There’s a new way to invest in indexes that offers tax savings and other unique benefits. It’s called direct indexing and we talk all about it in this episode.
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Speaker 1 (00:02):
And welcome back to 30 Minute Money, the podcasts podcast that delivers action-oriented smart money ideas and little bite-size pieces. And, uh, of course, joining me today, Steve worshiping from Focused Wealth Advisors, who's going to throw down the information for us, throw
Speaker 2 (00:19):
Speaker 1 (00:19):
Throw it down. And today it's called, it's, uh, direct indexing. Yes, it is. Which I know I had to explain it to you before we started just to make sure that you're,
Speaker 2 (00:28):
You know, I got by notes the ball. I hope I get it right. So just let me know if I go off course someplace here. .
Speaker 1 (00:35):
So what is it? What's direct indexing?
Speaker 2 (00:36):
Yeah, so, so, so let's set this up. Direct. Direct indexing is a, is a really, it's a cool new strategy. Not that new, but it's, it's, but it's relatively new. And, um, and it gives you a, a, a big added benefit if you have a bunch of money in a taxable account. So we talk about harvesting tax losses at the end of the year. Mm-hmm. typically it's at the end of the year. So if something has gone down, we want to, you know, sell a, sell a position that's in a loss so that we can capture that loss. We can use that to offset taxes elsewhere. Right. Um, so the, so the question is, what if we could do that all the way through the whole year and every time something dipped a little bit and we could pick up a little benefit, we pick it up and we just collect those all the way through the year. Maybe we could have more losses at the end of the year, just taking advantages of all the ups and downs and things so that we could save even more tax by the end of the year. And direct indexing is a way to do that. So let's talk about what indexing is first. So when we put portfolios together, you know, we subscribe to Modern Portfolio Theory, which says, you know, we, the most important portfolio decision that you make is how you spread the money across the different kinds of investments. There are
Speaker 1 (01:55):
Speaker 2 (01:56):
Diversification, good man , stocks, bonds, cash, real estate, commodities. And once we've figured out, and then, you know, stocks have large companies and small companies and international companies, once we've figured out what each of those pie slice, how big the, each of those pie slices should be, we typically put it in an indexed investment because they're low cost, you know, they're, they're, we, we take some of the risk out of it. And so if we're looking at large companies, we might, some of the portfolio may might go to an s and p 500 index fund because it gets us exposure to that part of the market. And it's very low cost. So we've got a por, an allocated portfolio invested in a bunch of index funds, but if you're looking for extra tax advantages in a taxable account, now we can take that s and p slice of the pie and buy a basket of stocks that mimics that index. Wow. And then, and then a computer watches it all year long, and if something in it drops a little bit, the computer will sell it off by something that's similar but not the same. So
Speaker 1 (03:04):
This is what we were talking about in previous episodes where you said, like, if you have Home Depot stock and you drop it and you get low stock Exactly. Something that's similar. That
Speaker 2 (03:12):
Is exactly, and that's the example I like to use. So let's say that there's a component of the s and p that is home improvement centers or retail or something like that mm-hmm. . And so Home Depot might be in the stock and exactly that, that example that we used before, things are going up and down. That part of the market goes down, okay, well, the computer says, oh, here's a loss I can pick up. It sells Home Depot, it buys Lowe's. So your portfolio hasn't changed at all, but it's picked up a little bit of a loss. And it does that all through the year. Now, the, um, so you know, the question is how much benefit can you, can you really get from it? Well, Vanguard did a study and there was an article in the Journal of Finance relatively recently, both of them relatively longer term studies.
Speaker 2 (03:57):
And what they found was that by doing this, you can pick up an extra percent and a half of return through tax advantages in your taxable portfolio. Last year, of course, was crazy. Last year was volatile. The market went down lots. And so the, you know, the company where, where I do most of this stuff did its own study of its own accounts last year, and they found that they could pick up 6% because the market was way more volatile than usual. So it's, it's a great way of, of, of keeping, of, of getting more and more tax benefits out of the same portfolio that, uh, that you would otherwise have. It's just a way of getting some more benefits.
Speaker 1 (04:36):
And even if it's just, I I, I want to say, you know, just 1%, but if you have a lot going on, 1% could be quite a bit.
