The Tax-Loss Harvesting Trick the 1% Uses — and How Regular Investors Can Copy It
One of the reasons rich investors stay rich is that they understand how to use tax laws to preserve their wealth. But everyday investors can use strategies like direct indexing to benefit from the same tax laws.
Here’s what it means and how it works.
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What Is Direct Indexing?
Direct indexing simply refers to owning the individual stocks that comprise an index instead of buying an index fund. It may seem like you’re getting the same investment, but direct indexing gives you a lot more flexibility for tax purposes, according to Charles Schwab.
When you own an index fund that tracks the S&P 500, you have one single investment for tax purposes, even though you gain exposure to the hundreds of stocks inside. If you want to generate a taxable gain or loss, your only option is to sell shares of the fund as a whole.
But if you own each of the stocks within an S&P 500 index fund, each individual name has its own gain or loss. Even in years when the S&P 500 is up as a whole, there are names within it that have fallen in price. If you took some profits on winning stocks during the year, you may have some losses on other stocks that you can sell to offset your realized gains.
How Tax-Loss Harvesting Actually Works
Per IRS rules, you can use realized capital losses to offset capital gains on a dollar-for-dollar basis with no limit. If you have additional losses, you can use those to reduce your ordinary income by up to $3,000 per year, with any excess carrying forward indefinitely into the future until it’s fully used.
That carry-over provision is where investors can really leverage the strategy, especially with direct indexing. By banking numerous losses, investors can build up a reserve to offset a future large gain, such as from the sale of a business or a big year in the stock market. With exposure to 500 individual stocks every year, the odds are high that numerous positions have losses, which can be harvested and then reinvested in “similar but not identical” stocks to maintain equity exposure.
Beware the Wash Sale
The reason investors buy “similar but not identical” stocks after selling stocks that have fallen is to ensure that the loss is allowed. As explained by the SEC, selling a stock at a loss and buying back the same or a "substantially identical" security within 30 days before or after the sale is known as a “wash sale,” and it voids the deduction entirely.
Direct indexing works around this by replacing a sold stock with a different one that has similar characteristics. For example, to avoid a wash sale, you might sell Visa (V) and buy MasterCard (MA), or sell Microsoft (MSFT) and buy Apple (AAPL). That way, your portfolio’s overall exposure stays roughly the same but you haven’t run afoul of the wash sale rules.
Recent Changes Have Benefited Small Investors
Until somewhat recently, it would have been difficult to impossible for small investors to manage hundreds of individual stock positions and track each one’s cost basis. That used to be the type of ongoing, hands-on management that required expensive, professional software.
But with advances in online brokerage technology, even small investors now have access to computerized tracking of portfolio gains and losses in real time. This has opened the door to strategies like direct indexing for many more investors.
It’s Still Not for Every Investor or Every Account
While direct indexing is easier than it used to be, it still takes some effort to keep track of hundreds of positions, both physically and mentally. Swapping stocks at the right time for comparable substitutes also takes a level of analysis, which can be a burden for some investors.
Tax strategies are also only relevant in taxable brokerage accounts. If your main investments are in a 401(k) account or IRA, for example, there’s no taxation of gains until you withdraw money from the account. Tax harvesting is therefore irrelevant for those accounts.
Savings from tax harvesting are also more beneficial to those in higher tax brackets who realize frequent capital gains, particularly short-term gains, which are taxable at ordinary income tax rates. Those who don’t trade that often or are in lower tax brackets may not have much of a need for tax-loss harvesting, as the long-term capital gains tax rate can fall as low as 0% for those with low-to-moderate income.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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