Pop quiz, CPAs: What do you tell a client who asks you about the tax benefits of direct indexing?
If your answer is “Pretend I need to go to the bathroom and hope I can get one of my advisor friends on the phone to explain it to me in time,” this article is for you. (If you’re reading this in the bathroom right now after searching “what is direct indexing tax benefits PLEASE HELP ME OH SEARCH ENGINE GODS and I promise never to Google myself again,” then this article is especially for you.)
The finance world is all aflutter over direct indexing and, among other benefits, its ability to allow investors to harvest more losses for tax purposes. Taxes can represent a larger drag on your higher-net-worth clients’ portfolios than fees or trading costs—so if your clients haven’t asked about direct indexing yet, they may very well soon.
Let’s unpack what CPAs should know about direct indexing from a tax perspective—and explore some unique and effective methods for explaining it to your clients.
What should CPAs know about direct indexing?
According to Investopedia, direct indexing is: “… an index investing strategy that involves directly purchasing the components of an index at the appropriate weights … (that) can provide greater autonomy, control, and tax advantages to certain investors over owning an index mutual fund or an index exchange-traded fund (index ETF).”
(We suppose you could stop reading here and just plan to repeat this definition to your clients verbatim as they stare blankly at you in response, but we recommend you give it some context.)
Before we dive in too deeply, it’s important to understand that direct indexing involves passive investments—and what that means. Passive investments are meant to gradually build wealth without the need for frequent trading. They include things like mutual funds and ETFs, which package underlying securities into a single vehicle accessible to investors.
Direct indexing takes this idea in a different direction. Instead of owning shares in a commingled fund, your clients own the individual securities in the portfolio directly, in a separately managed account (SMA).
Your clients get the same kind of broad market exposure as a mutual fund or ETF, but with the flexibility to customize their portfolios for a number of compelling advantages. These include the ability to:
- Actively and systematically harvest capital losses from individual securities for tax purposes—and do it all year round, not just at tax time.
- Adjust holdings to screen out industries or companies your clients find objectionable.
- Avoid redundant or risk-concentrating holdings in clients’ portfolios.
- Achieve more flexibility around charitable giving and estate planning.
For this article, we’re going to stay focused on the tax side of direct indexing, but check back for future blogs on some of these other benefits.
Now that we’ve defined the term, let’s go over some methods for talking to your clients about the tax advantages of direct indexing.
Method #1: Use a metaphor (any metaphor)
With commingled assets like mutual funds and ETFs, the losses of individual securities are trapped inside the fund, with your clients unable to use them for tax purposes. But with direct indexing, your clients can harvest those losses—potentially recovering up to 2% of annual after-tax excess returns.
We know what you’re thinking: “What a perfectly worded explanation of the tax benefits of direct indexing! I can stop reading now.” And we thank you for the praise. However, we at Going Concern feel that any explanation is made better by an overly complicated metaphor. And any explanation is made even even better by an overly complicated metaphor we don’t have to write ourselves.
So if your clients need a metaphor to help them understand the tax benefits of direct indexing, you’re going to have to put the work in. Fill in the blanks below to create an analogy that should be anywhere from adequate to awesome:
Made with Madlib Maker
Method #2: Show them this chart and wait for the gasps
Another way to demonstrate the potential tax benefits of direct indexing is to show your clients how many of the individual investments within a mutual fund or ETF were money-losers over a particular time period. This will get their wheels turning about the losses they’re potentially leaving on the table.
Obviously, you don’t want to get too specific—that’s for their advisors to handle. But a chart like this one can help demonstrate the principle:Despite the S&P 500 having an incredible year in 2021, with total gains of nearly 29%, 72 names in the index showed a loss. Further, 91% of the stocks in the S&P 500 had a maximum drawdown of more than 10% at some point during the year.
If your clients were index fund investors last year, they wouldn’t have been able to use those losses to offset capital gains elsewhere in their holdings because they were locked in the fund.
With direct indexing, however, your clients could put those losses to work through tax-loss harvesting. If your client is the type who’s interested in the nitty-gritty details of investing and taxes, they may want to know how that process works. Lucky for you, that’s the focus of our next method.
Method #3: Explain the process of tax-loss harvesting
For clients who like to track every dime and decimal, you may need to explain tax-loss harvesting in a bit more detail. Here’s how you can do just that:
Losses are inevitable in any portfolio. But with direct indexing, your clients’ SMA portfolio managers can harvest their losses on individual securities that would normally be trapped in a fund.
Your clients can bank those losses to use in the current or a future tax year. Then the manager can reinvest the sale proceeds in a similar security (while taking care to avoid IRS wash-sale rules) to preserve your clients’ exposure and risk-return profile.
Essentially, the manager sells a basket of securities at a loss and simultaneously replaces it with a different basket of (hopefully higher-performing) securities.
Your clients may have further questions (or even objections) about tax-loss harvesting, especially if they’ve read articles like this one. Be sure to tell them that, while tax-loss harvesting can lead to great benefits for some investors, it’s not for everyone. If your clients are curious whether tax-loss harvesting is right for them, you can direct them to this quiz—or take it with them.
Method #4: Go beyond tax-loss harvesting
If your client hits you with the dreaded “tell me more,” we suggest you send them to our friends over at Parametric. They’re the masters of direct indexing and powerful, innovative tax management solutions, including tax-loss harvesting and:
- Tax-efficient transitions: Balancing capital gains against an acceptable percentage of tracking error to the desired benchmark exposure.
- Gain-realization deferral: Evaluating which securities to sell now and which to hold on to, with the expectation of future loss harvesting at the opportune time.
- Holding-period management: Determining the optimum time to hold a security, with an eye toward differing tax rates for short- and long-term gains.
- Yield consideration: Advising on the treatment of dividend income.
- Tax-lot consideration: Identifying ideal tax lots to trade.
- Wash-sale avoidance: Helping investors navigate IRS wash-sale rules.
- Charitable gifting: Selecting highly appreciated stocks to gift to a tax-exempt charitable organization, donor-advised fund, or family members in lower tax brackets.
“Talk to your CPA about the tax benefits of direct indexing”
Hopefully, you now feel fully empowered to talk to clients at all levels of sophistication and interest about the tax benefits of direct indexing. Check back soon to learn about the impact of direct indexing on estate planning and charitable giving, and discover more resources here.