Wes Johnson, CERTIFIED FINANCIAL PLANNER™ practitioner and co-founder of ACT Advisors, joins Doug on “C.U. on the Show” to discuss direct indexing, a tax-focused investment strategy. The relatively new investment approach provides several benefits to investors, including tax opportunities, customization, and no-cost trading. Wes and Doug dive into the strategy and explain why it can be particularly powerful for credit union leaders.

What Is Direct Indexing?

Direct indexing, which can only be used in non-qualified or non-retirement investment accounts, simply replicates an existing index. For example, anyone can buy an S&P 500 mutual fund or ETF. However, with direct indexing, investors or advisors purchase a certain number of individual securities that replicate the behavior of the S&P 500 and yield comparable results. 

What are the Benefits of Direct Indexing?

Why would investors choose direct indexing over buying the actual mutual fund or ETF associated with the index they want to track? Direct indexing offers several benefits:

  • Tax Control: The primary benefit of direct indexing is tax control, which is particularly valuable during volatile market periods. For example, through tax-loss harvesting, investors can reduce their taxable income in high-income years and offset capital gains. Through the process, they can sell a stock, realize the loss, and purchase a similar security to maintain their portfolio’s overall behavior. The best part? If an investor doesn’t use their harvested losses on their tax return, they can carry those losses forward indefinitely and use them in a later year. Additionally, investors can also capture capital gains through tax-gains harvesting in low-income years, effectively reducing their tax impact while in a lower tax bracket.
  • No-Cost Trading: With direct indexing, there is no cost to purchase or sell stocks, which is a welcome change in the investing world that battled through high-cost trading wars in the past.
  • Customization: Direct indexing gives investors more control over their stock selection to reflect their social values or charitable giving or reduce their exposure to a particular industry or stock. For example, environmental, social, and governance (ESG) investing is gaining popularity in helping investors pick and choose companies based on their social values, such as avoiding the alcohol industry—and this is achievable through direct indexing. Also, if investors hold concentrated stock, or a lot of stock, in a particular company or industry, direct indexing can establish parameters to avoid the same or similar stocks.

How Can Direct Indexing Benefit Credit Union Leaders?

Direct indexing offers additional benefits, especially for credit union leaders, and creative solutions to control tax impacts before and during retirement. This can be powerful for credit union executives who generally experience a rollercoaster of high and low tax brackets pre-retirement, in early retirement, and later in retirement when required minimum distributions are triggered. Direct indexing allows these investors to switch gears as necessary based on their income from year to year. 

Since direct indexing is only for non-qualified accounts, this can also be an effective tool for credit union executives who generally enter retirement with a split-dollar plan, significant savings, and additional retirement benefits. As a result, credit union retirees can use direct indexing to manage their tax payments as they stagger the consumption of their various investment vehicles.

Stream the full episode to learn more from Wes and Doug about why direct indexing is an intriguing investing style to consider and how ACT Advisors can help clients integrate it into their portfolios.

Audio Transcription (pulled from the podcast)

Doug  (00:00)
My guest on today’s podcast is Wes Johnson, a CERTIFIED FINANCIAL PLANNER™ practitioner and co-founder of ACT Advisors. In this episode, we discuss the tax-focused investment strategy called direct indexing, including what it is, how it works, and why it’s so incredibly powerful, particularly for credit union leaders. Welcome to the show, Wes. We’re delighted for you to join us today and to learn all about direct indexing.

Wes Johnson  (00:34)
Thanks, Doug. Thanks for having me.

Doug  (00:36)
Let’s talk about direct indexing. I know from talking to our peers in the investment industry, there’s a lot of investment people who don’t know what direct indexing is. So I’m sure that means our listeners from the credit union movement don’t know what direct indexing is. So tell us about what direct indexing is, how does it work? And why should we care about this versus any other style of investing?

