offered through PMA. It represents a composite of model portfolios provided by RIM, in which each composite reflects model portfolios of RIM and third-party investment advisors selected by RIM. When the model is implemented, PMA is a separately managed account program of individually owned securities that can be tailored to meet an investor’s investment objectives. RIM partners with external third-party money managers to offer diversified, single or multi-asset managed accounts that can be customized to the investor’s investment objectives, circumstances and preferences, such as (but not limited to), market exposure, risk management, tax management, environmental, social and governance considerations, and return objectives. Excluding any allocations to pooled investment vehicles, if any, each investor’s account is managed separately from other investor accounts, allowing for a personalized experience to deliver unique investment outcomes.
The decision to use PMA in investors’ portfolios and related investment advice are provided through financial advisors and other financial intermediaries that are independent of RIM and its affiliates. Investors should consult with their financial advisor to determine which services and programs are appropriate to meet their investment objectives.
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