Speaker 2 (04:45):
Well, look at it this way, you know, if I manage a portfolio for somebody and we do their financial planning, you know, we, we charge 1% so you can get me for free , right? Yeah, because
Speaker 1 (04:55):
That's a good way to look at it though. Yeah. That's, it's, yeah.
Speaker 2 (04:58):
So you know, it one percent's a big deal.
Speaker 1 (05:00):
It's like you got your free shipping with that coupon
Speaker 2 (05:03):
. Exactly. I'll even throw in the Ginsu , it is
Speaker 1 (05:07):
Steve's out here cutting cans and men . Exactly. Tomatoes. That's right.
Speaker 2 (05:12):
What was that guy's name? Who was the, the, the guy who sold all that stuff? Um,
Speaker 1 (05:16):
I don't remember. I know who you're talking about. Yeah,
Speaker 2 (05:19):
Speaker 1 (05:20):
Speaker 2 (05:21):
Speaker 1 (05:21):
Speaker 2 (05:23):
But it's, yeah, so adding a percent that way and, and you know, when we talk about, when we talk about added return to a portfolio, you know, we talk about, uh, alpha. So that alpha is just the, the added add, the added return that you can add to a portfolio based on what you're doing over, over and above what level of risk you're taking. And the joke, I, I say, I say that just because I, I want to be able to say the joke among a lot of us financial advisors is there's no alpha like tax alpha. So if somebody says, well, I can manage the portfolio better than that guy over there, great, I mean, optimistically, they could add a percent or two the return over the long term. But, but if we can do the right tax management, we can add several percent to that.
Speaker 2 (06:07):
I mean, just the, the added value from the tax management is way above any of the fancy stuff you could do by portfolio management. And so direct indexing, if, if you've, you know, for the right situation is a great way to add more of that tax alpha, more of that tax benefit. Now there, there are a couple things that, um, that need to be true for this to work. First of all, it's, it's for a taxable account. There, there's no point in doing direct indexing in a, in an ira, right? Because, you know, you can harvest losses to, you know, to beat the band. It's never gonna make it to your 10 40. So they, they, these have to be taxable accounts. The other thing is that you need to have a portfolio that's big enough that the part of the portfolio that you would want to allocate, for example, to large US companies, or to at least US stocks, has to be big enough that you can do this. I mean, it, you can't do it with small amounts of money. It takes, you know, fairly substantial investments to be able to do this. But if
Speaker 1 (07:07):
You've, and, and does that mean like tens of thousands of dollars as opposed to
Speaker 2 (07:10):
Just thousands? Yeah, it means like a hundred thousand dollars that you would allocate specifically to US stocks.
Speaker 1 (07:15):
Speaker 2 (07:16):
So if you've got, you know, a half million dollar portfolio, well, you know, you could realistically want to allocate half a million bucks to
Speaker 1 (07:24):
Yeah, I've been, I've been trying to figure out what am I gonna do with my half a million bucks? I know. Well,
Speaker 2 (07:27):
I come talk clear, we might want to put some of it in direct indexing . Um, the other thing is that, that, you know, there are, there are uses that will, that we'll wanna make, uh, of this. So you, you need to have the, the losses that you harvest can offset any gains that you have in any, in any transaction. So you could sell stocks for a profit. You could also sell, you know, houses for a profit. You could sell businesses for a profit if you have capital gains to offset these losses can offset them. Or if you have more losses than gains, you can offset up to $3,000 worth of income. Like salary, any, anything that you can't use that way you can carry over to future years. It's just that you get delayed gratification.
Speaker 1 (08:12):
Now, I, I don't want to go too much on a tangent, but there's something that, you know, I know what essentially know what capital gains are, right? That's, that's when you make money off of your investments
Speaker 2 (08:22):
When, when you sell something for a profit.
Speaker 1 (08:23):
So when you sell, all right, so you buy something at, at 10 and you sell it for 20. What you
Speaker 2 (08:28):
Speaker 1 (08:29):
A capital gain. That's a capital gain. Now I've heard people talking about, you know, so you have time to reinvest that gain into something else before, or is it only when you cash out? Do you have to pay those taxes?
