One year ago today, I published a longish post on the advantages of direct indexing via tax loss harvesting (TLH). It became one of the most read pieces I wrote last year; RWM advisors found it to be a useful explainer for people managing capital gains for their low cost-basis stocks (ESOPs, founders’ shares, inheritances, etc.). People from Vanguard, Franklin Templeton, and VCs shared with me that it was circulated internally.
That’s incredibly gratifying.
The reason anyone puts their thoughts down in pixels is to share ideas and influence the thinking of one’s peers, clients, and colleagues. If you haven’t read Accessing Losses via Direct Indexing, hop over and give it a few minutes of your attention.
Because tomorrow is tax-day, it’s likely too late for you to do much 2021 tax planning. But it is not too late to start thinking about your (or your clients’) taxes for this year (‘22). This is especially true given how soft markets started this year and the opportunities presented to capture losses.1
Base case: Market performance in 2022 is unlikely to match 2021 or even 2020. Rising rates, inflation risks, and plain old mean reversion suggest this year is unlikely to be up high double digits; plus or minus single digits from flat is my more likely guess. The silver lining in this market scenario is that for direct indexing clients, there will be good opportunities to offset capital gains with technical losses.
A quick refresher:
Typical tax-loss harvesting consists of a portfolio of mutual funds or ETFs, where you sell portfolio positions that are down to capture that loss, replacing each with a nearly identical alternative. The realized gains in the portfolio can be offset by these losses.2 Done right, it can reduce a clients’ tax costs by a decent chunk of the capital gains. 2020 was unique given the 34% drop and quick bounce back, so savings were unusually substantial. Most years create far less TLH than the 400-500bps that unique situation created; the goal is more in the range of 25-75 basis points.
Before you shrug off a few bps, recognize this is found money, essentially risk-free cash. For those clients who have been slowly unwinding these positions, typically for purposes of diversification or getting liquid, this can accelerate that process by years.
Consider a household sitting on a portfolio of stocks at a very low cost basis. Those huge gains likely make this their largest asset, often a concentrated position with therefore higher risks. Accounts with stocks like Apple or Amazon purchased in the 2000s now dominate — not only that portfolio, but their entire net worth. The holder may be retiring, making a major purchase, or simply wanting access to more capital. Even if there is no need for liquidity, prudence suggests diversifying such concentrated positions into a broader set of risk assets.
Typically, these investors decide how liquid they want to get versus how much they expect to pay in long-term capital gains taxes each year. It’s a balance, and we can create a plan to do so over any period of time (3, 5 10 years, whatever). There are a series of tradeoffs: Risk versus reward, concentration versus diversification, capital gains taxes versus liquidity. The timing, the dollar amounts, the entire process is very much a matter of personal preferences.
If this was only about maxing out gains, there is an optimal mathematical way to execute this function.
But it rarely is about just the dollars. Usually, there are lots of personal elements at play. Stocks held for a long time may have an emotional aspect to them. Regret minimization is a key part of this framework. Selling stock after many years of investing and planning is a complex decision. What works best is whatever brings an investor to their desired goal with the most comfort and least amount of stress.
Done right, tax-loss harvesting can accelerate this process by years – at no additional cost, and at no increase in risk.
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If you want to learn more about managing concentrated stock positions and need assistance in creating an efficient way to manage your capital gains, we can help. Contact us here.
Previously:
Accessing Losses via Direct Indexing (April 14, 2021)
Regret Minimization: A Strategy for Deciding When to Sell (December 20, 2017)
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1. For the record, I am not a fan of the phrase “Tax Alpha” but was at a loss for a better title…
2. In whole or in part, depending upon the specific circumstances.
