In this episode of the Secure Your Retirement Podcast, Murs and Nick Hymanson discuss direct indexing with tax loss harvesting, a tax-efficient way to manage a taxable brokerage account. They explain how investing went from individual stocks to mutual funds and ETFs, and why it is now coming back to individual stocks. Then they break the strategy into its two parts: owning 50 to 100 stocks that track an index like the S&P 500, and selling the ones that dip to bank losses that offset future gains.

Listen in to learn how harvested losses can make a retirement withdrawal nearly tax-free, and how they help unwind a concentrated stock position without one large capital gains bill. They also cover how donating appreciated stock to a donor-advised fund and banking losses before a real estate sale fit into the strategy, along with its honest trade-offs.

In this episode, find out:

• The difference between owning an index fund and owning the individual stocks inside it
• Why not every stock in the S&P 500 goes up in a strong year, and how those losers create tax opportunities
• How tax loss harvesting offsets capital gains and can reduce your ordinary income
• How banked losses helped a client take a $20,000 withdrawal with little to no tax
• How to diversify out of a concentrated stock position like Apple or NVIDIA, with help from a donor-advised fund
• Why banking losses in the years before a real estate sale can save tens of thousands in taxes
• The trade-offs: no downside protection, taxable accounts only, and a minimum of about $250,000

Tweetable Quotes:

“We’re not trying to get losses, but we know that they will happen. And so, because they’re going to happen, we might as well benefit from that.” Nick Hymanson

“There are no perfect investment strategies. There’s only tradeoffs.” Murs Tariq

Audio check needed before publishing. Both quotes need verifying against the recording. The Murs line is lightly cleaned of filler words from the transcript.

Resources:

If you are in or nearing retirement and you want to gain clarity on what questions you should be asking, learn what the biggest retirement myths are, and identify what you can do to achieve peace of mind for your retirement, get started today by requesting our complimentary phone conversation with Secure Your Retirement!

Here’s the full transcript:

Well, Nick, thanks for coming on today to the podcast. I know you you’ve been talking a lot to clients about particular investment strategies in your financial planning meetings and there’s one that I think has picked picked up quite a bit of popularity. And and so we want to take some time to talk through it today and I want to ask you a handful of questions around how you’re explaining it to clients. you know, this particular strategy has we’ve been talking about it for a while, but I think it’s it’s picked up in popularity in our in our world of what we do in financial planning and wealth management and more and more people are asking about it. And I think it’s fantastic. the strategy that we’re going to discuss today for for all the listeners out there is what’s called direct indexing with tax-loss harvesting. so I it’s a mouthful of a strategy, but I kind of want to just set it up here a little bit before I dive into asking you all about it. is is you know, I think the world started off with investing around buying individual stock. That’s kind of what everyone did. They They watched CNBC in the mornings. They would look at the ticker and say, “Hey, I think that’s a good buy.” And so we we’re buying a bunch of individual stock. And then the world transitioned into buying mutual funds because stock picking and stock buying was overly cumbersome and it was a lot to manage and the world of mutual funds came in and made things a whole lot simpler. And then and then we had the evolution into ETFs, which is a stock you know, a stock of stocks which operates kind of like a mutual fund, but most would say a little bit more efficient today. But so the idea has been individual stock then to funds then to more efficient types of funds through exchange-traded funds. And now all of a sudden we’re making a case for going back to individual stock in certain scenarios. And so as we kind of got this whole full circle type of thing happening. But there’s got to be a good reason for it, right? And you know, what what we’ve seen and experienced ourselves as well as with clients is is while the mutual funds and the exchange-traded funds, they they come with a lot of convenience, what they typically come with as well is an element of tax inefficiency when we’re in brokerage accounts. So for anyone listening, you know, the brokerage account is really that scenario of I’ve had some extra cash laying around. I decided to buy this fund or that fund or that stock and and that stock did good, but now my problem is is that that type of account in particular is going to be subject to capital gains if I sell the stock, dividends and interest as well. And so it can really mess with your tax return over time. And so you know, the what we’ve seen quite a bit of is people buying let’s say like an NVIDIA stock or an Apple stock and it goes from $100,000 to a million dollars. Some of these have just ran away on us. And and now we’ve got this massive embedded tax problem. And so you know, I think that the gist of what we want to really talk about today is is there a better way to be doing this or is there a better way to be managing this particular type of money, right? For IRAs and Roth accounts, we believe that there should be different strategies in those types of accounts, but in particular for brokerage accounts and non or what we would call non-qualified accounts that are subject to those capital gains, is there a better way to be approaching this? And so, that’s really the problem that we want to address today, Nick, is kind of, you know, how do we get rid of this capital gains problem or this the the famous term that everyone talks about is these golden handcuffs, right? I have a stock or a fund that’s done really well for me, it’s made me a bunch of money, but now I’m stuck with it because of the taxes involved with getting out of it, which leads to all types of problems. So, let’s do let’s do this. Let’s take it in kind of baby steps for people. again, the the strategy that we want to discuss today is direct indexing with tax-loss harvesting. So, it there’s twofolds to this strategy. The one is, you got to understand what direct indexing is first, and then the other is, you got to understand what tax-loss harvesting is, and then why do we put them together? What what what makes this so good? So, would you mind and by the way, thanks for coming on today, and and and spending some time with me but would you mind kind of walking through, first of all, what is direct indexing for, for someone that, you know, wants a listener that has no idea about investment strategy? Make it nice and simple for them. What is direct indexing? so, you know, the first part, like Murs said, is direct indexing. And what that is is essentially going back instead of buying a fund, that could be a mutual fund or an ETF that holds anywhere from 50 stocks to hundreds of stocks, direct indexing is instead of buying that one fund, we would go and buy about 50 to 100 different individual stocks. And we do that to track an index. And we can track pretty much any index that we want to. We can customize it. But with technology and software now, instead of having to buy individual ETFs or individual mutual funds, we can break that fund open and go and buy a group of stocks that then we can go and very accurately track an index similar to, for example, the S&P 500. That’s a very common index that a lot of people look at to base how the market’s doing. And so, instead of buying 500 different stocks or instead of buying, really getting back to the original what most people do is buy SPY, which is one of the ETFs that tracks that. We go and buy 50 to 75, typically, different individual stocks that will still track the index. And we do that to couple it with the other strategy, but from from that standpoint of trying to track an index, that’s the first part to get us involved in in in implementing the strategy. and I think that’s a really key thing to understand, cuz like I said at the beginning, we’re going from, you know, individual stock buying to funds for convenience, and now we’re kind of back to saying, “Hey, it could make a lot of sense to own those stocks individually all over again.” And it’s because of this idea of indexing, right? If you own If you own the SPY, which is a very famous ETF, the SPY is going to have all 500 stocks within that one ETF. And so, what what Nick here is positioning is that instead of buying that one convenient ETF, instead we’re going to buy about, say, 50 to 100 stocks that are going to represent the movements of that SPY ETF. So, that it’s going to mimic the movements. But why would we do that? And I think