Direct Indexing Seeks to Minimize Year-End Capital Gains Impact
Investment brief outlines how direct indexing can offer investors a way to mitigate year-end tax surprises and take greater control of their financial outcomes.
Dec 12, 2024
After a second consecutive year of outsized equity returns, investors eager to lock-in profits and/or rebalance portfolios may benefit from direct indexing.
Equities had a second consecutive year of outsized returns in 2024, leaving many investors eager to lock in profits and/or rebalance portfolios. The situation calls attention to the tax implications of investment success, and it is not isolated to stocks. Properties, businesses, cryptocurrencies, and other assets sold at a profit also generate tax liabilities.
Direct indexing offers a solution for improving after-tax outcomes, and demand for it is growing as investors learn how direct indexing can help them keep more of what their investments earn.
Decisions to sell can be complicated, perhaps most of all because profitable asset sales trigger capital gains taxes. While details vary by situation, investors in the highest bracket pay 20% to 40.8% in taxes depending on the nature of the gains. State and local taxes add to the tally. Reluctance to sell often corresponds with the size of the gain.
Direct indexing is straightforward. Executing a direct indexing strategy is not. Often modeled after a broad market index (e.g., S&P 500), a direct indexing portfolio is meant to deliver index-like performance and risk characteristics. The investment manager monitors the portfolio and sells loss-making positions, using the proceeds to buy a substantially similar investment to maintain the portfolio’s market exposure. The losses harvested through the sales can then be used to offset capital gains generated elsewhere.
Risk management. Rebalancing taxable investments can be an inefficient process. Concentrated positions in appreciated company stock, a portfolio with several high-flying holdings, and a sector fund that benefitted from artificial intelligence enthusiasm represent scenarios that call for tax-triggering moves to diversify. Direct indexing offers the opportunity to reduce associated tax liabilities, unwinding positions gradually while using losses to help offset capital gains generated by sales.
Offset anticipated capital gains. A business or real estate owner can employ a direct indexing strategy early that may enable the stockpiling of significant tax losses to use to offset gains from proceeds of the eventual sale of the business or property. Tax losses harvested do not need to be used in the year they are captured and can be used to reduce future tax obligations. *
Benefit from market conditions. Volatility comes with the territory. With stocks near all-time highs, equity markets may experience short-term volatility. Since 2000, the S&P 500 declined by an average of -16% at some point during the year, with a range of -3% to -49%1. The securities that comprise the index experience even greater volatility, making them a fruitful source for tax-loss harvesting.
Addressing the obvious. Nobody wants to pay more in taxes than necessary, giving tax-smart investing strategies widespread appeal. Only net capital gains are subject to taxes, so any realized losses can reduce an investor’s tax obligations.
Source: Morningstar Direct as of 11/30/2024. Bitcoin represented by S&P Bitcoin Index. Past performance does not guarantee future results. The investments are being used as examples of appreciating assets. They are being used to help illustrate the points being made in the article.
Head of PGIM Custom Harvest
Investment brief outlines how direct indexing can offer investors a way to mitigate year-end tax surprises and take greater control of their financial outcomes.
PGIM Custom Harvest shares views on the ever-evolving tax-loss harvesting landscape & how direct indexing can help investors capture stronger after-tax returns.
PGIM asset managers highlight key trends and related opportunities that they believe warrant the most investor attention as 2025 gets underway.
* Please consult with your tax advisor as PGIM Investments does not provide tax advice. Clients may be able to use losses from their Direct Indexing account to offset gains in other investments. After netting out short-term gains and losses and long-term gains and losses, investors have the option to use long-term gains to offset your short-term gains (and vice versa). Using short-term losses to offset long-term gains is generally not recommended because the long-term gains are taxed at a reduced rate. Using the short-term losses to offset regular income or carry them forward might be better use of any short-term losses that might be left over at the end of the year.
1.Source: Bloomberg as of September 2024
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