Investment returns are only part of the picture. What an investor actually keeps after taxes can fund their retirement, a home purchase, or a legacy for the next generation. Two positions with identical pretax returns can leave very different amounts in an investor’s pocket, depending on how and when gains are realized.
At Lido, tax-managed indexing may create additional opportunities for tax-loss harvesting, which may help investors manage the difference between pretax and after-tax investment results. This Perspective explains how tax-loss harvesting and tax-managed indexing work, how they generally work together, and what trade-offs may be worth weighing.
Why Tax Efficiency Belongs in the Investment Conversation
Realized capital gains are generally taxable in the year they occur, and the rate applied depends on how long the investment was held, among other factors. Gains on assets held more than a year are typically taxed at long-term capital gains rates (usually lower than ordinary income), while gains on assets held a year or less are typically taxed as ordinary income. That difference alone can make the timing and sequencing of a sale meaningful, separate from any decision about whether to hold or sell the underlying investment.
For investors managing a single account in isolation, tax outcomes are sometimes an afterthought. For investors coordinating a broader financial picture, including other accounts, income sources, and future liquidity needs, tax considerations may be one factor in how a portfolio is constructed and maintained, not a separate consideration layered on at year-end.
Different vehicles offer distinctive tax advantages, and sometimes those advantages come with trade-offs. ETFs, for example, can be attractive because they’re low-cost and can defer capital gains at the fund level, but because an investor holds shares of the fund rather than the underlying securities, an investor generally cannot directly harvest losses on individual securities held within the ETF.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the practice of selling a security that has declined in value to realize a capital loss, then generally replacing it with a similar, but not identical, investment to maintain the portfolio’s overall market exposure. Subject to applicable tax rules and an investor’s individual circumstances, a realized loss may be used to offset capital gains elsewhere in the portfolio. Under current federal tax rules, certain excess capital losses may generally be used to offset up to $3,000 of ordinary income annually, with remaining losses potentially carried forward. Investors should consult their tax professional regarding how these rules apply to their circumstances.
The word “similar” matters here because of the wash-sale rule. Under the wash-sale rules, a loss may be disallowed if the same or a substantially identical security is purchased within the applicable 30-day period. Investors should consult their tax professional regarding the application of these rules. This is why tax-loss harvesting typically pairs each sale with a replacement security chosen to preserve similar market exposure without being substantially identical to the position sold.
The Practical Limits of Tax-Loss Harvesting
The potential usefulness of tax-loss harvesting generally depends on whether losses are available to harvest and whether an appropriate replacement investment is available. Both conditions can become harder to meet over time.
A portfolio concentrated in a small number of names, particularly large, dominant companies, can be difficult to harvest effectively. If one of those positions declines, there may not be another security similar enough to serve as a reasonable replacement without meaningfully changing the portfolio’s exposure and affecting performance. And as a portfolio’s holdings appreciate over successive market cycles, the number of positions sitting at a loss, and therefore available to harvest, generally shrinks. Even a position that has appreciated and then pulled back, but not below its original purchase price, is technically sitting at a taxable gain if sold. That’s why a long-held, well-performing portfolio can eventually reach a point where few or no positions carry an unrealized loss worth harvesting, even during a market pullback.
This is one reason a broader set of individual holdings may provide additional opportunities for tax-loss harvesting, which is where tax-managed indexing comes in.
What Is Tax-Managed Indexing?
Rather than buying a single fund or exchange-traded fund that tracks an index as one packaged unit, a tax-managed indexing approach generally involves holding many of the individual securities that make up, or closely approximate, that index directly in the account. This approach may be especially relevant once stock market exposure crosses a certain size threshold in the portfolio. When investors have a relatively small amount to allocate, it’s relatively easy to access indexes and achieve instant diversification through an ETF. However, once an investor allocates hundreds of thousands of dollars to broad stock market indexes, direct ownership of individual securities may become an approach worth considering, depending on the investor’s circumstances and objectives.
Because the investor holds the underlying stocks directly, rather than shares of a pooled vehicle, losses in individual positions can potentially be identified and harvested at the security level, something that is generally not available inside a traditional index fund or ETF, since an investor in a fund only owns shares of the fund itself, and gains and losses are calculated at the fund level as a whole. Of course, while markets have historically trended upward over longer time periods, stocks don’t all move together. Within an index, some names do better in the short term, and some do worse.
Direct ownership can also open the door to customization that a packaged fund does not offer, such as:
- Excluding an entire sector or a specific company from the portfolio, for example, to avoid overlapping with a concentrated position the investor already holds elsewhere.
- Applying values-based or faith-based screens, meaning rules that include or exclude companies based on criteria such as environmental practices, labor standards, or religious guidelines, by pairing the strategy with an index built for that purpose, rather than maintaining a static list of excluded names. A static exclusion list generally needs review and updates as an index’s constituents change over time, while an index purpose-built for a given mandate is generally maintained on an ongoing basis by the index provider itself.
