The power of direct indexing: tax-loss harvesting and customization

Overview: Direct indexing offers a cost-effective approach to investing in stocks and index funds, providing the advantages of tax-loss harvesting and enhanced customization without the need for manual intervention. By engaging in direct investing, an investor has the potential to attain a higher annual return compared to not participating in direct indexing.

Tax-loss harvesting is a strategy designed to minimize taxes by employing capital losses to counterbalance taxes owed on capital gains. This is a manual process that demands a considerable degree of organization. However, with direct investing, tax-loss harvesting gets done for you.

As tax season is underway, let's delve into the workings of tax-loss harvesting and its implications for your tax filing. Basic tax-loss harvesting is something that’s straightforward to do on your own.

As your income increases (esp. over $80k when you need to start paying capital gains taxes), more advanced techniques are available and it’s increasingly common to pay a portfolio management fee for this. 

Basic tax-loss harvesting 

Each year, the government allows you to “realize” up to $3,000 in losses and reduce your taxable income by that amount. That reduces the amount of taxes you owe. Say you invested $10,000 in a stock that went down to $7,000. You could realize it by selling all the shares valued at $7,000 before December 31st, in order to use that to lower your income.

How advanced tax-loss harvesting works 

Advanced tax-loss harvesting works differently. It can’t be used to reduce your income, but it can be used to reduce your investment capital gains.

If you bought a stock for $70,000 and sold it for $100,000, you would have a realized capital gain of $30,000. You now have tax to pay on the difference between the sale price of the stock and its cost basis. 

If the stock was held for less than a year, short-term capital gains tax rate would apply which is equal to the tax you pay on your regular income (your marginal federal income tax rate to be precise). However, if the holding period is longer than one year, the long-term capital gains tax rate comes into play–it’s typically much lower than your marginal federal income tax rate.

To reduce the amount of capital gains taxes you may owe, you can use an IRS-endorsed strategy known as tax-loss harvesting. This involves identifying and selling a stock that went down, to ‘cancel out’ the capital gains on your stock that went up. There is no limit on how much in gains you can ‘offset’ with ‘realized losses’. Once you sell a stock, you can’t rebuy it for a 30 day time period (called the ‘wash’ rule).

Of course, if you believe your investments might rebound, selling stocks just to minimize your capital gains tax might not be the best approach, as it could be premature.

When to use tax-loss harvesting

In the above example, to offset the $30,000 in capital gains, you'd need to sell securities at a loss within the same calendar year. The crucial deadline for realizing these capital losses is December 31, ensuring they can be used to offset capital gains for that specific year.

In other words, if you had $30,000 in capital gains in 2023, selling stocks in 2024 with $30,000 in losses wouldn’t eliminate the $30,000 in capital gains from 2023. The capital gains tax on that amount would still be applicable when filing your 2023 taxes.

If you're considering taking action in 2024 to reduce your 2023 capital gains, unfortunately, it's too late for the 2023 tax year. However, since you plan to be around for another year, you can implement tax-loss harvesting this year to counteract capital gains or potential capital gains from selling stocks.

While the optimal holding period for stocks may be forever, occasional selling can be beneficial to fund your desired expenses. Stocks by themselves may not provide utility or joy, but they can serve a positive purpose when sold to finance purchases or experiences. Tax-loss harvesting aims to minimize capital gains tax, which can enhance your overall return and provide more post-tax buying power from your sales.

The higher your income tax bracket, the more advantageous tax-loss harvesting becomes.

Your marginal federal income tax bracket directly impacts your tax liability. In other words, shielding your capital gains from taxes is typically more beneficial in higher tax brackets.

For instance, let’s say you fall into the 37% federal marginal income tax bracket because your household makes $800,000 a year. If you had a $10,000 short-term capital gain from selling Google stock, you would owe $3,700. If you had a $10,000 long-term capital gain from selling Google stock, the long-term capital gains tax rate you would face is 20% or $2,000. 

Now let's use a middle-class household income as an example to demonstrate the effectiveness of tax-loss selling.

If your married household income amounted to $75,000 and you sold $10,000 worth of Google stock, realizing a long-term profit, your long-term capital gains tax rate would be 0%. This zero tax liability stems from the fact that married couples filing jointly, earning less than $94,050 in 2024, are subject to a 0% long-term capital gains tax rate.

In this situation, there is no need for tax-loss harvesting. However, if you think your stock investment will continue to decline, selling might still be a reasonable choice, notwithstanding the tax shield benefits.

Some restrictions and rules for tax-loss harvesting 

Here are some other rules to follow if you plan to conduct some tax-loss harvesting.

1) Annual tax deduction carryover limit is $3,000

Let's consider a situation where you have $20,000 in capital loss and $15,000 in total capital gains for the year. You can utilize $15,000 in capital losses to offset the corresponding amount in capital gains. This results in $5,000 in remaining capital loss.

Now, what happens with the remaining $5,000 in losses? You can carry over the $5,000 in losses and use it against future capital gains indefinitely. In future years when you don't have a capital gain, you can use your capital loss carryover to deduct up to $3k against your income (aka basic tax loss harvesting).