Wes Johnson  (01:00)
Okay, so what is direct indexing? All we’re doing is we are replicating an existing index. But rather than just buy the ETF or a mutual fund that copies the index, we buy individual stocks that will replicate the behavior of that index. An example would be the S&P 500. You could just buy an S&P 500 mutual fund or ETF; they’re dirt cheap. Or we can do a direct indexing account where we buy approximately 100 stocks. And those 100 stocks will replicate the 500 stocks that are in the S&P 500. So the next question would be why would we do that—if we can buy the ETF for the mutual fund, why bother buying all these individual stocks? And there are a couple of reasons. The first one, and this is the biggest one, is tax control. Direct indexing gives us the ability to do tax-loss harvesting. And what that means is if you have a stock or a security and it has a loss on paper, you can sell that security and realize the loss, which you can then use on your tax return, and then immediately buy a very similar security or security that behaves in the exact same way. That way your portfolio hasn’t changed, the behavior of your portfolio hasn’t changed, but you’ve realized those losses. Now, this only works in non-qualified accounts or non-retirement accounts. But the tax control is huge, especially during market volatility. We’ve had a few months of really rough market volatility. And that is an awesome time for direct indexing, because we can do tax-loss harvesting trades weekly sometimes and capture these losses. We’re still riding the rollercoaster down and riding it back up; we’re not getting out of stocks—we’re just taking advantage of the losses on paper. So when we come through this thing, we’ll have a significant amount of losses banked so we can use those on the tax returns.

Doug  (02:50)
All right, so I want to repeat what I think I’ve heard is that with direct indexing, if we use the S&P as an example, the S&P is made up of the 500 largest companies in the U.S. And if you just buy that index from Vanguard or wherever else to track the S&P, you’ll get the result of the S&P. But what you’re doing is using software to just get a smaller subset of securities and still track the S&P. Is that right? 

Wes Johnson  (03:23)
You got it. Now the index we actually track is the Vanguard Total Stock Market Index, which is 3,300 stocks. We can replicate that index with about 250 individual stocks. And we like that index for a number of reasons, but the biggest reason is it contains large-cap stocks, mid-cap stocks, small-cap stocks, growth and value. We have a lot more tax loss harvesting opportunities because we only hold 250 stocks and when we need to sell one, we’ve got over 3,000 to choose from that are in that index. So it’s a lot easier to accomplish the goal of tax- loss harvesting with that index as opposed to the S&P 500.

Doug  (04:01)
You’re buying a subset of these 500 stocks, and then you are changing them, you said as much as weekly. All that activity must be expensive, all that trading activity.

Wes Johnson  (04:14)
It would be except we custody the accounts on a platform that has no trading costs at all. And that’s why direct indexing is in existence now and it wasn’t five years ago. There’s a trading war cost among the various brokerage firms—Schwab, TD, Fidelity—they’re in a race to see who can be the cheapest and now most of them are completely free for stock trades or ETF trades. So we can buy as many stocks as we want and we can sell as many as we want. There are no ticket charges, there’s no transaction cost. That did not exist two or three years ago.

Doug  (04:52)
So what is the incentive to do tax-loss harvesting? What is the historical amount of additional return you get and tax deduction?

Wes Johnson  (05:00)
We don’t have a huge amount of data on this because again, it’s only been around for a fairly short amount of time, for a couple of years. But in the data we’ve seen in the industry, on true after-tax dollars, we’re seeing somewhere on average around 1% per year extra return In more ideal tax-loss harvesting environments like what we’ve seen here more recently, it’s as high as 3% or 4%. But on average, let’s just say somewhere around 1% of extra rate of return. You don’t see it inside the portfolio—it shows up on your tax return—but it’s there.

Doug  (05:33)
And how much of a difference does that make over time?

Wes Johnson  (05:34)
If you do that for 20 years, I mean, that’s massive. That can be a 30% increase in your return over an extended period of time.

Doug  (05:41)
And then you’re still tracking the return of the index. So you still get the same return you would have gotten anyway, right?

