For taxable investors, an appreciating portfolio can be a mixed blessing. But regular loss harvesting isn’t the only way to reduce your portfolio’s tax bill, especially as its value rises. We share some important tax-management techniques for the future.
The goal for most long-term investors in the stock market is to build wealth through long-term appreciation. Despite some volatile periods in the last decade, the annualized return of the S&P 500® over the last 10 years has been almost 12%. With this index as its benchmark, a direct indexing portfolio could not only capture this appreciation but systematically increase total after-tax return in two key ways: harvesting losses when available and deferring gains by maintaining the most appreciated lots.
The good news, of course, is that the account has grown in value over the decade. But as the portfolio has appreciated, the opportunity for harvesting losses has decreased over time. Depending on the scale of that appreciation, there may be very few loss-harvesting opportunities left, making the portfolio feel locked up. But investors still have multiple tax-management techniques available at this stage. Let’s take a look at what these techniques are and when they make the most sense to use.
How does tax management work in a direct indexing portfolio?
Investors have many decisions to make before their portfolio reaches the point of feeling locked up. First they must choose their desired exposure and the ideal vehicles to get it. Many choose ETFs, which provide diversified, tax-efficient exposures at a low cost. For investors who prioritize active tax management and customization, a separately managed account (SMA) may be better. This is the typical vehicle for direct indexing, and it can provide exposure to a wide range of indexes, as well as harvesting tax losses and adding customizations like blended benchmarks or responsible investing screens.
The next question is how to fund the account. Direct indexing investors can fund their SMAs with cash, in-kind securities, or a combination of the two. If funding the account with in-kind securities, the typical goal at inception is a tax-efficient transition to the benchmark. If funding the account with cash, the investor and their advisor will decide on the exposure and customizations. The resulting portfolio will aim to track the customized benchmark as tightly as possible.
As the SMA begins to appreciate after inception, the goal will be to realize capital losses when available while aiming to track the benchmark. Investors can use losses to offset current capital gains realized outside the SMA, which can help reduce overall portfolio taxes or be carried forward for use in the future. If the account is funded with legacy positions, the investor can use some losses to offset realized gains, reducing the risks from the at-inception holdings.
Over its lifespan, the portfolio will appreciate with the market. Opportunities to harvest losses will diminish, but they won’t disappear. Even with the market’s strong appreciation over the last 10 years, we’ve seen volatile periods like 2020 and 2022, where appreciated portfolios saw new losses to realize. But appreciated portfolios are likely to reach a point where gain deferral becomes more important than loss harvesting. When this happens, other tax-management techniques become more useful.
Consider the benefits of active tax management
Contribute additional cash
It may sound simple, but the addition of cash is always helpful from both the tax-management and risk perspectives in a direct indexing portfolio. Contributing cash refreshes the basis of a portfolio, creating new lots with a higher basis, which are likely candidates for loss harvesting during more volatile periods. For example, a direct indexing portfolio invested in the S&P 500® might hold 300 to 400 positions within the benchmark, managed at the lot level. Investors would hold multiple lots of most positions, all of which have a different cost basis. When making tax-management trades, managers target the most tax-efficient lots first. They may use additional cash contributions to purchase a basket of securities that matches the benchmark’s overall risk profile, potentially filling in any underweights the portfolio may have. These new lots are also likely candidates for losses as the market fluctuates.
Donate appreciated securities
For investors who are charitably inclined, gifting securities can reduce or eliminate tax liabilities. Instead of giving cash each year, investors can benefit from gifting securities from their direct indexing portfolios. This provides the same deduction as cash and allows the investor to transfer out the tax liability of highly appreciated securities. Portfolio managers can identify a list of securities that can reduce overall portfolio risk if specific lots are donated. Investors can also consider replacing the value of gifted securities with cash, which can help increase the portfolio’s cost basis, as we discussed above.
Realize long-term gains
Some investors have a consistent supply of short-term realized gains that face the highest tax rate. These investors may benefit from strategically realizing long-term gains, which refreshes the basis at the lower long-term tax rate, creating more potential for generating short-term losses in the future to offset the short-term gains. Portfolio managers can provide a tax-lot analysis that highlights the potential benefits of strategic gain realization. Investors who don’t need increased short-term losses can also benefit from gain realization, primarily to reduce their portfolio’s tracking error.
Maintain gain/loss optimization
Some investors may not have additional cash to contribute to their portfolios. Others may be averse to using gain realization to increase basis. In this case, it may be best to keep tax-managing the portfolio in the traditional ways: using limited losses to offset some gains and strategically deferring others. Benchmarks change over time, and customizations can change alongside the investor’s needs and goals. Portfolio managers should be prepared to adapt to these changes over time by continuing to track the benchmark, with the goal of long-term deferral until the eventual step-up in basis. Along the way, if investors need to make withdrawals for short-term income, managers can make these tax-efficient through an optimization process that balances tracking error and gains.
The bottom line
In the end, having to deal with an appreciated portfolio is a good problem to have. Whether the best tool to unlock a locked-up portfolio is contributing additional cash, gifting appreciated securities, realizing gains to refresh the basis at the lower long-term rate, or maintaining an approach of gain deferral through gain/loss optimization is up to the client. Parametric has been helping clients make these decisions for over three decades and has many tools to make these difficult choices easier.
