At the Money: How to Pay Less Capital Gains Taxes

At the Money: How to Pay Less Capital Gains Taxes (January 24, 2024)

We’re coming up on tax season, after a banner year for stocks. Successful investors could be looking at a big tax bill from the US government. How can you avoid sticker shock when Uncle Sam comes knocking? On this episode of At the Money, we look at direct indexing as a way to manage capital gains taxes.

Full transcript below.

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About this week’s guest:

Ari Rosenbaum serves as the Director of Private Wealth Solutions at O’Shaughnessy Asset Management, now part of investing giant Franklin Templeton. He leads the team that delivers OSAM strategies to advisors, consultants, wealth management firms, multi-family offices and private banks.

For more info, see:

Canvas

LinkedIn

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Find all of the previous At the Money episodes here, and in the MiB feed on Apple Podcasts, YouTube, Spotify, and Bloomberg.

Transcript:

I’m Barry Ritholtz, and on this episode of At The Money, we’re going to discuss tax lost harvesting. via direct indexing, effective tax policy, a net migration of taxpayers at the upper end, just reduce taxes for everybody, cutting taxes for individuals and businesses, tax.

One of the most popular innovations of the past 50 years has been the tax-qualified account. You know, these is 401 K’s IRAs, 403 B’s. They’ve become more popular because you get to keep more of your net after-tax returns.

Savvy investors understand this. They maximize their tax-advantaged accounts. What about your taxable accounts? How can you maximize your net? After-tax equity returns from your non-tax-exempt portfolios. Well, some investors have turned to direct indexing to do just that. They reduce the capital gains they pay on appreciated stock by improving their tax loss harvesting.

I’m Barry Ritholtz, and on today’s edition of At The Money, we’re going to discuss using direct indexing to maximize your after tax net. Equity returns. To help us unpack all of this and what it means for your portfolio, let’s bring in Ari Rosenbaum of O’Shaughnessy Asset Management, now a division of investing giant Franklin Templeton.

Ari Rosenbaum, welcome to At The Money.

Ari Rosenbaum: Barry, thanks so much for the opportunity to be here.

Barry Ritholtz: So, before we get started, full disclosure, my firm, Ritholtz Wealth Management, was one of the first clients to use O’Shaughnessy’s direct indexing product, Canvas. We currently have over a billion dollars on that platform, so I just want everybody to know, disclosures out there, we never get in trouble by disclosing more rather than less.

So Ari, for the layperson, let’s talk a little bit about direct indexing and tax loss harvesting. For the typical non-tax deferred account that maybe consists of a dozen mutual funds and ETFs, what does tax loss harvesting look like there?

Ari Rosenbaum: Tax loss harvesting in a mutual funder, an ETF would be done at the price of the, of the fund or the ETF would be selling out of the entire position of the funder, the ETF.

Barry Ritholtz: So in other words, I have a dozen funds. One of ’em is doing poorly that year. I sell that fund, I replace it with a similar funds, and capture that loss to offset my gains.  Uh, how, how big of a harvest, how much taxes can I avoid through that method?

Ari Rosenbaum: The challenge with that is that markets go up more often than they go down. 75% of years since the founding of the S&P 500, the market’s actually up. And so the opportunities for harvesting in mutual funds or ETFs can be, can be less because generally speaking, those strategies are going to be at a net gain.

Barry Ritholtz: So now let’s. look within the wrapper of the mutual fund or within the ETF, tell us a little bit about direct indexing and how that allows us to access more of the losses that take place within those wrappers.

Ari Rosenbaum: Great question. So the benefit of a mutual funder and ETF is that you’re getting a diversified portfolio and professional oversight.

But again, you’ve got that net gain generally over time in a direct index, you’re getting that same professional and diversification, but instead of investing in a product that’s got one price, you’ve got access to the individual securities underneath – all trading at different prices. In essence, you’re getting a strategy that’s very similar to say an S&P 500 index or mutual fund, but you’re investing in the individual constituents.

Barry Ritholtz: So in other words, I will own in a direct index product, all 500 of the S&P 500, or let’s take the Vanguard total market. That’s like 2300 stocks, something like that. You literally own all of those stocks individually.

Ari Rosenbaum: A little bit less than that, say probably 300 because many of those stocks had very, very small positions in the S&P 500 that really aren’t meaningful to returns. So we, for practical purposes, remove those from the portfolio.

Barry Ritholtz: All right. What about a bigger, uh, index like the Vanguard total return, total market return?

Ari Rosenbaum: Again, similar, probably a few hundred stocks.

Barry Ritholtz: Okay. So now a typical year goes by and the mutual fund is up. Uh, so if you’re holding the S&P 500, There may not be losses to harvest, but what if you’re holding the 300 companies within that index?

Ari Rosenbaum: Historically, what we see in a large cap passive portfolio like that, year by year, about 36% of the individual stocks are down – even if the index as a whole is up, In a fund or an ETF, because it’s up, you can’t extract that for tax purposes. But in a direct index, you can get at those 36% of stocks by selling those that are at a loss, maintaining the fidelity toward your overall investment strategy, and using those losses to offset gains over time.

Barry Ritholtz: So when I sell those individual companies, am I replacing them with something or am I just sitting in cash?

