Insurance executives 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 a 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, see Figure 1. Unfortunately, if you own the index mutual fund you can't harvest the stock losses in the fund to offset gains elsewhere. That is a huge, missed opportunity, here's why:
The IRS allows taxpayers to net our stock gains with our stock losses, the 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 insurance executives of public companies who are routinely compensated in their employer stock.
HERE'S HOW I USE DIRECT INDEXING WITH MY INSURANCE CLIENTS
Insurance executives of publicly traded companies - AIG, CHUBB, Everest, for example - can use direct indexing to tax-efficiently divest out of their company stock. Why is that important? Insurance executives may be unwilling to sell their company stock due to the tax consequences - 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 insurance clients who may be 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. 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 invested. The client can then use the loss to offset the gain from selling his or her employer stock.
For example, I have a client at a major insurance company. He owns $700k of his employer stock. If he were to sell all the stock, he would incur a $50k tax bill. However, he also has $250k in a direct index investment with us. The direct index strategy has harvested $35k in unused losses over the years. Instead of selling all $700k of his company stock, we sell only the amount that can be offset with the unused losses from the direct index strategy. The net result is he sold a portion of his company stock and his tax bill was zero. As time goes on, we will continue to sell employer stock as it matches up to the losses generated by the direct index strategy.
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. 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.
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. Insurance 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.
Are you sitting on a large unrealized gains in your stock portfolio?
Email me for my Whitepaper: How to Manage a Concentrated Stock Position
Type "Whitepaper" in the message box.
See also my article in Kiplinger's: 4 Ways to Dilute a Concentrated Stock Position
The views and opinions expressed in this post are solely those of the author and do not represent those of, nor should they be attributed to Summit Financial LLC. 01212022-0059
By clicking on the link, you will enter the web site created, operated and maintained by a third-party. The information and opinions found on this web site (sites) have not been verified by us, nor do we make any representations as to its accuracy and completeness. By linking to this web site, Summit Financial, LLC and affiliates are not endorsing this third-party’s products and services, or its privacy and security policies, which may differ from ours. We recommend that you review this third-party’s policies and terms and conditions to fully understand what information may be collected and maintained as a result of your visit to this web site.
Investment advisory and financial planning services offered through Summit Financial, LLC., an SEC Registered Investment Adviser. Insurance is offered through Summit Risk Management, LLC, an affiliate of Summit Financial, LLC. Securities offered through Purshe Kaplan Sterling Investments, Member FINRA/SIPC Headquartered at 80 State St., Albany, NY 12207 ("PKS"). PKS and Summit Financial, LLC. ("Summit"), are not affiliated companies. Investments through PKS and Summit are: NOT FDIC INSURED NOT BANK GUARANTEED MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPAL NOT INSURED BY ANY STATE OR FEDERAL AGENCY
Investors cannot directly purchase an index. Summit only transacts business in states where it is properly registered or notice-filed, or excluded or exempted from registration requirements. Follow-up and responses that involve the rendering of personalized investment advice and financial planning for compensation will not be made without state investment adviser and investment adviser representative registration requirements, or an applicable exemption or exclusion. To learn more about the differences between brokerage and advisory services contact your Wealth Manager or go to https://summitfinancial.com/Important-Client-Information.pdf.
The Summit financial planning design team includes admitted attorneys and/or CPAs who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consultation with their independent tax or legal advisors.