2) No expiration date on capital losses

Let's say you have $90,000 in capital losses because you sold stocks during a bear market. And let’s also say you have zero capital gains that year.You can use the $90k against future income (aka basic tax loss harvesting) or future capital gains (aka advanced tax loss harvesting) in the many years to come.Luckily, there is no expiration date for capital losses. 

3) The wash sale rule nullifies tax-loss harvesting benefits

A loss is disallowed if, within 30 days of selling the investment (either before or after) you or even your spouse invest in something that is identical (the same stock or fund) or, in the IRS’ words, “substantially similar” to the one you sold.

4) Losses must first offset gains of same type

In other words, short-term capital losses must first be used to offset short-term capital gains. And long-term capital losses must be first used to offset long-term capital gains. Not only can capital losses offset capital gains, but—if losses exceed gains that year—you could also use the remaining capital-loss balance to offset personal income (up to a limited amount). Please check with a tax professional for detailed advice on this. 

Direct investing benefit: tax-loss harvesting for you

If tax-loss harvesting seems like a daunting task that’s because it can be. You must pay close attention to your investments and track your gains and losses. By December 31, you also need to determine which underperforming stocks are worth selling to counterbalance any capital gains and minimize taxes.

Rebalancing your portfolio annually or semi-annually can be beneficial because it can keep your investments in line with your objectives and risk tolerance. 

For example, over time, a single stock or sector may grow to represent 35% of your portfolio due to strong performance. However, based on your risk tolerance and objectives, your preference is no more than 20% exposure. To get your current asset allocation back in line with your preferences, selling becomes necessary.

For do-it-yourself investors, the challenge with all this lies in potentially lacking the time, skills, or knowledge needed for effective investing. This is where Direct Indexing can be highly beneficial for the average investor.

Source: Fidelity Investments

How direct indexing helps investors manage taxes

What’s direct indexing? Check out this video by Plenty co-founder and CEO Emily Luk.

Direct Indexing operates by utilizing technology and advanced algorithms to replicate the performance of a specific index. Managers can leverage this technology for tax optimization within an investor's portfolio. According to a 2023 MorningStar study, direct indexing portfolios may yield an average additional return (tax alpha) of 1.08% per year due to tax management; at income levels above $100k, we’ve estimated that the benefit could range between 2-4%.

The potential performance boost stems from the tax-loss harvesting process discussed earlier. Technology, algorithms, and investment managers of direct-indexing funds handle the tax-loss harvesting on behalf of the investor. If the retail investor pays a lower fee than the benefit derived from tax-loss harvesting, it becomes advantageous for the investor.

The snapshot below from MorningStar in 2023 highlights the top money managers offering direct indexing for clients. Observe the starting fee ranges between 0.23% to 0.4%, which is below the estimated 1.08% additional return projected through direct indexing tax management.

In comparison, at Plenty, our minimum investment is only $100, making direct indexing available to almost anybody. In the past, direct indexing was usually only available for high net worth individuals. You’ll also appreciate our fee of only 0.2% starting on March 1, 2024. 

Customization is also a benefit of direct indexing

Another less-discussed benefit of direct investing is customization. When you invest in an ETF, you do not have a say in what is included in the ETF. When you invest directly in underlying stocks, you have much more control over what your money goes towards.

For investors who appreciate investing according to their values, taxsummaries.pwc.com, direct indexing offers such a beneft. Although, as you can see from the investment minimums above, not everybody can gain access–until now with Plenty. 

Direct indexing with Plenty

At Plenty, we plan to offer automatic direct indexing, with the help of AI, giving you the ability to fully personalize your investments based on what’s important to you, aka values-based investments. Again, with only a $100 minimum and a 0.2% fee, almost anybody can get started on March 1, 2024. 

Invest for the long term with Plenty

The best way to avoid paying capital gains taxes is to refrain from selling. However, when the time comes to sell some stocks to enhance your life, remember the advantages of tax-loss selling. It can significantly reduce your tax liabilities.

We hope you’ll join us at Plenty where you can benefit from maximized tax-loss harvesting across your portfolio. We’ll automatically look for tax-loss harvesting opportunities every week, adding potentially an extra 2-4% on top of your portfolio’s after-tax returns.* That means lower taxes and more money in your pocket.

About Plenty

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*Plenty's cash management product invests 99.5%+ of the portfolio in US-government backed securities as of October 1, 2024. Although the strategy seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. You could lose money by investing in the strategy. Plenty's cash management product is SIPC insured. An investment in the strategy is not a bank account and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The rate quoted is subject to change and will decrease or increase based on changes in market conditions, interest rates, among other factors. The rate quoted is net of transaction and advisory fees.

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The information provided herein is for general informational purposes only and should not be considered individualized recommendations or personalized investment advice. The type of strategies mentioned may not be suitable for everyone. Each investor should evaluate an investment strategy based on their unique circumstances before making any investment decisions.

Investing involves risk, including risk of loss. Past performance may not be indicative of future results. Asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. We recommend that you consult a tax professional before taking action.

Plenty does not provide legal or tax advice. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic, and geo-political conditions