Ari Rosenbaum: You’re replacing them with stocks that have characteristics that are similar to the ones that you’ve sold out, so that you’re keeping that. underlying investment strategy similar to what you intended.

Barry Ritholtz: So it may not look exactly like the S& P 500. But mathematically, it’ll perform similarly, that’s the expectation.

Ari Rosenbaum: Very similarly.

Barry Ritholtz: So if I’m managing tax loss harvesting with 15 mutual fund ETF portfolios, the general rule of thumb is, hey, 20, 25 basis points of your portfolio’s gains can be offset with losses.

What do those numbers look like, if I’m holding a few 100 stocks instead?

Ari Rosenbaum: So, our research suggests that over a full market cycle, it would be more like about a 0.50% to 1% over time.

Barry Ritholtz: So, fifty to a hundred basis points versus twenty to twenty-five. [Exactly]. And, I recall in the first quarter of 2020 right as the pandemic ramped up, the S&P 500 fell 34% within that first quarter. It bottomed a few days before the quarter ended, and right as the typical tax loss harvesting and rebalancing took place, how did that quarter look for people invested in a direct indexing product like Canvas?

Ari Rosenbaum: Yeah, we were doing a multiple of what we would have normally seen.

So certainly after-tax benefits north of 3%, 300 basis points over time, where we would have normally expected between 50 and 100.

Barry Ritholtz: That’s a huge number. I recall seeing some portfolios that were even more than that. 400, 450, 500. Let’s put this into context. Typically, people take 3 years, 5 years, 7 years, 10 years to kind of work out of those positions, and manage their tax obligations.

How much can this accelerate that process and allow people to either diversify or Cash out sooner than the typical route?

Ari Rosenbaum: Yeah, I think that in this regard, there’s both a risk and a tax benefit. When you think about individual positions in stocks, our research actually suggests that most individual companies underperform the market and do so with about twice the volatility over time. You had mentioned the pandemic – we actually have an investor who came to us shortly before the start of 2020 with about half of their net worth invested in low-basis positions in a public company for which they worked. And they were really emotionally invested in this particular position.

Because they’d worked for the company and had done so well over time, they were also interested in finding ways to improve their risk and manage a taxable exit.

Barry Ritholtz: So in other words, they’re trying to do two things. They want to diversify away from that concentrated position and at the same time not pay a giant tax bill if, you know, if it could be avoided

Ari Rosenbaum: Exactly right. So what they did was they brought the position to us. We actually built a risk-aware exposure, understanding that company’s particular characteristics. We built a passive exposure to pair with the name that was underweight to similar companies so that immediately their risk was mitigated because of that diversification.

And then, we started to look for tax loss harvest opportunities when there were losses in the market, we were able to take those losses and offset positions in the name, selling them down over time. We were actually able to do so in 2020. Remember, they started with a 50% position. [Right] We were able to reduce that to in a short period of time about a 15% position net of any gains.

Barry Ritholtz: Meaning they’re not paying. [Exactly] Long-term or short-term capital gains taxes on that, and by the way, this isn’t like, I, I’ve jokingly described certain tax concepts as Wesley Snipes, Gray, you know, we don’t know what the IRS, this is black letter law, the IRS has signed off on this. All of this is totally kosher and above board.

Ari Rosenbaum: Yeah, the positions are at a gain; this particular concentrated position, it is a gain. We’re able to take losses to offset that and work the position down over time. Now, in this instance, because the market movement was so significant to the down, we were able to do so in a very accelerated fashion, all within the context of of that calendar year, they got down to about a 15% weight of the name.

Remember, they had started with 50 – as a percentage of their total net worth. At that point, they decided to liquidate the entire position to move away from the risk exposure of that name. And they did so with a fraction of the tax consequence that had they sold out to begin with.

Barry Ritholtz: So this sounds like this is a sophisticated and expensive technology. What are the trading costs like this? How pricey is this?

Ari Rosenbaum: One of the things that’s occurred in the market is that trading costs have dropped pretty dramatically,

Barry Ritholtz: Practically free at most custodians, right? That’s correct.

Ari Rosenbaum: That’s correct. On our platform, the average fee a client is paying is, we’ve talked about basis points, 21 basis points. [Not bad]

And so, certainly with regard to many other options out there, when you’re then adding the, potential tax benefits on top on an after-tax basis quite attractive.

Barry Ritholtz: I’d say the very least. So is this for fat cats with millions and millions of dollars or is this for ordinary people? Can I do this?

Do I need, uh, can I get into this with less than five million dollars?

Ari Rosenbaum: Two hundred and fifty thousand dollars are minimum.

Barry Ritholtz: Okay, so not nothing but not an unreasonable amount of dollars to do this. So to wrap up, if you’re an investor sitting with a big pile of employee stock option plans, equity, founder stock, venture investment, startup, a sale of a business or a house. You’re looking at a substantial capital gains tax.

What matters most to you as an investor is your net after tax returns. Direct indexing is a really good way to allow you to keep the most amount of your gains net of taxes. It takes some money, about a quarter million dollars invested in a taxable portfolio, but ultimately that can save you big dollars on your tax bill.

You can listen to At The Money every week, find it in our Masters in Business, feed at Apple podcasts each week. We’ll be here to discuss the issues that matter most to you as an investor. I’m Barry Ritholtz. You’ve been listening to at the money on Bloomberg radio.

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