Tax Harvest Myths: Don’t direct index because… it’s just delaying the inevitable

Avatar photo by Hiren B. Patel, Head of Advisor Solutions

Key Takeaways

Counterarguments to the benefits of direct indexing and tax-loss harvesting say they’re unnecessary complications that only defer taxes and don’t reduce them. While these arguments can be incomplete and dated, they should be understood.

Today, technology hasn’t just nudged the tax-aware investing needle, it’s increased the opportunity and the potential for improved results. 

55ip’s tax-smart solutions can differentiate advisors’ services, augment their client relationships, and meaningfully enhance investment outcomes. 

Tax Loss Harvesting: Innate Value or Naïve Optimism?

Proponents of direct indexing and tax-loss harvesting (like us, admittedly) argue that tax-loss harvesting can benefit investors, and that automated, continuous tax-loss harvesting can potentially benefit investors significantly. There is, however, a counterargument – that it’s an unnecessary complication that only defers taxes and doesn’t reduce them.  

The naysayers raise an issue worthy of discussion. But their argument blurs some important facts and misses the impact that technology can have. A fuller understanding is needed. 

First, a quick primer. For taxable accounts, losses at the stock or fund/account level can be realized by selling when the market price is below the cost basis. Losses up to $3,000 can be deducted against ordinary income each year. Losses greater than this can be carried over indefinitely and used to offset future gains or ordinary income*.

The Glass is No Longer Half Empty 

Thanks to tax-smart technology like 55ip’s ActiveTax platform, tax-loss harvesting is no longer a year end, manual task. Technology hasn’t just changed the process; it’s changed the size of the opportunity itself – as well as the ease and scale at which it can be accessed.  

By continually seeking, evaluating and identifying uniquely market-, security- and tax-lot level prices, opportunities beyond those at year end are now easily actionable. For each individual security and tax lot in a portfolio, intra-year volatility becomes a tailwind.

For Illustrative Purposes Only 

As a thought exercise, horizontally mirror our hypothetical stock price line in blue. The year now ends in a gain, but intra-year volatility still generates harvesting opportunities. Intelligent, automated tax-loss harvesting throughout the year can improve processes and results while managing for cost.  

Ordinary Income, Compounded Outcome

The first $3,000 of harvested losses can be deducted against ordinary income at the investor’s marginal tax rate. Using a 35% bracket (in 2023 the highest is 37%) as an example:  Over the course of 30 years, reinvesting these relatively small annual savings and compounding them at 4% generates more than $100,000.*   

* An initial investment of $1,050 ($3,000 x 35%) with subsequent annual investments of the same amount at the end of each period compounding at 4% annually generates $101,643 over 30 years. 

Deferring Isn’t Just Deferring 

Potentially the main benefit of tax-smart investing is the accumulation of harvested losses (over and above those reducing taxable ordinary income) to offset capital gains elsewhere in the portfolio. Again, the counterarguments are worthy of discussion.  

Counterargument 1: All Other Things Often Aren’t Equal…

First, the impact on cost basis is often a point of focus for harvesting naysayers. If I sell a stock (or bond) at a loss today and benefit financially from realizing that loss, I’ve also lowered my cost basis going forward and therefore raised my tax bill when I sell that asset in the future. The skeptic would say “Why delay the inevitable? Heck, if tax rates increase, I could actually owe more.”  

While technically true, it’s an incomplete thought. Yes, rates could go up. The tax savings from realizing, say, a $10,000 loss today could be less than the tax bill owed later on this same gain if that happens. But avoiding a real dollar benefit today in case tax rates change in the future could be more expensive.  

What is known though is that the S&P 500 has never had losses over rolling 20-year periods and only rarely over 10 years. All other things being equal (and let’s acknowledge they aren’t always), I’d rather have more money working for me and compounding over the next 10-20 years than less.  

Counterargument 2: Benefiting Beyond Accumulation 

A tax-smart investor can manage the tax impact of decumulation – perhaps prioritizing those investments with the lowest gains and delaying the sale those with the largest. And let’s not forget the intersection of the two certainties in life: Some investors may never sell the security. Inheritors of appreciated stock receive a step up in basis at death. Passing on stocks with the highest gains to heirs optimizes this benefit – reducing the investor’s decumulation tax bill without raising that of the inheritors. 

Counterargument 3: Tracking Error Isn’t Error 

Another concern often voiced is portfolio composition. The worry is that the security trades inherent in tax loss harvesting and avoiding wash sales create too much change in an indexed portfolio.  There’s therefore a risk of underperformance if harvested securities are replaced with underperformers.  

Again, another potentially expensive “if.” Yes, the subsequent reinvestment after a realized loss could underperform. It could also outperform or perform similarly. Speculation is just that. We’d certainly agree that balancing the degree of difference between a tax-managed portfolio and the index it’s designed to emulate (tracking error) is essential. But doing this is much less of a concern now than it was in the past. 

For Illustrative Purposes Only 

Today, 55ip’s technology can help establish effective guardrails around this variance, and thus ensure the portfolio’s composition and risk-return characteristics are accurately monitored and effectively managed.  And remember, if a position is harvested and replaced with a different security, after 30 days any subsequent losses in this new position can be harvested and the second security replaced with the first – expanding opportunity while reducing tracking error. We’ve written in more detail about this important point. 

55ip: Tax-smart sophistication delivered with operational simplicity 

Investors and advisors alike are justifiably asking questions about how direct indexed portfolios can benefit from automated tax-loss harvesting. Understanding the cons of the tax-loss harvesting debate is essential to fully appreciating the pros.  

55ip is built to be the new standard for automated, personalized tax-smart investing. Our platform combines a highly sophisticated tax-smart trading engine with a simple user experience and operational efficiency. Freed from the restrictions and labor of a manual, year-end process, advisers are able to differentiate services, manage risks and scale practices – while helping their clients keep more of what their portfolios earn. Contact us to learn more. 

* Short-term gains from mutual funds are treated as ordinary income and cannot be offset with capital losses. Long-term capital gains are taxed at rates of 15 to 20%, depending on income. Harvested losses are first used to offset gains of the same type – long-term or short-term. Net losses above this offset can be deducted against the other type of gain.  

09wq240901144728 1/10/24

Keep Reading

Related Insights