that’s what’s really important to understand. I could buy one position and get the movement of ETFs, or I could buy 50 to 100 and get the movement of the of the index itself. One seems more cumbersome than the other, right? And that’s why I think it’s really important to understand this next element of the strategy, which is tax-loss harvesting, cuz that’s going to really, really sell the idea of why we would want to what for what seems like more effort of buying 50 to 100 positions versus just the one ETF why does that make sense? And so, Nick, take us kind of through what is the second element of this strategy? Help someone understand what tax-loss harvesting in a brokerage account really is. so tax-loss harvesting is and many people may have heard of this typically at the end of the year you go in and you harvest losses. The difference here in what we’re talking about kind of setting this up as a strategy is not only looking at the end of the year for harvesting losses or selling losses to help on a tax return, but doing that throughout the year. And so, what we are essentially able to do with when we invest in 50 to 100 different individual stocks is that we can then identify which stocks are at a loss, and then we can reposition those into a not identical but similar stocks to still make sure we’re tracking the index overall, but taking advantage of those losses and banking those losses so that we can offset gains and essentially lower tax bills in the future. So, not only that year, but also in the future. So, in a nutshell, that’s what it is and you know, a lot of people ask you know, why would we ever want to accumulate losses? That isn’t that kind of counteracting the gains? The The truth is, when we break open an ETF like SPY, and if we just look at the S&P 500, out of if we’re we’re in a really good year in the stock market like let’s say 2023 or 2024 where there was a really good year not all 500 stocks are going to be positive in that year. So, there are a significant amount that if we look back at those years, there were some that were down throughout the year and when we’re mimicking the S&P 500 for example, there will be stocks in that group that are down even though we are still in a positive year. and so if we were holding the ETF we wouldn’t be able to get any tax advantages from that but if we’re holding individual stocks we can use the losses from those stocks to get tax advantages and actually increase our performance and lower our taxes when we do that. So that is kind of basically in a nutshell how the tax-loss harvesting couples with the direct indexing to make this strategy so powerful. and I think you said a couple key things there to the strategy that I want to kind of reiterate to everyone listening is the first is is when you why would you I guess why would you sell for a loss? It’s almost kind of it’s it’s it’s backwards right? Most people say I’ve heard this phrase so much that you know it’s not a loss until you sell it otherwise it’s just a paper loss right? And if it comes back I’m back in a gain position so why why on earth would we sell on purpose to recognize a loss? Well that creates the ability that’s what tax-loss harvesting is. We sell this one position for a loss; that’s going to let us sell something else that’s at a gain. And when we couple those two numbers together, it offsets the tax of the gain because we have that loss. And take it even a step further in, in a perfect scenario, we sell something for a loss and we don’t really have any gains that we want to offset, and so that transitions onto our tax return to help us with reducing our overall ordinary income, so it can be a twofold type of benefit there. The other thing I want to mention is is so say you’ve got that you bought that ETF right? The SPY is the example we’ve been using and you buy it today and then within a week now the S&P just had a tremendous run and and in one week the S&P or the SPY ETF went up 10% and that’s your only holding right? So all of a sudden there’s nothing in your portfolio that is going to be in a position to generate any losses right? That one position that has a bunch of stocks inside of the fund, which we can’t have any access to, has grown. It’s a It’s It’s got growth to it, and now it’s in a gain position, so we’re kind of stuck. We’re either waiting for it to come down to sell it at a lower taxable impact, or we just hold on to it and deal with the taxes at some point in the future. But when we break out those 500 stocks, like I like what you said is that not all stocks go up at the same time. And so the S&P 500, I think we all know is kind of led by a handful of stocks, right? The reason that the markets have done so well over the last 5 6 years is really because of AI and technology and a handful of the big players that have really driven the market. But if you were to look at every single stock in the S&P 500, not all fit that same story, right? Some have been have been terrible stocks in that you would never want to be a part of, but in the fund, you’ve got no choice. You are a part of them. and so all we’re saying here is if we if we break it out and say instead of buying the fund, let’s buy the stocks that represent the fund. And what’s nice is technology today makes it so much more manageable than it used to be. Go back 20 30 years ago, you had to have your own, you know, portfolio manager that that’s all they did for you. And this type of strategy is really reserved for the ultra high net worth. Today it’s made it downstream to where a lot of people can access this. And so now I tell people it’s like, “Hey, let’s create a playground, right?” That seems like a a not so serious investment strategy when I say playground, but in reality what it is is now we’ve got a playground of 50 to 100 stocks that are going to do part one, which is index, right? So if the S&P is up 10%, this 50 to 100 stocks are very likely going to be up very close to that 10% number. It’s going to mirror. and then also now that playground allows us to sell some of those losers, which we wouldn’t have access to if we’re in the funds, and create those losses while still getting the return of the index itself. So I I I it’s really cool to put those two things together. but it Is there I guess anything to add to what I just said around the combination of the two and how they work together around indexing and tax-loss harvesting and why it’s so important? so I mean one thing that stood out I think is is we get a lot of questions on, “Hey, if or when I need withdrawals, what are my tax implications going to be and which which accounts do I pull that from, right?” And so, one of