In this issue: Using a Direct Indexing strategy to tax-efficiently divest of employer stock, opportunities, tradeoffs, and what makes one direct indexing strategy different from the next?
Corporate professionals who are hesitant to sell their employer stock because of the tax bill, can use the losses generated from a direct indexing strategy to offset the gain from selling. What is a direct indexing strategy? Rather than buy an index mutual fund, investors in a direct index strategy buy the actual stocks in the index or a close approximation. Why? The problem with owning an index mutual fund is there is no way to harvest the losses in the underlying index. In any given year, there could be dozens if not hundreds of stocks in the index that trade at a loss, even if the index finishes up for the year. For example, in 2021 there were 72 stocks in the S&P 500 Index which experienced a loss at some point in the year even though the index finished positive, see Figure 1. If an investor only owned the S&P 500 index mutual fund, they missed the opportunity to harvest the losses from those 72 names. That is a huge, missed opportunity, here's why:
The IRS allows taxpayers to net stock gains with stock losses. The net result at the end of the calendar year is a taxable gain or taxable loss. Unused losses are carried forward to future years on Federal Tax Returns (state rules vary). This is especially important for executives of public companies who are routinely compensated in their employer stock.
How I Use Direct Indexing for My Clients with Company Stock
Executives of publicly traded companies - Chubb, Johnson & Johnson, Google, Microsoft, for example - can use direct indexing to tax-efficiently divest out of their company stock. Why is that important? Corporate professionals may be unwilling to sell their company stock due to the tax consequences - if they sell, they will incur an income tax or capital gains tax depending on their holding period. However, holding a large concentration in any one stock can be risky.
For my clients who are reluctant to sell their company stock due to the tax bill, we use a direct index strategy for the core of their taxable money (non-IRA or non-401k). We buy the underlying stocks in an index - or a close approximation - at varying entry points in the market to create different tax lots. Buying different tax lots creates additional tax loss harvesting opportunities - the ability to specifically identify which tax lot to sell. We then screen out the client's company stock if it’s included in the direct index, so we don't buy any more than what he or she may already own. As the year goes on, if some of the stocks trade at a loss, beyond a predetermined range, we book the loss for the client then immediately buy a like-kind security to stay fully invested. The client can then use the loss to offset the gain from selling his or her employer stock.
We buy the underlying stocks in an index - or a close approximation - at varying entry points in the market to create different tax lots. Buying different tax lots creates additional tax loss harvesting opportunities - the ability to specifically identify which tax lot to sell.
Making Lemonade out of Lemons - One Executive's Example
I have a client who owns $1MM of Chubb stock. If he were to sell all the stock, he would incur a $200k taxable gain. However, he also has $400k in a direct index investment with us. Last year, 2022, his direct index investment portfolio harvested $90k in short-term losses even though the overall performance of the strategy was similar to the index itself. Sure, he wasn't happy about being down for the year, no one likes losses. But at least he was able to make lemonade out of lemons, meaning he can now sell a portion of his Chubb stock without incurring a taxable gain. He uses the $90k of losses to offset a portion of the gain incurred from selling the Chubb stock. The net result is he was able to reduce his Chubb stock exposure and his tax bill was zero. He is still fully invested in the direct index strategy. As time goes on, we will continue to sell employer stock if there are losses generated by the direct index portfolio.
Figure 1 - Tax-loss Harvesting in an Up Year? In 2021 the S&P 500 Index finished up for the year, however, there were 72 opportunities for tax-loss harvesting:
Tradeoffs and Solutions
Every investment has its tradeoffs. The tradeoffs with direct indexing may include transaction costs and the cost of the direct index program. When weighing the costs versus the benefits of direct indexing it’s important to add back the value of the losses harvested. For instance, Parametric – a leader in direct indexing – “seeks up to 2% in after-tax excess returns on an annualized basis” by adding back in the value of tax-loss harvesting.
Direct indexing may lead to more losses harvested in the early years. This is because as the direct index employs active tax-loss harvesting techniques - selling at a loss and buying like-kind stocks at lower prices – this lowers the cost basis on the overall portfolio over time and could mean less opportunities to harvest losses in the future. If that happens there are solutions. Charitably inclined clients can gift the low basis stocks in the direct index to a donor advised fund or gift directly to their favorite charity. There is no tax consequence to gifting stock to a qualified charity. Other clients plan to hold their direct index stocks indefinitely and leaving the portfolio to their kids who can, under current tax rules, inherit with a step-up in basis. There are other solutions beyond the scope of this post, one involving using a "short" bias to smooth out the tax-loss harvesting over time. Please reach out to me for further information. Ideally, you employ the direct index strategy in the years you need the losses – when selling out of employer stock or you have a large gain somewhere else in your portfolio.
Ideally, you employ the direct index strategy in the years you need the losses – when selling out of employer stock or you have a large gain somewhere else in your portfolio.
Not all Direct Indexing Strategies are Created Equal
As more and more investment firms introduce direct indexing strategies, it's important to note the differences. Tracking error measures how much the direct index strategy differs from the underlying the index. Some strategies have wide tracking errors, while others hug the benchmark closely. It depends if you truly want index-like returns or if you are okay with some latitude. Also, how experienced is the manager? Do they have the teams, technology, and infrastructure to produce the desired effect? Can they smooth out the tax-loss harvesting so as not to clump in the early years, if that is important? Also, what are the fees? Fees are a drag on a portfolio's return. As independent advisors, we source from a variety of institutional quality direct indexing strategies which we screen for tracking error, management tenure, fees, and other due diligence criteria.
Finally, can the overall advisor help holistically in your financial planning? Maybe direct indexing is or isn't for you? Or maybe a covered call strategy is a better fit or even an Exchange Fund? An advisor with experience in concentrated stock strategies can develop a plan suitable to your goals and objectives.
As independent advisors, we have access to a variety of institutional quality direct indexing strategies which we screen for tracking error, management tenure, fees and other due diligence criteria.
No one invests with the express purpose of taking a loss. But stock market investors know losses may occur. Direct Indexing takes those underlying losses and makes lemonade out of lemons. Executives sitting on large unrealized gains of their employer stock can use the losses generated from direct indexing to offset the gains from selling their employer stock. It's a win-win. The executive diversifies out of their employer stock but does so in a smart way. I believe in index funds, but I also believe index funds are not enough for executives routinely paid in their employer stock. In my opinion, direct Indexing is a better approach.
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