Wes Johnson  (05:50)
Exactly. We use some pretty sophisticated software to help the basket of stocks we own. The goal is for it to track the index exactly—as close as humanly possible. So even when we swap out securities, it’s all done around trying to match the behavior of the index as close as possible. So yes, whatever index we’re tracking, your rate of return should be almost identical over time.

Doug  (06:13)
And you said it can only be done in non-qualified accounts. Our listeners may not be familiar with that language. So can you talk a little bit about what does that mean and what does it not mean as far as 401(k)s, etc.? 

Wes Johnson  (06:28)
Retirement accounts are also known as qualified accounts and non-retirement accounts are non-qualified accounts; there’s a pretty important difference there. In your 401(k) or an IRA or any qualified account, transactions don’t generate tax consequences; only withdrawals generate a tax consequence. So you can buy and sell stock all you want with no tax consequences in a retirement account. In non-qualified accounts or non-retirement accounts, everything that happens in that account is a taxable event. So in our industry, we will call those taxable accounts. Any dividend you receive is a taxable event. If we sell something with a gain, that’s a taxable event. So when we manage non-qualified accounts, or taxable accounts as we call them, we have to be very careful of the tax consequences of any trades we make. But that’s why direct indexing works so well for non-retirement accounts or non-qualified accounts—because we can harvest those losses along the way.

Doug  (07:26)
Let’s talk a little bit more about those losses. So you’re trading these things weekly, you’re creating losses. How are our investors able to use those losses? And then do they expire after a period of time?

Wes Johnson  (07:41)
Great question. So let’s just say we have an extended rough patch in the market, like we have recently had. We’ve been harvesting a lot of losses, and those losses can be used to offset any future capital gains, any capital gains this year or future capital gains. So let’s just say the market just continues giving us losses all year, and we don’t have any gains to match up with. In years where we don’t have any gains, we can use up to $3,000 as just a deduction on your tax return, and then you carry forward the remaining losses forever. So you will use them all at some point. At some point, there will come a time where the market is really good. And we need to incur some capital gains instead of capital losses. And sometimes there are scenarios where you want to incur capital gains. But the point is, you can carry those forward forever. And any year you don’t use them, or any year you have extra to roll forward, you can reduce your income by $3,000 each of those years.

Doug  (08:39)
So the capital gains you can offset, can they be capital gains from other investment activities? Maybe real estate gains or other sorts of gains you might have?

Wes Johnson  (08:45)
Absolutely. It doesn’t have to be from the same account, just any capital gains that hit your tax return you can match up capital losses from the tax-loss harvesting.

Doug  (09:03)
So, if I can summarize what I’ve heard so far, the use of direct indexing tracks the index that you might buy anyway. It doesn’t add any cost to the exercise of tracking that index, and it creates this tax offset that can be used and carried forward indefinitely to reduce the tax effect of capital gains from this account or from any other account. Is that right? 

Wes Johnson (09:50)
You got it. 

Doug (09:51)
So as you just said a minute ago, sometimes it makes sense to harvest capital gains instead of capital losses. So as our listeners may know, when a credit union executive has a split- dollar plan, and properly orders the way they spend their money in retirement, there is a period of time between retirement and mandatory distribution age, which is currently 72. There’s a period of time where we often see optimized financial plans with effective tax rates of 4% and 5% for those years between retirement and age 72. And of course, the credit union leaders who are paid pretty well will see effective tax rates of 30% to 35% prior to retirement. So I think it’s fairly obvious that in those high tax years, the tax-loss harvesting would be pretty helpful to offset the income in those years. Talk to us about what the credit union leaders would do in those low tax years. And how would the capital gains harvesting work?

Wes Johnson  (10:43)
Yeah, you bring up a very good point. Credit union executives are—this is one of the only industries I’ve encountered—where you go from a very, very high tax bracket to a very, very low tax bracket for a number of years. And then back to a high bracket once you hit the required minimum distribution age. So we would switch gears; instead of harvesting losses, we will start taking some gains, because long-term capital gains if you’re in a lower tax bracket, according to current tax rules, if your tax bracket is low enough, they can be taxed at zero or worst case, it’s 15%. But we try to capture as many gains as we can without causing you to go up a tax bracket. So we want to harvest those while you’re in a low bracket. And then once you are back into a high bracket, once your requirement on distributions kicks in, then we switch it back to tax-loss harvesting.

