Maximizing Wealth with Direct Index Investing: A Tax-Efficient Strategy for High-Income Earners

In this episode of 'Retired Early, Retired Now,' Hunter Kelly, a certified financial planner, introduces a unique investment strategy known as direct index investing. This strategy, historically accessible only to the ultra-wealthy, is now more widely available due to advancements in technology and zero trading fees. Hunter explains how direct index investing allows for significant tax efficiency through tax loss harvesting and customization. The episode elaborates on the criteria for effective use, such as high-income brackets, concentrated stock holdings, and charitable giving, and emphasizes the importance of professional advice for managing the complexity of this strategy. Ideal for high-income earners, the conversation provides valuable insights into minimizing tax liabilities and boosting long-term wealth.

00:00 Introduction to Unique Investment Strategy

00:34 Understanding Direct Index Investing

01:45 Tax Efficiency in Brokerage Accounts

04:06 Benefits of Direct Index Investing

13:10 Managing a Direct Index Portfolio

16:41 Criteria for Direct Index Investing

21:08 Conclusion and Final Thoughts

Dimensional Advisors Research Paper

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Transcript

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If you earn over$250,000 or more and have a million dollars in a taxable brokerage account. And then today's discussion only unique investment strategy is one you will not want to miss. Even if you don't meet these criteria, you'll still gain valuable insight to this strategy. I'm hunter Kelly certified financial planner, and this is retired early, retired now. New episodes drop every Tuesday morning and they're designed to help high income earners maximize their wealth. If you're watching this video on YouTube, go ahead and subscribe to my channel, like the video. And if you're listening to on your favorite podcasting app, please leave a five star review. So what strategy are we talking about today? This strategy has been available to the ultra wealthy for many, many years. Uh, generally the minimums for this type of strategy would be 20 plus million dollars. Um, but giving the advent of new technology trading systems, zero trading fees. Things of that nature. Uh, it has become a little bit more widely available and that's what we call a direct index investing. And so you may have heard this before. And direct indexing on it and itself, or by itself, um, is a good way to invest for a number of reasons. But when you overlay it with some of the tax strategies that we'll talk about today, it can really help you boost your wealth over a long period of time. And so what we'll learn today is one, what is this, uh, investment strategy? How does it work to what are the benefits that you can achieve from this strategy? And then three, what are the criteria that make it a good strategy for you? And so listen to today's podcast and. Uh, we'll learn a little bit more about investing and hopefully, uh, help you out, uh, in the longterm and gain a little bit more wealth. So, uh, what is the strategy? What is it trying to achieve? So in your brokerage account, obviously these, uh, investments are going to be taxed a little bit different than how your investments would be taxed in an IRA, a Roth IRA or 401k where all those taxes are generally deferred or potentially tax-free. Once you take those distributions, depending on the type of account, but. In these brokerage accounts, there's a number of ways that you can be taxed, whether that be through capital gains. Dividends things of that nature. And so we want to make sure that we're investing in a way. That will minimize these taxes because taxes will be the biggest drag on your return as you start to build wealth and gain wealth through this account. And so. Uh, Generally speaking, there's a number of different investments. There's mutual funds, ETFs stocks, bonds. Uh, or, or the most common right. And so as you talk about tax efficiency, Uh, working from lease efficient to most efficient mutual funds are going to be the least efficient. They don't trade intraday that you got the cat calculate something called the net. Uh, asset value at the end of. Um, the day called the now. Um, and the way they do distributions of capital gains and things of that nature, they're just not as tax efficient. And so the next layer to that came the advent of ETFs. These are much like mutual funds. They're more passive though, and they do trade throughout the day. So they're a little bit more tax efficient, but if you want to have the most tax efficiency or the most tax flexibility in your brokerage account, single holdings like stocks and bonds. Make most sense, but with that level of more tax flexibility or tax efficiency comes more complexity. So you have to be careful. So if you're unsure on how to pick stocks or how to buy them or how you should be evaluating them, certainly seek a professional. Uh, to do that. And that's something that we do here at Palm valley Wolf management. But, uh, so from there, Uh, you can kind of determine, okay, well, how, how efficient am I? Do I have mutual funds? You have ETFs. What's the best way to online these and make, uh, my, uh, Brokerage account more efficient things of that nature. And then what's, you're really trying to achieve with, uh, the, the strategy that we're talking about today. Direct index investing, which we'll define here in just a second is we