Executive summary:
- The sale of a business, property or large stock position can generate a financial windfall that may trigger a large tax liability
- A Direct Indexing strategy can help manage these tax burdens, either over a set timeframe or with an annual tax budget
- Advisors may benefit from happy clients who could provide a referral
Some of your high net-worth clients may be planning to sell a business, property or large stock position in the future. These transactions typically generate a significant capital gains tax liability that needs to be planned for years in advance. Unfortunately, we’ve found that many clients don’t let their advisors know until they’re only a few years out from their chosen retirement date. And that means many advisors probably don’t have a plan in place.
This gap could provide an opportunity for you to introduce Direct Indexing. With Direct Indexing, you can help your clients prepare for these life-changing transactions and minimize capital gains taxes by selectively harvesting losses to offset those gains, and implementing tax-efficient trading strategies.
A Direct Indexing strategy can potentially earn a return similar to a chosen benchmark – while simultaneously harvesting losses that can be stockpiled to offset the future capital gain. This can help the investor manage their tax liabilities and potentially reduce the taxes due on the future financial windfall. Starting this process ahead of the event gives the client (and you) plenty of time to adapt and adjust over time as the markets move—and as the investor's situation evolves.
The first step is to identify the potential for your client to realize a windfall. You can incorporate questions into the client discovery process:
- Are you anticipating any large financial events in the future, such as selling a property or a business?
- Are you involved in any financial transactions, like the sale of a family business, receiving a large legal settlement or insurance payout, that could lead to a significant cash inflow?
- Do you expect any financial milestones, such as selling real estate or vesting company stock, that could impact your financial planning?
- Are you planning to retire or make another significant life change in the near future, and if so, what changes to your financial situation do you foresee as a result?
Once you and your client determine the source of the future windfall, the timing of it and the potential for capital gains, you can then explain to your client how to use Direct Indexing to either reduce the potential tax liability related to those capital gains over time or manage the tax liability within a certain budget parameter.
How does Direct Indexing help solve this issue?
With Direct Indexing, the investor owns a basket of individual securities, each with their own cost basis. The basket is generally held in a Separately Managed Account which gives the investor the ability to buy and sell those individual securities. While the process is a little more complex than this, essentially the investor can sell the stocks that have fallen and replace them with similar names. 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 the client’s financial windfall.
At Russell Investments, our trading team is systematically looking for opportunities to harvest losses all year long, while balancing risk and index tracking. As we would harvest losses on a monthly basis, the investor would be continuously banking those losses to use when that expected windfall comes in.
A common question I often encounter is whether tax loss harvesting is only effective during years when the markets are performing poorly. Clients are often surprised to learn that every year – good or bad – the stock markets provide investors with opportunities to harvest losses.
The chart below shows how many of the individual names within three key equity indexes were down at specific points in the past six years, even though the indexes themselves rose significantly in four of those years. Clients who invested in a Direct Indexing strategy would have had the opportunity to take losses in those names and bank them against their gains—all while maintaining performance potentially similar to that of the index.
Even in up years, there are opportunities for loss generation
Analysis is based on S&P 500, Russell 3000 and MSCI World Ex-USA Index constituents as of 12/31/2023. "Full period up" indicates stocks that were never down YTD at the end of any month during the year. "Down during year" means stock was down YTD for at least one month during the year. Stocks that do not have full year returns were excluded. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Even in a good year, markets don’t go up in a straight line
Let’s look at 2023 as an example. The S&P 500 ended the year 26.3% higher. Even so, there were 374 individual stocks in the index that spent part of the year lower than they started the year. That means there were 374 opportunities to tax-loss harvest in a year of stellar performance such as 2023. The Russell 3000 Index provided even more opportunities, with 78% of the individual constituents spending at least part of the year in a down position.
While we certainly can’t control the outcome of the markets, we can employ strategies that can take advantage of the volatility and harvest tax losses throughout the year. Regardless of what the market overall does, there will always be some stocks trading at a loss at some point.
As you can see from the table above, no matter the final outcome or the index used, there are tax-loss harvesting opportunities available every year. By offering a Direct Indexing solution, you may find yourself with an appreciative high net-worth client who will likely be very relieved to have such a forward-thinking advisor by their side and may refer you to others who would benefit from a similar strategy.