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.
Source: FactSet, Morningstar Direct. As of December 31, 2024. U.S. equity represented by S&P 500 index. For months January 1950-January 1099: Price Return. February 1998 forward: Total Return. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment.
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.
DIRECT INDEXING
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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.