want to try to add tax alpha. So what is tax alpha? Tax alpha is just a fancy word of saying, Hey, we want to, uh, minimize as much tax liability off of this account and keep that money invested. And so. Uh, how does that work in practice and theory? That sounds great. Right. And so dimensional advisors, uh, ran a study and said, if you utilize direct index investing, plus some of these tax efficiency. Uh, strategies then. Uh, you could add up to 1.5 to 1.8, 5% each year on your, uh, your brokerage accounts. Right? And so if you add that and you compound that year of a year, that can be a. Uh, mass difference. Uh, of account values over a 10-year period, 15 year period, 20 year period. And so in practice, this can actually work, but there's a lot of systems that have to be in place. A lot of due diligence. Um, and a lot tracking. So there's, uh, like I said, as you move to more of these more complex or more tax efficient portfolios, there becomes more complexity and things that you have to watch out for that. We'll talk about here in just a little bit. And so how do you, one way that we track it at Palm valley wealth management, we actually have what we call a tax save report. So at any moment we can jump into our client's portfolios. Uh, Ron, what we call a tax save report and we can see, okay, well, how many losses have we captured? Um, to save on taxes and things of that nature. And so how much are we actually keeping in the pockets of our clients? So that, uh, we can, uh, keep that money invested and help their, uh, wealth grow more over time. Right. And so. Back to the original, um, strategy. What is, uh, index direct index investing? Right. Um, so we've talked about a counter, the efficiencies and what we need to achieve in these a brokerage accounts, but what is a strategy that we're actually talking about? So let's compare the S and P 500. Most people know what the S and P 500 is the vast majority of my clients, especially when I first meet them. They always want to compare their investments. How am I tracking against the S and P 500, whether they own silver stocks or holdings or not, they always just want to tracking inside the S and P 500. So the S and P is the largest five. 500 companies. Uh, in America. And it has what they call cap weighted. Right? So if they larger company, they're going to have more of that particular index. And so generally most people buy this through index mutual funds or through an ETF where they can just buy. Uh, that particular holding and then you would own those stocks through that ETF. But if you go to sell those, uh, ETFs, you would sell basically the whole entire index. Right. And so the difference between that and what direct index investing is, is the fact that you buy each individual component of that. Uh, index. So instead of going to buy. Something like voo and having the index in one share, you're going to buy an apple. You're going to buy Amazon. You're going to buy. Dougal and the rest of the 500 companies inside of that index. And so this is going to give you a couple of things. One, it'll give you more tax flexibility, and we'll talk about how that works in just a second. It'll give you more customization. So if there are certain stocks that you don't want to own, so if you don't want to own, uh, stocks that deal with, uh, war or tobacco or for religious reasons, whatever that may be, you can leave those out. Right. Um, or let's say you have a very concentrated holding because you work for a big tech company. Well, maybe you don't want, uh, apple or Google in your or Nvidia and your portfolio. And videos, probably the most recent, uh, big news stock that has gone, uh, the last year, big, big run. So maybe you have a large holding because you work at Nvidia. Um, and it's. 30 40, 50, 60, 80% of your net worth. Well, if I go to buy this index directly, like we're talking about why can leave out Nvidia and start to build a portfolio around it. Right. And so the customization is the great one. Great park. But where we start to see better returns. Uh, and can really gain a wealth over the longterm is using things like tax loss, harvesting. So if you take a year like 20, 22, the market's down 25 ish percent, um, where all of these. Uh, stocks essentially were down. Um, And the S and P is down. Uh, 22%. Well, you would be able to, if you started out. At the beginning of 2022, you put a million dollars into a brokerage account. You bought the index directly. Uh, through the single holdings. You may have been able to capture up to$250,000 worth of losses, and then you can use those losses to offset gains elsewhere, whether that be in other holdings later on down the road, because you can carry these forward. Right? So if I have$250,000 of losses, then I can carry those forward to, uh, Uh, future year. So if I hold onto those losses and I don't use them, let's say for five years, I'm ready to sell for whatever number of reasons. Uh, in my portfolio, if I say I need a hundred thousand dollars to go buy a house or help my kids with college, whatever the case may be. Um, well then I can sell that and then I can use the$250,000 worth of losses to offset maybe.