the nice parts of about direct indexing with tax-loss harvesting is that because we manage losses to offset gains, a lot of times if people have brokerage accounts and we’re implementing the strategy, they come to us and say, “Okay, what’s my tax bill going to be?” I need $20,000.” And the thing is, which is so powerful and such a great benefit, is that a lot of times we’re going back to them and saying,”There is no tax bill. We’re we’ve been using the tax-loss harvesting to offset the gains. We can get you that 20,000 without any tax implications.” And that’s a a very powerful thing to have in a retirement plan because things come up, vacations happen, and are planned, and there’s a lot of goals in retirement. And so having this strategy as a way to get an incredibly tax efficient withdrawal in place is so powerful. And the difference is if we were just holding the the S&P ETF like you said, we would have no choice what to realize gains. Right. And so that’s kind of the how how important this strategy is. I think so. So, let’s let’s give the our listeners a a handful of examples that you’ve experienced around like where this strategy really comes into play. I think you you you you just gave us one, which is the the simpler scenarios of,”Hey, I need some cash. What’s Where’s the best place to take cash from?”Oh, we’re running this tax-loss harvesting strategy for you and you could access 20,000 with next to no tax liability. That one’s a no-brainer, right? That’s a perfect scenario for this type of strategy. but what are some other ones that you’ve come across? so a few other ones and and in specific scenarios, you know, a lot of folks have been either because they were employed at a company and got a lot of stock options and grants throughout the years and they’ve held them for so long because of taxes. There are a lot of folks in situations where they don’t want to sell any of that stock because it could result in a huge tax bill and and so many long-term capital gains and they’re just kind of stuck holding the stock. And so we I see that a lot. One strategy that we this strategy that we do a lot is to couple that stock with the loss harvesting so that we’re able to slowly get out of that highly appreciated stock. A lot of times that stock is a large portion of someone’s retirement plan. So it’s very important to get out and diversify because we just don’t know what’s going to happen with the stock. Some people are very confident in the in the company. Others aren’t, but either way it’s very difficult to get out if you don’t have losses to offset. You’re kind of just you know, make the only other option is to sell the stock, diversify and pay the taxes. So having the losses basically removes the tax implications and gets it that stock into a more diversified position. I think that one’s that one’s huge and that may be the most common reason is I’ve got a concentrated stock position. I’m worried about the risk I’m carrying by having that much stock, but I also don’t want to realize all the taxes to diversify away. So is there a better way? And it the the direct indexing with tax-loss harvesting works really well for that of unconcentrating the stock, but then also at the same time creating the ability to get a little bit more diversification in that portfolio. I’ll add another layer to that that I’ve seen that’s more common as well for our families that are charitably inclined. So and I one example of a client of ours that comes to the to the top of my head is they’ve got a tremendous amount of Apple stock. And and while they like their Apple stock, they realize that it’s it’s too much risk, you know, it could be it’s somewhere in the realm of say 20 to 30% of their overall portfolio. And so if Apple stock has a bad year or Apple stock it goes kind of sideways as far as its growth, their entire portfolio is affected by that. and and there’s a lot of embedded capital gains in that Apple stock position. Now, they happen to be charitably inclined, and so but you know, they’re not going to give away a million dollars of Apple stock. They just want to give away every single year a normal amount, and let’s just say that that amount is $50,000. So, rather than just writing a check to their charities of choosing out of their bank account, what what what is one of the more advantageous ways to give to charity is through a tax strategy that we talk about all the time of a donor-advised fund. So, what they’re doing is they’re donating that Apple stock from that highly appreciated portfolio into their donor-advised fund. And what that does is it creates it does two things. It it allows us to remove some of the Apple concentration to the donor-advised fund completely tax-free. So, when you donate stock, you you don’t have to deal with any capital gains. Which also then satisfies their ability to now divvy out those dollars to their charitable inclinations however they want. So, that takes care of that. So, we reduce their Apple exposure. We’ve taken care of their charitable giving, but then as we couple tax-loss harvesting thing with it, as losses come about, we’re still still able to chip away at their Apple exposure until we get it down to a reasonable amount. So, there there’s a handful of different strategies that are working together with the tax-loss harvesting kind of being the base of that one, which works really well for them. any other examples that you want to throw out? one one big one that I see a lot also is gains from selling real estate. That is huge right now just because real estate’s gone up in value so much over the last 5 to 6 years. And so, selling rental properties. A lot of times people have significant gains due to taking the depreciation on their properties and they a lot of times don’t want to sell because of those gains. And if they do need to sell or really want to sell, they’re paying a lot of taxes. Right. And you know, that’s that’s not the ideal scenario and having these losses banked from another account helps to directly offset the gains from that real estate transaction. and if there are significant gains from a real estate transaction, having the direct indexing strategy not only implemented in that year when the real estate sale happens, but in many prior years, and just having that going in the… having that going for a potential real estate transaction would just allow for those losses to continue to accumulate, really helping reduce taxes in the realm of tens of thousands of dollars. So, the sooner that people or that that the account can generate losses, the better because it’s never a bad idea to have losses that can offset gains in the future. Not only