Tax Smart Investing: How Tax-Loss Harvesting and Direct Indexing Can Help High-Earners Keep More Money
As an experienced professional or business owner, you likely face unique tax challenges related to your investments and compensation. Many high-income professionals are exploring strategies to help manage their tax burden while working toward maintaining their existing long-term investment strategy.
Two approaches worth understanding are direct indexing and tax-loss harvesting.
What Are Direct Indexing and Tax-Loss Harvesting?
Direct Indexing Explained
Direct indexing involves owning the individual stocks that make up a market index (like the S&P 500) rather than owning a fund that tracks that index. This approach provides greater control over the specific securities in your portfolio and allows for more personalized tax management. An example could be if you own a stock from an international beverage company, and that stock starts to trade at a loss. You can sell that stock and lock in that loss for your taxes and then go out and buy a stock from a different international beverage company to keep your portfolio balanced. Direct indexing is a sophisticated investment strategy to practice tax-loss harvesting.
Tax-Loss Harvesting Fundamentals
Tax-loss harvesting is the practice of selling investments that have declined in value to realize a capital loss. These losses can then be used to offset capital gains from other investments, potentially reducing your overall tax liability.
When combined, these strategies can create an approach to managing investments with greater attention to tax implications.
Relevance for Executives and Business Owners
Executives and business owners often face specific financial situations where these strategies may be particularly relevant:
- Managing capital gains from equity compensation
- Diversifying concentrated stock positions
- Investing significant bonuses or liquidity events
- Addressing higher marginal tax rates
The Potential Advantages:
- Capital Gains Tax Management: Potentially reduce the tax impact of realized investment gains
- Year-End Tax Planning: Incorporate strategic loss realization into annual tax planning
- Equity Compensation Coordination: Consider tax implications when exercising stock options
- Portfolio Customization: Adjust holdings to account for existing concentrated positions
How These Strategies Work: An Example
To illustrate the concept, consider two hypothetical investors:
Investor A invests $100,000 in a traditional S&P 500 index fund. The fund generates $10,000 in capital gains. The investor would typically owe capital gains tax on the full $10,000.
Investor B invests $100,000 in a direct index that tracks the S&P 500 through a platform like Parametric or JP Morgan. During the year, some stocks in the index decline in value. By selling those specific stocks, the investor realizes a $5,000 loss. This loss can offset half of the $10,000 gain, potentially reducing the taxable gain to $5,000.
Both investors maintain similar market exposure, but Investor B may have a different tax outcome.
Considerations for Different Compensation Types
Equity Compensation Considerations
Different forms of equity compensation have distinct tax treatments:
- Incentive Stock Options (ISOs): May qualify for favorable tax treatment if specific holding periods are met
- Non-Qualified Stock Options (NSOs): Generally taxed as ordinary income upon exercise
- Restricted Stock Units (RSUs): Typically taxed as ordinary income when vesting occurs
- Employee Stock Purchase Plans (ESPPs): May offer tax advantages with qualifying dispositions
Understanding these differences is important when considering how tax-loss harvesting might fit into your overall financial picture.
Concentrated Position Management
For those with significant holdings in a single company (often business owners or long-tenured executives), direct indexing can be one approach to gradual diversification. By selling portions of concentrated holdings and investing in a broader portfolio of individual securities, it may be possible to diversify while managing the tax impact through strategic loss harvesting.
Technology Developments
The technology behind direct indexing has evolved significantly in recent years. That’s why we use a variety of platforms from providers including Parametric and JP Morgan.
Parametric's custom indexing platform allows for the creation of tailored portfolios that can be managed with tax efficiency in mind. JP Morgan's technology and research capabilities provide additional tools for portfolio construction and management.
These platforms help facilitate the complex process of tracking numerous individual securities and identifying tax-loss harvesting opportunities throughout the year.
Important Considerations
While these strategies can be valuable, they come with important considerations:
- Wash-Sale Rules: IRS regulations prohibit claiming losses when substantially identical securities are purchased within 30 days
- Transaction Costs: More frequent trading can generate additional costs
- Complexity: Managing numerous individual securities requires sophisticated systems
- Long-Term Perspective: These strategies should align with broader investment goals
Occasionally, we’ll have a conversation about tax loss harvesting and direct indexing, and the person thinks they can manage this themselves. We strongly advise against it, for the reasons we outlined above. When we work with clients, we also make sure that they have a close partnership with an accountant, and we work together with their preferred professionals as part of our holistic approach (or we can recommend several accountants who our clients have had positive experiences with).
How to Approach Implementation
When considering direct indexing and tax-loss harvesting, it’s best to work with a financial advisor who will take a comprehensive approach. Look for one who is also a CERTIFIED FINANCIAL PLANNER® Professional, as they have the highest level of accreditation in their industry. Ask them these questions when you speak to them about their approach to direct indexing, tax loss harvesting, and financial planning in general:
1. Education: How will you help me understanding how these strategies work and their potential benefits and limitations? How many calls or conversations do you typically have with clients before you begin?
2. Portfolio Assessment: How will you analyze my current investments and tax situation?
3. Strategy Development: Have you worked with other clients who have portfolios and backgrounds that are similar to mine? How will you create an approach that’s specific to my circumstances?
4. Implementation: How will you execute the tax loss harvesting and direct indexing strategy? What technology do you use and why?
5. Ongoing Management: How will you monitor my accounts? How often will you adjust a strategy, why might you need to make changes, and will I be updated when that happens?
Understanding Your Options
Tax loss harvesting represents just one component of a comprehensive high net worth tax strategy. At Primary Financial Advisors, we work to implement sophisticated approaches that are tailored to your unique circumstances. We look at your life as if it were a business of its own and develop a strategy – the same way that the CFO of a company approaches their day-to-day work. Most importantly, we believe in providing clear information so you can make informed decisions about strategies that may help you work toward your financial goals.
Schedule a 15-minute conversation with us today to better understand how you can better navigate the complexities of wealth tax mitigation in today's challenging tax environment.
Any opinions are those of Primary Financial Advisors and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional.
Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP® and CERTIFIED FINANCIAL PLANNER® in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization's initial and ongoing certification requirements to use the certification marks.