$20,000 of gains or, or$50,000 again. Right. If I don't use all of them, I can continue to carry those losses forward until they're gone. Um, The other thing. Uh, as you may be thinking, okay, well, um, well, 20, 22, yes, there was a down year. Everything was down, right. Well think about last year, last year, the S and P was up about 26%. And if you own the, the, um, If you own the ETF that tracks the S and P. Well, then you would have almost no opportunity to capture any loss, but if you held these single holdings to mimic the S and P about 34% of those stocks were down, so then that gives you opportunities to sell those stocks. Uh, to capture losses and get back in after 31 days to avoid wash sale rules. Right. Um, and so this is where the direct indexing strategy really becomes fruitful. Is that even though your portfolio as a whole Navy up, you're still going to have some really good winners and some stocks that just aren't doing well that year. And so that will give you opportunity to tax loss harvest. Um, and be able to minimize taxes along the way. And let's say you're able to accumulate, uh, hundreds of thousand dollars of losses and you own a company, uh, and you're going to sell that company to retire or just, it's a good time to sell whatever the case may be. You can actually use these losses to offset those, those, uh, gains that you have in that individual company. Right? So if you own a company. Let's say it's worth$3 million. And your cost basis is essentially zero. Well, if you've racked up a$500,000 worth of losses on a million dollars worth of losses, you can use those losses to offset. Those gains for that cell about business. And save quite a bit in taxes moving forward. Right. Um, and so this is a great strategy, not only to help you within your brokerage account, but maybe some, some other satellite investments that you have, whether that's owning a business or a different brokerage account. Uh, elsewhere, wherever that may be. Right. And so, uh, harvesting those losses can be a great tool. Now you have to be careful with harvesting losses. Um, you don't want to just harvest losses to harvest losses, right? Uh, you don't want to just sell low because you're, you have a loss and capture that loss and have no plan. With the funds afterwards, because then you're just locking in that lossing. And you're not necessarily doing anything with it. You want to have a plan to either buy back after the, the wash sale rule ends after that 31 day period, or have a similar stock. Uh, that performed similar, but is materially different? Uh, so that you can get that money back into, uh, some sort of investment and hopefully continue to work for you a longterm, right? And so we want to be careful about how we're, uh, doing these strategies just because there is nuance there, right? We, again, we just don't want to sell low and, and keep cash and, and stay there forever. We want to have a plan, how to move forward. We want to make sure that we get these losses on paper, but we're right back in the market so that we can keep our money working for us. So what does it actually take to manage a type of portfolio? Um, like, uh, this we're we're, we're picking, let's say the S and P 500 and S and P is just an example. You don't have to just use the S and P 500. You can do this with small companies. A mid-sized companies, international companies. Obviously there's nuance there. Um, but you can follow other indexes. Where now you can build a well-diversified portfolio. You can have potentially thousands of holdings. So now we're getting the customization, we're getting the diversification, we're able to capture losses. We're adding that tax alpha that I talked about earlier. Um, but. Again, with that. Uh, comes more complexity, right? So, so what does it take to manage this type of portfolio? Well, you need a robust daily trading system. Um, mainly, uh, if you add more, uh, if you're adding more than just ETFs and you're adding these single holdings. And you're not necessarily doing this tax loss harvesting, or, some sort of, offset where you're trying to. compensate for maybe you're outside holding through. a company where you have stock like Nvidia or whatever. Um, you want to make sure that you're not just buying these single holdings to buy these singles holdings because you're making your. Your situation just more complex for no reason, right? You want to have a plan? for this portfolio and, and the way to do that is to have a daily trading system. So if you have, if you add more indexes outside of the S and P looking at reviewing over 500 stocks per day, um, that can be time consuming and you probably don't want to sit in a computer all day while the market's open, trying to figure out, should I capture losses? Should I not? and that's just the S and P right. If you have the Russell 2000 or, any other indices, you would have, quite a bit of holdings to look for losses and you have different. What we call a different tax lots. So even though you own Google, maybe some Google shares are at a loss, but somewhere out of gain. So which ones do I share? And so having that trading system in place, can help minimize that work. Right. Uh, and then on top of that, you need. That trading system to have high tax sensitivity. Um, because you, again, you don't want to get caught with, uh, selling something and buying it too early, buying it back to early because then you're hitting, what's called the wash sale rule. Right? Um, and you're going to. potentially, negate those losses that you thought you had on paper. Um, so you want to have a system that is high. has high tax sex. Sensitivity high tax sensitivity. Right? And so. that requires a sophisticated trading software. Right. And so having a great custodian. Uh, to do that again, that's something that we do here at Palm valley wealth management. And I would say the vast majority of just retail