CPAs: Make Direct Indexing Your Estate Planning Secret Weapon

Traditionally, the role of accounting professionals in estate planning has been tertiary at best, with clients consulting CPAs only on the tax implications of select decisions—or simply leaving them out of the process altogether. 

As you’re certainly sick of hearing by now, however, today’s most successful CPAs are taking on more advisory functions, with one study projecting that accounting firms can increase their monthly client revenues by up to 50% if they offer strategic advisory services. 

So, as the roles of accountant, planner, and advisor continue to blur, your clients—particularly those with higher incomes—may soon look to you for estate planning expertise that goes beyond tax. Increasingly, you’ll need to collaborate with finance and legal teams to maximize returns and minimize burdens throughout the accumulation, preservation, and transfer of client wealth.

While we can’t give you a crash course on all things estate planning in the space of this article (what do we look like, your CPE vendor?), we can give you the scoop on an investment strategy that will set your estate planning services apart from the average CPA’s: direct indexing.

We covered the tax advantages of direct indexing—and some fun ways to talk to your clients about them—in a previous article. So check there for a more in-depth definition of the term and an explanation of the strategy’s larger tax benefits.

For this article, we’ll explore how direct indexing can enable and enhance a few particularly powerful estate planning strategies. You’ll want to work with or refer your clients to a financial advisory firm to truly put these techniques to work.

The more you know about innovative ways to save your clients money and help them build wealth, the more valuable your services will be to them. So read on, and discover how to make direct indexing your estate planning secret weapon.

The estate planning benefits of direct indexing

As we talked about in our previous article, direct indexing is a strategy wherein the investor directly owns the individual securities that would normally make up a benchmark or commingled fund, like a mutual fund or exchange-traded fund (ETF), within a separately managed account (SMA). This enables a great deal of flexibility, which can lead to a number of compelling advantages—while still providing the broad market exposure of traditional passive investment vehicles.

 

Direct indexing also unlocks greater flexibility for estate planning. Instead of granting blocks of shares in mutual funds or ETFs to heirs or a charity, your client can grant individual stocks or bonds. This is especially valuable for highly appreciated positions within the security (i.e., investments your client purchased for a much lower price than they are currently worth or projected to be worth upon the grantor’s death). Donating these investments directly gives heirs a step-up in cost basis once they’re transferred, reducing the amount of the estate that will ultimately be taxed.

And because direct indexing gives investors more flexibility over the types of securities they own and the types of companies they want to support, it can also help provide more control over how the estate is ultimately divided up. Direct indexing could, for example, help your client avoid leaving oil company stocks to an heir who is a prominent environmentalist (even though that might be hilarious) or donating an asset that could cause controversy or create undue complexity for the receiving charity.

From a high level, direct indexing’s benefit to estate planning is really quite simple—it can help investors improve their after-tax performance and minimize the burdens on their beneficiaries and heirs.

While just being able to communicate the estate planning benefits of direct indexing to your clients can put your CPA practice a step ahead, understanding advanced techniques like the ones we’ll describe in the next three sections is more like taking a leap forward. 

Combine direct indexing with GRATs for substantial estate tax savings

By combining direct indexing with grantor-retained annuity trusts (GRATs), your high-income clients can radically reduce the estate tax burden on their heirs—or even eliminate it entirely. GRATs are powerful wealth transfer tools that can be used to remove assets and their appreciation from the grantor’s estate. 

Additionally, GRATs serve as easy pun-fodder for bored financial writers looking to spice up their article headlines. Check out some of these real-life zingers we found via Google:

  • “Grateful for GRATs”
  • “Kiss My GRATs”
  • “GRAT Expectations”
  • “GRITs, GRATs, GRUTs, What?”

And our favorite, even though it isn’t a pun:

  • “The Care and Feeding of GRATs”

To create a GRAT, a grantor establishes an irrevocable trust that exists for a set period. The grantor funds the GRAT with assets that have substantial growth potential—such as pre-IPO stocks or private equity holdings. The trust then pays the grantor a fixed annual amount (aka an annuity) for the life of the trust.

When the term of the trust ends, the beneficiaries receive the assets remaining in the GRAT, free of gift and estate tax.

Add direct indexing, and GRATs become even more powerful. With direct indexing, clients can fund their GRATs with high-growth-potential assets that might otherwise be trapped in an ETF or mutual fund. Direct indexing provides them—and, ultimately, their heirs—with more flexibility and control throughout the creation, term, and transfer of the GRAT.

Minimize post-retirement estate reduction with direct indexing for fixed-income investments

Retirement planning is a critical—and, far too often, overlooked—component of estate planning. Minimizing financial drain during the grantor’s retirement period helps keep the estate healthy, and planning ahead for the tax implications of a transition toward a fixed-income portfolio is crucial.

Direct indexing allows for greater flexibility and control throughout this process. As your clients work with their financial advisors to create bond ladders to deliver more consistent returns, direct indexing enables them to use money-saving techniques like tax-loss harvesting to greater effect. Your clients will be able to write off losses from individual bonds and apply them elsewhere, rather than having those losses trapped in a commingled fund.

Bond ladders are kind of like “Chutes and Ladders,” only without the chutes and with a recommended age of 65 and up.

Use CRTs to reduce the taxable estate

Wealthy investors often include charitable gifts in their wills. Using a combination of charitable remainder trusts (CRTs) and direct indexing can help maximize the benefit to their selected causes—while also providing an income tax deduction for a portion of the donated value.

CRTs come in two forms: the charitable remainder unitrust (CRUT) and the charitable remainder annuity trust (CRAT). However, CRUTs are better suited in a low-interest-rate environment to achieve the dual purposes of a CRT: financial security for the donor’s family and support for their chosen charity.

CRUTs, in addition to sounding like a Zoomer slang word we’d pretend to know the meaning of but then discreetly look up on Urban Dictionary, can get pretty complicated. So we won’t go into them too deeply. But the general idea is that assets are placed into a trust that creates both a tax deduction and an income stream for the donor. At the trust’s completion, the remaining assets move out of the donor’s estate, and the chosen charity receives the remainder.

As with GRATs and fixed-income portfolios, direct indexing offers greater flexibility in how the CRT is funded. Securities that would normally be locked in a commingled fund can be placed directly into the CRT, providing the investor with more control—and potentially delivering better results for donor and charity alike.

How CPAs can take estate planning to the next level

As we mentioned earlier, you’ll likely want to partner with a financial advisor or firm as you talk with your clients about these and other advanced estate planning practices. And if your clients and their advisors want to use direct indexing as part of an estate plan—and why wouldn’t they?—Parametric is the best place to send them for help.

With nearly 30 years of direct indexing experience, Parametric works with financial advisors to help clients access efficient market exposures, solve implementation challenges, and design portfolios that respond to their evolving needs. 

Ready to get started? Learn more about Parametric’s offerings and access additional resources on direct indexing and other topics. And check back with Going Concern soon for a deeper look at the charitable gifting benefits of direct indexing.

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