Speaker 2 (08:41):
It's, um, no, it's at the end. Well, yeah, when you sell something. So if you have a stock and you buy it at 10 and it goes to 20, you don't owe any tax on it. When you sell it for 20, then you have to pay tax on it. And
Speaker 1 (08:53):
You pay it right. When you, when you, you pay
Speaker 2 (08:56):
Sell it. No, you pay it on, on the, when you, when you file your 10 40 form. Okay. You've gotta have an accounting for all that stuff and that's when you pay the, the capital gains tax.
Speaker 1 (09:04):
And someone like you would be the guy that would provide that information, be like, here's what happened and
Speaker 2 (09:10):
Yeah. Yep. Okay. Yeah, we provide all the, the records and stuff so that the tax preparer can figure that out.
Speaker 1 (09:15):
But so once that, once that is sold, there's nothing cuz I've, I've heard, and I don't know what this is, but I've heard about people saying, uh, you know, reinvesting their capital gains so they or deferring it or something. Yeah, yeah. There's tricks or something. I was just curious
Speaker 2 (09:30):
About there's Yeah, that's, that's another episode. Probably another,
Speaker 1 (09:32):
Speaker 2 (09:33):
A different episode that's, that's called a, that's called a section 10 31 exchange. And there are all kinds of rules around it. But that's, this is, you know, typically people don't do that within a portfolio. If, if they've got a portfolio and they're buying and selling securities, or even, even if it's just because you're rebalancing, you know, it, you go through the year and the stock market goes up 10% and the bond market goes up 2%. Well, you want to, you know, sell a little stock, buy a little bond. So you restore the original thing that, that, that could create a capital gain. So that's not the, those tax-free exchanges are for really big transactions. If you sell a business, if you sell a, a house or an investment property, that's where you start talking about tax-free exchanges. Gotcha. You don't do that in, in portfolios, in, in little amounts.
Speaker 2 (10:13):
Okay. But, but the idea is that if you can do this successfully, you know, one of our accord, you know, again, our objective is that we want to get people into a, a low tax or no tax situation. And any, anything that you can pay a capital gains tax on is gonna be better than paying tax like you would on income because it's gonna be in a lower bracket and the lowest bracket for capital gains is 0%. So, you know, if we can offset enough gains to get you down far enough, you know, you might be able to make a few gains during a tax year and not have to pay any capital gains tax on it. So that's, that's part of what the, uh, objective is here. So we wanna limit the amount of capital gains that we have for, uh, within any one year.
Speaker 2 (10:59):
Now, there are some other thing, other interesting things that you can do within these portfolios as well. Um, one of the things that a lot of people talk about is, uh, you, you'll, you'll hear the term e ESG thrown around mm-hmm. , um, what we used to call it as socially responsible investing. And so some people feel strongly that they want to avoid certain kinds of companies. They may want to avoid defense contractors, they may want to avoid tobacco companies or, or those kinds of things. Well, if you buy an index fund, there's no way to avoid that because those companies are in the index. But if you direct index, you can specify depending on who provides the direct indexing service, you can specify to, to many of these companies, Hey, I don't want any tobacco companies in here. I don't, you know, I I want this social filter applied to it or those kinds of things. Because you're buying the individual stocks, they can pick and choose. They, they'll still wanna try to mimic the s and p 500 or whatever index as well as they can. But if you're buying the individual stocks, it gives you the opportunity to avoid some of those things. So not only can you get tax benefits from it, but you can invest, you know, in, in a way that you might consider more ethical. So that's another benefit of it. That's
Speaker 1 (12:09):
Very cool. And I, I always wondered about that cuz I know that there are, I've spoken to people who say, you know, I would never invest in that company or whatever. Yeah. Um, and so you kind of answered my question. I was wondering about when you buy these, you know, these, when you invest in these big index, you know, groups of, of different funds and different stocks, so you can actually pick and choose with direct indigency. That's
Speaker 2 (12:33):
Pretty cool. Now, now if, if you, if that's important to you, there are mutual funds and exchange traded funds and stuff that, that are E S G sensitive, that, that, you know, that, that are organized with specific screens. One of the challenges there is that you, you need to make sure that you find a fund that, you know, whose filters, whose screens line up exactly with the particular ethical concerns you have. Mm-hmm. , that's not necessarily that easy. Yeah. But, but the point is that if, uh, but, but you don't get those tax benefits by, by, by doing it that way. But if you wanna invest a portion of your portfolio in, for example, the s and p 500, there's sort of this extra layer. So you can accomplish a couple of goals at once. So you don't necessarily have to go to an e ESG fund, but you can still accomplish some of maybe your e s G goals by doing that. So that's an opportunity. Now of course these, this is not a DIY kind of thing. This is, you know, you would make yourself Yeah. Crazy watching this all the time. This is something we have to leave to the computers. Um, yeah,
Speaker 1 (13:36):
That's actually, that's exactly what I was gonna ask you. Yeah. Because it seems like it's, uh, it's a full-time job to be worrying about that. Yeah.
