Tax-loss harvesting involves selling underperforming stocks at a loss and then using the proceeds to invest in correlated securities. This process mitigates an investor’s tax bill while navigating the wash-sale rule.
Most advisors already use TLH at the end of the year to help improve their clients’ after-tax returns. However, Vanguard notes that direct indexing offers more opportunities for TLH that can help capture additional tax alpha.
See more: “The Opportunities Within Direct Indexing Accounts”
Harvest Losses at the Security Level
Unlike mutual funds or ETFs, direct indexing lets investors harvest losses at the individual security level. And since investors directly own the individual stocks in their direct indexing accounts, losses can be captured even in a year when the index gains in value.
For example, the S&P 500 went up 9.76% in the fourth quarter of 2021. And yet, 133 companies lost value during that time.
“Harvested losses can be used to offset capital gains and then up to $3,000 of ordinary taxable income (as of the 2021 tax year),” according to Vanguard. “Losses can also be carried forward to future years.”
Direct indexing services like Vanguard Personalized Indexing can scan portfolios for TLH opportunities quarterly, monthly, or even daily. VPI automatically reviews each account daily and harvests individual security losses as opportunities arise. Direct indexing services that scan portfolios for TLH opportunities daily have increased some after-tax returns by more than 2%.
Bypassing Issues With Steady TLH
One issue that can come with steadily harvesting tax losses is that eventually, all the underperforming stocks will be sold. Since the potential capital gains would result from selling those low-cost-basis stocks, switching to another investing strategy could be expensive.
That’s why VPI is more effective when there’s regular cash flow to buy new stocks. It can also be a good strategy for high-net-worth investors who’ve realized gains from other types of investments.
“Other investors may decide not to sell the stocks in their personalized indexes at all but, rather, plan to leave them to charity, since nonprofits don’t owe federal income tax on gifts,” Vanguard added.
Vanguard CEO Tim Buckley said at Exchange 2023 that the company will “be investing heavily” in the direct approach to indexing. More information about VPI can be found online.
For more news, information, and analysis, visit the Direct Indexing Channel.