Is Custom Indexing Right For You? How to know if this tax efficient tool should be a part of your financial plan
Many of you have probably heard the old adage that a penny saved is a penny earned. In the case of direct indexing, the adage is that a penny lost is a penny earned. While this may seem counterintuitive, this can occur with a custom index. The taxable account is a powerful type of investment account that allows for investment in various securities such as stocks, bonds, alternatives, and more. The tax treatment of this type of account is advantageous over accounts such as traditional 401ks or IRAs because withdrawals and qualified dividends distributed are subject to capital gains taxes instead of ordinary income taxes. Historically, these accounts were very difficult to fund with a multitude of stock positions with ongoing trading without incurring high costs associated with this activity. As a result, those who could afford to stack their taxable account with hundreds of positions were only the very wealthy. With the advent of algorithmic trading and technology, the custom index is now possible for a much broader audience. With the ability to have many individual securities in a portfolio, you unlock the opportunity to benefit not only when stocks are up but also when they are down. This seems counterintuitive but has to do with the rules allowing for losses to carry over or offset gains within a portfolio or that are foreseen due to your individual circumstances. More on this later, but this strategy is not best for everyone. How do you know if this is right for you? Let’s break down the custom index and what it means for your financial plan.
What is a custom index?
A custom index, also known as a direct index, refers to an investment allocation within a taxable account where you own individual securities that comprise a larger market index. The most common example would be the S&P 500 index. This is an index of the 500 largest companies in the United States, and the relative weight of each company is determined by its market capitalization. Simply put, the larger the company, the larger the weight within the index. When you buy an S&P 500 index fund, you do not actually own the individual securities in the weights that comprise the larger index. Rather, you own a fund (ETF or mutual fund) that will have a performance that more or less tracks the performance of that larger group of companies. Custom indexing, by contrast, is when you actually own a fraction of each company in the relative weight that makes up the index, such that the return will mirror that of an index fund, but you participate in the individual performances of the companies that are owned. The benefit of this is that the performance of the overall market can be driven by small pockets within the index, and the performance of individual companies can be down even when the index is up for the year. Why does that matter? Enter the adage of a penny lost is a penny earned. In a custom index, you have the ability to harvest losses that occur throughout the year and utilize them either in that given year as a benefit to you or carry them over in preparation for a long-term gain in the future. This strategy essentially lets you have some positive impact on your overall financial plan even when the index as a whole is down. This is called tax loss harvesting.
How does tax loss harvesting work?
When a stock price decreases from the market value in which shares were purchased a loss occurs. The loss can either be short-term (if the position was held for less than 12 months) or long-term (if the position was held for more than 12 months). With a custom indexing approach, the normal volatility in the market as a whole can be leveraged to sell these securities that lose and replace them with another security that is substantially similar; while maintaining the same overall index exposure and consequently a similar overall portfolio return as in the case where the security was not held directly. Short-term capital gains are taxed as ordinary income, and long-term capital gains are taxed at capital gains rates (which are usually lower than ordinary income rates). In a custom index, many sales occur throughout the year with algorithm trading, so as to leave losses that can either be used to deduct against ordinary income (up to $3000 per year) or to offset capital gains that occurred elsewhere. This can be a powerful addition to other investment strategies and used strategically as part of an overall financial plan.
Who benefits most from custom indexing?
- Those in the highest tax bracket- If you are in the 37% federal tax bracket and you do nothing else but offset $3000 in losses each year as a result of a custom index, you have effectively saved $1,110 just for investing the right way. That’s pretty powerful! Alternatively, you could use any additional losses to offset short-term gains that may be held elsewhere. For example, if you know you are going to sell another stock that has been a big winner for you within a calendar year, you can offset those short-term gains (taxed at 37%) with the short-term losses that are incurred from the custom index. If you had a stock position that went up $5,000 in one year and you wanted to sell, you would be paying $1850 in tax to liquidate that position; however, if you had a total of $8,000 in harvested losses in that year, you could first offset the $3,000 against ordinay income and offset the $5,000 capital gain with the additional losses. That is a total yearly tax savings of $2960.
- Those who have large real estate transactions or will sell a business– Why do these clients benefit from custom indexing? If we know a large capital gain will occur in the future, the carryover losses can help to offset the future capital gain that is foreseen. This can be used strategically for these clients. Losses that are unused can carry over indefinitely so this is often a long term planning strategy. As long as the losses are not offset in a tax year with realized losses of the same type, they can carryover for future use.
- Those who are charitably inclined or want to leave money for the next generation
As with any strategy, custom indexing does have some downsides and one of which is that the strategy does not eliminate taxes but only defers them. It does this through lowering the cost basis of the securities within the index where losses were harvested. Essentially this means that at some point in the future when distributions are made from the account, a larger proportion of the distribution receives capital gains treatment than what otherwise would have been the case if loss harvesting did not occur. Is this a bad thing? The answer is it depends. If you plan to donate appreciated stock in the future or you want to leave the assets to your heirs, then this is actually part of the strategy and not harmful in the slightest. The reason has to do with the concept of basis in a security. When you buy a stock or other security, the price you pay is called your cost basis. When the stock appreciates and you sell at market price, the capital gain of the stock is the difference between your cost basis and the sale price. If there is a larger gain, you will pay more capital gains taxes. There are a few exceptions to this and one of which is when you leave the account to someone in your will, and they inherit it at your death. In this case, they receive what is called a step-up in basis, meaning their new basis is “stepped up” to what the market value was on the day of their death. This means that large capital gains are wiped away completely. If your custom indexing account is going to be left this way, then this is very tax-efficient. If you plan to donate to charity, there is perhaps no better way to do this than through appreciated stock. The reason is that when you do this, you can deduct the full market value of the stock (subject to percentage of AGI limitations) while at the same time not paying anything on the capital gains of the stock that was donated. It is a win-win for both you and the charity of your choice. This is a great way to use the lowered basis in a custom index to your advantage. You can also utilize this strategy in a fund called a donor-advised fund (DAF), where you donate a large amount in one year (often with a large tax deduction) and give the amount to charity or charities over a period of time
4. Those with concentrated stock positions– Those who have equity compensation through employer stock are often over-leveraged in a particular company. That company may or may not represent a part of a broader index. The risk in this case is that if this client simply owned an index fund, they have no ability to exclude similar companies that map onto the stock that their company already represents. This can lead to a suboptimal risk profile. This is where the custom name comes from in custom indexing. In this case, it would be advantageous to exclude certain securities from the index if they are already held elsewhere. Another problem that occurs with concentrated stock positions is when the decision to liquidate is too costly due to embedded capital gains. Enter the direct index with tax loss harvesting. In this case, you can utilize the losses within the direct indexed portfolio to offset the sale of shares in the concentrated stock held elsewhere. This provides an off-ramp for a stock that should be sold but was held unnecessarily due to the sizeable tax bill that would be incurred upon sale.
Conclusion
The direct or custom index is a powerful tool when used for the right client at the right time for the right reasons. As with most cases of financial planning, personalization usually yields the best result. The uses of direct indexing are varied but require careful planning and forethought. This is exactly the kind of value that a good financial advisor can bring by recommending certain strategies over others for an individual client.
Resources
For those who want more reading on this topic, please check out this article by Michael Kitces:
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