Converting an Existing Portfolio
While investing cash into the stock market in taxable accounts is one way to create these loss-harvesting opportunities, transitioning an existing, appreciated portfolio to a tax-managed indexing strategy may involve realizing capital gains along the way, since positions that already fit the target index can often be kept, while others may need to be sold. That transition is usually paced according to how much in gains an investor is comfortable realizing at a time, so it can happen gradually, sometimes over several years, rather than all at once.
This pacing may matter for portfolios built around a small number of highly concentrated, highly appreciated legacy positions. The more concentrated and appreciated those holdings are, the longer a full transition may take, and the more limited the opportunities for tax-loss harvesting may be until that position is trimmed or otherwise diversified.
It is also worth noting that the rationale for tax-managed indexing is not exclusively about tax. The flexibility to customize a portfolio around sector preferences, values-based screens, or an existing concentrated position can be a reason to consider this approach on its own, separate from any tax benefit. The potential tax consequences of any transition should be evaluated with the investor’s tax professional.
Layering on Additional Tools When Needed
For portfolios where individual-security tax-loss harvesting opportunities have become limited, certain additional investment strategies may be considered as part of a broader portfolio and tax-planning discussion.
One example is a long-short overlay, which adds extra long positions (investments that can gain value as a security rises) and short positions (investments that can gain value as a security falls) around an existing portfolio, while keeping the overall market exposure about the same. Because those added positions are separate from the original holdings, they may create additional opportunities to realize losses, subject to market conditions and applicable tax rules. The amount of added exposure is generally tailored to an investor’s risk tolerance rather than applied the same way for everyone.
A long-short overlay may be considered in connection with a concentrated or highly appreciated position because it may create additional loss-harvesting opportunities without requiring the core position to be sold. Whether any resulting losses may be used to offset gains depends on the investor’s individual tax circumstances and should be discussed with a tax professional. It is one of several tools available for managing concentrated or highly appreciated positions, alongside approaches such as hedging a legacy position or using structures designed to defer gains on the sale of real estate or a business. Which combination makes sense, if any, generally depends on the specific portfolio and an investor’s broader goals.
Things to Consider Before Pursuing a Tax-Managed Approach
Tracking error is a real trade-off, not a footnote. Tracking error, meaning the degree to which a portfolio’s returns differ from its benchmark’s, is generally affected by how many individual securities the portfolio holds. More holdings tend to track more closely, while fewer holdings can diverge further from the index. No fixed number of holdings eliminates this trade-off, so the right balance generally depends on how much divergence from the benchmark an investor is comfortable with.
Frequent harvesting can itself affect tracking error. Every time a position is sold and replaced to harvest a loss, the portfolio’s composition shifts slightly away from its original target. Over many trades, this can accumulate, which is one reason ongoing rebalancing is generally treated as part of managing a tax-managed portfolio, not a separate, occasional task.
The potential tax benefit of harvested losses generally depends on whether and how those losses can ultimately be used. A loss that can be used to offset a capital gain may provide a tax benefit, depending on the investor’s circumstances. A loss that simply accumulates without ever offsetting a gain, beyond the annual $3,000 allowance against ordinary income, provides comparatively little practical value. Ongoing tax-loss harvesting may be less relevant for some investors with very long time horizons and limited expectations of realizing gains.
This is generally a taxable-account strategy. Losses realized inside a tax-advantaged account, such as a traditional or Roth IRA, generally have no tax value, since gains and losses inside those accounts are not taxed as they occur. The wash-sale rule can also apply across accounts, including IRAs, so buying the same or a substantially identical security inside an IRA within 30 days before or after selling it at a loss in a taxable account can still disallow the loss under IRS rules. The customization features described above, such as sector exclusions or values-based screens, may still appeal to some investors for IRA assets, even though the tax benefits of loss harvesting do not apply there. Investors should consult their tax professional regarding the application of wash-sale rules across their accounts.
Bringing the Pieces Together
Tax-loss harvesting, tax-managed indexing, and, where appropriate, overlay strategies are best understood as different levers within the same broader objective: managing the difference between pretax and after-tax investment results. Which levers make sense, and in what combination, generally depends on the composition of the existing portfolio, how concentrated or diversified it already is, an investor’s tolerance for realizing gains along the way, and whether there is an anticipated need to draw on the account over time.
Because these decisions intersect with income planning, estate considerations, and the rest of a household’s financial picture, they tend to work best as part of a coordinated plan rather than a standalone account decision. If you would like to discuss how tax-aware investment management may fit within your broader portfolio strategy, contact our team to get started. Tax-specific considerations should be reviewed with your tax professional.