investors. Um, most are not going to be able to do that, right. Because just reviewing the number of holdings alone. We'll take a lot of time. So, so this is something that interests you. And after we talk about the criteria, if it's a good fit, go find someone to help you do this because I think it would outweigh any whatever costs that would be. Um, because you, you would end up receiving that tax alpha. Um, maybe some more customization for your portfolio, whatever that may be. And so the value may outweigh whatever that costs may be. Right. And so, again, Historically, this has been for the ultra wealthy, but with the advent of, uh, zero trading fees, being able to buy partial shares. Uh, better technology, things of that nature, direct index investing, uh, is becoming more widely available. So if you have$500,000,$750,000 a year ready to invest. Um, this is, this could be a good. Uh, situation for you, it gets Chaterjee for you. And then the five things or four things where I think it could be a no brainer for you. It would be as if you're in those higher tax brackets. If you're making$250,000. Or more a year you're hitting that 24% tax bracket working up to the 30, 37% tax bracket. Um, and you're in that upper capital gains where you're paying 20%. Uh, this should be a no brainer. Uh, the higher the tax bracket, you have, the more fruitful some of these strategies will be for you. If you have gains elsewhere, right? Um, then this would be a great strategy for you because you can start capturing losses. Uh, and be able to offset, uh, particular gains elsewhere. And I talked about owning an outside business, right? If you own a private business and you go to sell that business and you're. You're accumulating losses within side of these accounts. Well, then now you can offset those gains. Or maybe you have a portfolio and you're trying to unwind that portfolio to get to something like this will, as you start accumulating, uh, assets into this account, whether it's through dollar cost averaging. Uh, through your, uh, cash load date, uh, each month and things of that nature. Uh, you can start to capture losses and maybe unwind those ETFs and things of that nature to get into this type of portfolio. Uh, to be a little bit more optimal from a tax standpoint, longterm. If you have concentrated stock. So again, if you work at Nvidia or Google or. Any number of these publicly traded companies and a LAR a large portion of your compensation has come from stock and that stock has done well. Well, this can be a great strategy for you because again, if your stock is traded on the S and P 500 index, Um, Uh, the S and P 500 index. And you don't want to own that index? Well, if you go buy the ETF, you have no choice. You can't tell that manager, Hey, I don't want Google, or I don't want Paylocity or whatever index work we're talking about. Right. Um, you can do that. If you go and you buy the index directly. Uh, through single holdings, right? And so now I don't have to have Google and my portfolio. And then as this, uh, direct index investing strategy becomes a larger portion of my, uh, portfolio. Then I can start to unwind or potentially buy some Google. Uh, if, if it's something that I want to do. The next thing would be charitable giving. If you're terribly inclined. Uh, giving appreciated stock. Uh, can be much more fruitful for one the, the charity that you're giving to. And then two for your deduction. Right. Um, if you have a stock that's worth$10,000, but you paid 5,000 for it. And you sell it to go give to a charity. Well, you're going to pay. Capital gains on that$5,000, right. That you earned through interest, uh, or growth. And so, uh, if you just go ahead and give that to the charity and well, now you get to gift the entire 10,000 and you get a bigger write-off. And so there's some limits and nuance to that. So, Um, if you're into charitable giving. Uh, make sure you seek a tax advisor, financial advisor to make sure. Uh, that you understand those rules and everything, but, um, those were, uh, Four criteria. And if you're meeting those, you're like, Hey. That's a great strategy. I think I should start looking at that. Uh, meet with a financial advisor, start researching financial advisors because again, direct index investing. can allow you to gain up to half a percent to 1.8, 5% a year. through these things like tax loss, harvesting. Um, making sure that we're not getting over concentrated, and other stocks that we haven't either our company or whatever the case may be. Right. And so being in a higher tax bracket, Maybe having gains elsewhere, concentrated stock and Sharewell giving. If you meet those criteria, this should be a no-brainer for you. Right. To end this. direct index investing can be a great strategy for where you obviously, it adds a lot of complexity. If you're confused, if you're like, Hey, I need these criteria, but I just don't understand how to do those sort of things. Reach out to us. me@palmlawm.com. Love to have. Conversation with you on how this could help you. Uh, and, and hope help you grow more wealth over time. So, uh, hope you enjoyed this podcast. Go ahead again. Share this with a friend. Uh, like the video on YouTube and leave a five star review on your favorite podcast or not. And we'll see you in the next one.\ This podcast is for educational purposes only. It is not meant to be financial, legal or tax advice. Please seek a professional about your specific situation. Key Palm valley wealth management in mind when making those considerations.