The Power Of Tax Loss Harvesting And Direct Indexing

"Buy low, sell high" is common advice we get.

And it's good advice. But there are times where selling low can actually make sense.

Sounds counterintuitive, right?

Well... here's why it can make sense. This concept is called tax loss harvesting. And it's something very few DIYers understand and do well.

Tax-loss harvesting is a powerful strategy that can help investors reduce their tax liabilities and improve their after-tax returns. By strategically selling investments that have declined in value, you can offset gains from other investments, lowering your overall tax bill.

In this post, we'll explore what tax-loss harvesting is, how it works, the advantages of doing it, and introduce the concept of direct indexing.

What is Tax-Loss Harvesting?

Tax-loss harvesting involves selling investments that have lost value to realize a capital loss. This loss can then be used to offset capital gains from other investments, reducing your taxable income. If your losses exceed your gains, you can even use up to $3,000 of the excess loss to offset ordinary income each year, with any remaining losses carried forward to future years to then offset capital gains then income.

How Does Tax-Loss Harvesting Work?

Here's a step-by-step breakdown of how tax-loss harvesting works:

1. Identify Losses: Review your investment portfolio to identify securities that have declined in value and could be sold at a loss.
2. Sell the Losing Investments: Sell the identified securities to realize the capital loss.
3. Offset Gains: Use the realized losses to offset any capital gains from other investments. Short-term losses offset short-term gains first, and long-term losses offset long-term gains.
4. Reinvest Proceeds: To maintain your investment strategy, reinvest the proceeds from the sale into similar, but not "substantially identical," securities to avoid the wash-sale rule. Ideally it is something that is correlated and moves similarly.
5. Carry Forward Excess Losses: If your losses exceed your gains, you can use up to $3,000 of the excess loss to offset ordinary income and carry forward any remaining losses to future years. You want to track this so you can make decisions in the future.

Advantages of Tax-Loss Harvesting

1. Reduce Taxable Income: By offsetting capital gains with losses, you can lower your taxable income, potentially reducing your tax bill.
2. Improve After-Tax Returns: Lowering your tax liability can improve your overall after-tax returns, allowing you to keep more of your investment gains.
3. Flexibility in Managing Investments: Tax-loss harvesting allows you to strategically manage your portfolio, selling underperforming investments and reinvesting in more promising opportunities.
4. Offset Ordinary Income: If your losses exceed your gains, you can use up to $3,000 of the excess loss to offset ordinary income, providing additional tax savings.
5. Carry Forward Losses: Any unused losses can be carried forward to future years, providing ongoing tax benefits.

Introducing Direct Indexing

Direct indexing is an investment strategy that involves buying the individual stocks that make up an index, rather than purchasing an index fund or ETF.  Imagine you have a direct indexing portfolio that mirrors the S&P 500. If a few stocks in your portfolio decline in value, you can sell those specific stocks to realize a loss and offset gains from other investments. You can then reinvest the proceeds into similar stocks within the same sector or industry, maintaining your overall investment strategy while optimizing for tax efficiency.This is extremely impactful for high income folks in high tax brackets.

This approach also allows for more personalized portfolio management and can enhance the benefits of tax-loss harvesting.

How Direct Indexing Enhances Tax-Loss Harvesting:

1. Greater Flexibility: Direct indexing provides more opportunities to harvest losses by allowing you to sell individual stocks that have declined in value, rather than being limited to the overall performance of an index fund or ETF.
2. Customization: You can tailor your portfolio to exclude certain stocks or sectors, align with your values, or focus on specific investment themes. You can also remove stocks you already are over exposed to.
3. Tax Efficiency: By harvesting losses at the individual stock level, you can maximize your tax savings and improve your after-tax returns.
4. Avoiding Wash Sales: Direct indexing makes it easier to avoid the wash-sale rule by allowing you to replace sold stocks with similar, but not identical, investments.

Tax-loss harvesting is a valuable strategy for reducing your tax liability and improving your after-tax returns. By strategically selling losing investments and offsetting gains, you can keep more of your hard-earned money. Direct indexing takes this strategy to the next level, offering greater flexibility, customization, and tax efficiency.

Direct indexing is something we have started to do with more and more of our clients and it is something I personally do as well.