Tax loss harvesting is a strategy that can help minimize taxes in your investing plan.
In this post, I asked Bill Martin, CFA and partner at key resource Earned, to give us an introduction to this strategy with a special focus on custom indexing to maximize the advantages of tax loss harvesting.
Traditional investing strategies can often fall short of addressing your financial needs as a doctor. Plus, high earners often face limitations with common investment vehicles. Because these are rarely designed to minimize taxes or offer the degree of customization needed.
To address these unique needs, you may want to consider an approach to investing. One that provides the flexibility and tax efficiency that traditional strategies lack. This all starts with custom indexing and tax loss harvesting.
Custom Indexing: A Personalized Approach to Investing
Pooled investments like mutual funds and ETFs are essentially locked. You can’t directly access individual assets within the fund to tailor your approach.
Custom indexing unlocks your options by allowing you to own individual stocks within an index.
This provides a few key benefits:
- Tax Management: Since you directly hold the stocks, you can apply specific tax strategies, like tax-loss harvesting, more effectively.
- Personalization: You can exclude certain sectors or companies that don’t align with your preferences, such as avoiding stocks in certain industries.
- Greater Control: Custom indexing lets you adjust your portfolio to meet your personal financial goals without losing the benefits of diversification.
Here is a more in depth analysis of custom direct indexing.
Tax-Loss Harvesting: Making Losses Work for You
This is a sophisticated investing strategy that can turn market dips into tax deductions. By claiming a loss on an investment, you can lower your tax bill and keep more of your hard-earned money. Even better, you can reinvest those savings, creating a compounding effect on your wealth.
Step 1: Identifying the Loss
Let’s say you own one share in a medical device company initially worth $100 and the price subsequently falls to $80. This dip represents a $20 unrealized loss. Tax-loss harvesting allows you to capture this loss and use it to your benefit.
Step 2: Harvesting the Loss
Thanks to our tax-smart portfolio management, we swap your investment for another medical device company, which keeps your portfolio’s risk tolerance steady. We realize the $20 loss and add it to your “bank of losses”.
Step 3: Reducing Your Tax Bill
You can use the “bank of losses” to reduce your overall tax bill by offsetting realized capital gains – both inside and outside your portfolio. You can also offset up to $3,000 of personal income via tax loss harvesting annually. Our technology continues to manage these swaps, looking for opportunities to minimize your taxes whenever the market offers a chance.
Accelerated Tax-Loss Harvesting: When Big Transactions Are on the Horizon
Doctors often have major life milestones that result in realizing large capital gains. These transactions, such as selling a practice or property, can trigger hefty tax obligations. This is where accelerated tax-loss harvesting comes into play — it’s an intensified version of tax-loss harvesting designed to have an even greater tax benefit over the long term.
When To Use It:
- Selling a Practice: Accelerated tax-loss harvesting can let you generate significant losses to offset the capital gains from the sale, helping to reduce your tax liability.
- Selling a Property: If you’ve invested in real estate, this strategy can help you avoid substantial taxes when you sell, making it easier to diversify or reinvest.
- Diversifying Your Investments: For those who hold a concentrated position in a particular stock and want to slowly diversify over time, accelerated tax-loss harvesting allows you to rebalance your portfolio while helping minimize the tax impact.
How It Works:
Accelerated tax-loss harvesting leverages a long-short equity portfolio to increase the amount of losses generated. This strategy investing in both long and short positions, with the total portfolio calibrated to a desired “net exposure”. For example, a portfolio that is 130% long and 30% short (130/30) will generate more losses due to both long and short positions, while its net exposure (100%) is identical to a traditional “long-only” custom indexing portfolio.
By systematically building a large “bank of losses” over several years, you have an additional cushion for when these large gains occur. You can then use this bank to more rapidly offset capital gains from the sale of a practice or a property without feeling the sting of high taxes.
The Bottom Line
Your financial strategy should work just as hard as you do. Leveraging tax-efficient tools like custom indexing, tax-loss harvesting, and accelerated tax-loss harvesting helps you retain more of your earnings, reduce your tax burden, and build a stronger financial future.
Tax loss harvesting with a custom indexing strategy can be a great option to achieve these goals.
If you think this may be a good fit, feel free to reach out to Bill and Earned to learn more here.
And here are some additional resources to help you with your investing and tax strategies:
- How To Buy Index Funds in 4 Steps For Beginners
- 3 Reasons We Can’t Exploit Pricing Errors in the Stock Market
- The Stock Market Is Getting Even More Efficient
- 5 Important Tax Tips for Physicians
What do you think? Do you tax loss harvest? How has it worked for you? Have you considered custom indexing? Let me know in the comments below!
One Response
Nice summary Bill and very informative. another physician blogger FI physician mentions Becoming Locked In, that Eventually, you will have only gains in your account and can’t tax loss harvest, and You are locked into 80-200 individual positions. and these securities have very low cost basis when you sell them in retirement. is this a potential problem using the direct indexing strategy, or more theoretical? also is this potential problem magnified in your long/short strategy?