for real estate transactions, but like we talked about earlier, the very simple”Hey, I need money to fund my retirement,”whether it’s a monthly distribution or a a big distribution for a fun vacation or an expense that needs to happen, having the ability to take a big portion of money out without any taxes is huge. I think that that’s a really good one, too, on the real estate side. So, you know, I I tell people with investment strategies that cuz as we talked through some of these on the on the podcast, a lot of times they just sound so fantastic and perfect, but I tell people that that there are no perfect investment strategies. There’s only tradeoffs. And we if we understand the tradeoffs, then we can kind of diminish the tradeoffs a little bit cuz we we’re more educated about them. And if we pair together multiple strategies that all have their own sets of tradeoffs, well, if you look at them individually, the tradeoffs may not be something great. But when we pair them all together with a handful of different strategies, all of a sudden those trade-offs get smaller and smaller, cuz we’ve got a lot of different things working together at the same time. But, if I had to talk about trade-offs in this particular strategy, I would say one is is that, you know, you can’t have it’s really difficult to have risk management and tax efficiency at the same time in a brokerage account. So, what we try to educate our clients around in this particular strategy is there’s you’re you’re you’re indexing. So, what we are trying to do is mimic an index. Now, there’s more conservative indexes that we can utilize than the S&P 500, but there’s an element of the index is going to do what it’s going to do and we’re not stock picking here to try to maximize return. We’re trying to mimic the index return and add in tax benefit, which end which ends up really maximizing return at the end of the day. If I’m saving on taxes, that’s more dollars I’m keeping in my pocket, which allows me to really compound on that growth and I get a better return in the long run. but, it’s not a risk managed strategy. That’s one of the trade-offs, right? I think the other is is it’s it’s probably not for everyone. again, it has to be you have to have dollars in a non-qualified type of account, non-IRA. and it’s to in order to be able to buy 50 to 100 stocks in in enough quantities, really what we would say is the minimum account for this really needs to be around $250,000. and so, I think those are the two major not major, but there are things that we just need to be aware about in this type of strategy. but, you know, I I don’t ever like painting a perfect picture cuz there’s no perfect picture. We need to understand, the pros and cons. But I think for anyone that’s got highly appreciated stock, or they’re going to sell a business in the future, sell real estate in the future, or, or just looking to have tax efficiency as far as their withdrawals, from their brokerage account, you know, I think this, this particular strategy should be worth exploring. Just like what we say with Roth conversion, should everyone be doing a Roth conversion? we don’t think so, but should everyone be looking at it as a potential? Absolutely. There’s going to be years where it makes sense, there’s going to be years where it doesn’t. For tax-loss harvesting, I think it’s the same deal. Should you explore whether or not this fits into your portfolio and your risk tolerance? I think so. but you know, I think I think we’ve given them enough, Nick, as far as kind of introducing them to this concept. Are there any any kind of closing remarks that you would say around this direct indexing with tax loss strategy? Anything you want to make sure that they the last thing they hear, what do you want them to hear? I would say, you know, one of the main questions I get all the time when I talk to people about this strategy is, “Hey, why would I want losses?”Like I don’t get that. Why would I want to sell at a loss? And the thing that I I kind of go back with here is the truth is we can never avoid all losses. if we’re invested in the stock market, it’s impossible to avoid all losses. And so, we’re not looking for losses, but at the end of the day, if we’re invested in the stock market at all, if we are indexing, we can use those losses to offset and create a a more efficient tax scenario. So, that’s the biggest thing. We’re not trying to get losses, but we know that they will happen. And so, because they’re going to happen, we might as well benefit from that. Right. Let’s take advantage of it if we’re going to deal with it anyways. I I totally agree. And that actually reminds me of what, a client of ours said to me when I was explaining She’d been in the strategy for a little bit over a year, and we’re kind of going through a just a a financial planning strategy meeting, and, and I was walking her through how this strategy had operated for the last year. And what she said back, she said, “How is this possible that I made money and lost money at the same time?”And I made, you know, I think her return was back in that that time frame was around maybe 10% for the year. But also, we were able to realize somewhere in the realm of, say, 10 to 12,000 dollars of losses that helped offset some capital gains. But we couldn’t use all of that, so it also went on to her tax return to reduce overall tax liability. She’s like,”How is that possible that I made money and lost money at the same time? And I And And to me that’s just the beauty of what this strategy can do. so, with all that said, thanks thanks Nick again for coming on here today and sharing some of your experiences with our clients. But, you know, if you’re in a scenario where you’ve got a any one of those scenarios of of concentrated stock or you know, a significant amount of non-IRA dollars or non-qualified dollars and you’re worried about how it’s being managed, or you’re worried about tax efficiency or, what we hear even more and more is “I’ve got those mutual funds that’s get me with these surprised capital gains distributions at the end of the year and it really messes with my taxes.” I think there can be a more efficient way to do this. and so, we’d be happy to, you know, have a conversation with you. Best way to do that is head over to our website, pomwealth. net, and from there you’ll have the ability to schedule a call with one of our advisors and. We’d be happy to kind of walk you through our process, our evaluation process, and what it looks like to get to a place of getting these types of recommendations. But, with all that said, we appreciate everyone tuning in and we’ll talk to you again next Monday.