Tax-loss harvesting involves selling an investment at a loss, then reinvesting the proceeds of that sale into another asset. It’s also one of the main benefits of direct indexing.
Unlike a mutual fund or ETF, personalized indexing allows investors to harvest losses at the security level. A direct indexing strategy can open more tax-loss harvesting opportunities that can help ultra-high-net-worth investors capture additional tax alpha.
Stocks that fall below their cost basis are sold, then correlated replacement stocks are instantly repurchased to avoid violating the wash-sale rule. Since investors directly own the individual stocks in their direct indexing portfolios, losses can be captured even in a year when the index gains in value.
Vanguard offers an example of how this can work. While the S&P 500 rose nearly 10% in the fourth quarter of 2021, there were still 133 companies that lost value during that time. Since investors own the securities in a direct indexing strategy, they could sell off those underperforming securities.
Harvested losses can be used to offset capital gains and then up to $3,000 of ordinary taxable income as of the 2021 tax year. Losses can also be carried over to future years.
The Frequency of Scans Is Key
The frequency that a personalized indexing portfolio is scanned for harvesting opportunities is also key to maximizing investors’ tax alpha. A direct indexing service like Vanguard Personalized Indexing automatically scans portfolios quarterly, monthly, or even daily for tax-loss harvesting and rebalancing opportunities.
Personalized indexing with daily tax-loss harvesting has improved some after-tax returns by 1% to 2% or more. Tax-loss harvesting in a direct indexing account can deliver tax alpha even if markets experience sustained volatility.
Vanguard CEO Tim Buckley said at Exchange 2023 that the company will “be investing heavily” in direct indexing. More information on Vanguard Personalized Indexing can be found online.
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