Speaker 2 (13:42):
Constantly. So this is something that we have to leave to, to the, to the computers that we have Now when it says, oh, I found something I, i I want to get rid of in the portfolio and capture a loss, you may have a portfolio manager that looks at it and says, okay, so what are we gonna substitute this with? Mm-hmm. . But monitoring those positions every day and finding those opportunities, even sometimes they might have some of the substitutions programmed in. Yeah. That's something that we really need to leave to a computer. So this is, this is the kind of thing that you've, you need to work with a firm that does this kind of thing. It's, it's not a practical thing to do on your own. Um, if you're gonna do that, the other thing that you want to inquire about is the costs.
Speaker 2 (14:23):
Because again, we wanna be very sensitive to costs. Um, we don't know where the market's gonna go, but, but we know if whatever they charge you, that's gonna be a drag on the portfolio. So you wanna make sure that on two levels, one is whatever they're charging you for the service is reasonable. And we also wanna make sure that when they do a transaction, there aren't a lot of transaction costs. Because if there's a charge every time they buy a stock or sell a stock, that can add up real fast. So that's one of those things that if you talk to somebody about doing this, you'll wanna make sure you get full disclosure on all of the different fees and costs that could be involved in the, in the service to make sure that you don't wipe out all of your tax benefits with higher levels of expense. Right, exactly. And so that's a little bit about direct investing. So, um, 30 minute action list.
Speaker 1 (15:14):
Your retirement is at risk, not from the stock market, not from inflation. Taxes are putting your retirement at risk. I'm certified financial planner, Steve worshiping and I specialize in helping people create low tax retirements. Unmanaged taxes can take 30, 40, even 50% of your retirement income. Learn how to defend yourself against excess taxation. Our complimentary webinar will cover all the principles you need to know to protect your money for you and your family and keep it away from the government. This free webinar will cover how taxes are different in retirement, the taxes you pay in retirement that you don't have to pay during your working life. How to move tax savings into a tax free environment. The Widows Tax, the Secure Act, the Secure Act 2.0 and what they mean to you. The webinar is free, but you have to register to save your spot. So go to focused wealth advisors.com/webinars and find out more and sign up right there. Even if you're not planning to retire for the next five or 10 years, this information will be critical for you. The longer you have to put the strategies into effect, the more you can accomplish. That's focused wealth advisors.com/webinars to find out more and to sign up today.
Speaker 2 (15:35):
So here it is, 30 minute action list. Look at your last form, 10 99 B and 10 99 diviv, um, and see what, what kinds of numbers you have there. Those are the two tax number, the, the two tax forms that get reported for buys and sell and for how many dividends you get. That gives you an idea of what kind of benefit you could get by converting some of your portfolio to direct indexing. So 30 minute action list. Take a look at your 10 90 nines, B and diviv.
Speaker 1 (16:05):
All right. Once again, a altitude or altitude is that
Speaker 2 (16:10):
Work? Multitude. I like it. We'll use it we'll with it. Altitude. It's a new, it's a new, it's a new word. A
Speaker 1 (16:14):
Cornucopia of information. Once again from Steve worshiping, you can find me Rock vox recording in production. My, uh, is my Jesus . Let's go back and do that again, shall we? And of course, I'm here with Steve and, uh, I kind of like trail along to find out to, to, to, to pull the nuggets of information outta Steve. But you can find firstname.lastname@example.org if you have any desire to do, uh, podcasting or any kind of production work. And of course, Steve can be email@example.com. Thank you for joining 30 Minute Money. We'll catch you next time.