Doug  (11:33)
So in the pre-retirement years, we’re tax-loss harvesting to reduce the tax impact of any capital gains or ordinary income. And then in those early retirement years, or capital gains harvesting, because for at least for most of the clients we see, they’re in 0% capital gains for several years. So that’s why you would harvest capital gains because you can’t beat zero, right? So as low a tax rate as you’re going to get. And then when they hit required minimum distributions, we go back to plan A and tax-loss harvest, again to help reduce those other tax effects. So talk to me a little bit about the tailoring you can do in the portfolio. Sometimes we see folks who have large, concentrated positions, sometimes folks are inclined toward charitable giving. And sometimes folks want to be socially responsible or use a social filter. Talk to us about how you could use those.

Wes Johnson  (12:36)
So there are two main reasons people use direct indexing. The first is the tax-loss harvesting we already talked about. The other is customization. One area of customization. A big topic nowadays is ESG or environmental, social, governance investing, also called socially responsible investing. And you can get these mutual funds or ETFs. There’s hundreds of them out there. But each of those mutual funds or ETFs has their own definition of what is a socially responsible fund. And the gist of a socially responsible fund is they avoid certain hot topics, maybe it’s weapons or alcohol or drugs or whatever it is. But what we’ve seen with our client base is that nobody seems to have the same definition of which industries they would like to avoid. With the direct indexing software we use, we can pick and choose exactly which industries we want to eliminate. We may have a client who does not want to invest in any weapons, but they’re okay with alcohol companies. So everybody has their different definition of what a socially responsible investment portfolio looks like. We can customize it just about any way our clients want it customized. So that’s one way we can customize. The other one is with concentrated positions. If we have a client who has, you know, maybe they inherited a ton of individual company stock where they work for, let’s say, a pharmaceutical company. We can customize around that; we can avoid one particular company or we can avoid an entire industry. If a client has a concentrated position in a pharmaceutical company, we can either avoid that company altogether or we can avoid that entire industry. So we do have a lot of customization ability within the direct indexing software we use.

Doug  (14:17)
Tell me about how that software works with concentrated positions.

Wes Johnson  (14:21)
So if you own a lot of one stock, that’s what we call a concentrated position, we can go into the software and say, do not buy this stock. We could even take it a step further and say do not buy any stocks that behave like this stock or are in the same industry. And that helps reduce your exposure to any one company.

Doug  (14:41)
So kind of the key takeaway for me is that a credit union leader can’t do this in their 401(k) or 457b; this strategy only works for taxable assets. And in our work with credit union leaders, most of the time we see those taxable assets come from just plain saving money over time or the payout of a 457f or maybe a stay put bonus. And once they have those taxable assets, then they can use direct indexing to reduce their effective tax rate during the high-income years. And then it takes advantage of no potential income tax during those very low-income years that happen from retirement until required minimum distribution age. So it’s a pretty interesting strategy, particularly for credit union leaders, because they have that tax delta that’s so large, where you have that 37% rate before retirement, maybe 0% rate during the first years of retirement, and then back up to perhaps a 15% effective tax rate in the later years of retirement. So I think this is a pretty interesting strategy for credit union leaders. And I’m excited for the information you have presented for our listeners today. Any final takeaways or suggestions for how they can learn more about direct indexing?

Wes Johnson  (16:06)
You can always go to our website. If you go to act-advisors.com, there’s a link at the top that says credit union executives and down below that you’ll find all the information you could want. 

Doug  (16:18)
Awesome, Wes. Thanks for your time today. We appreciate your information.

Wes Johnson  (16:22)
Thanks for having me, Doug.

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