E150: Tax-Aware Investing: Insights for Family Offices and UHNW Individuals
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How do ultra-rich individuals use tax loss harvesting?
Ultra-rich, the billionaires, the sent-up millionaires are using a very specific type of tax loss harvesting. I know we can't talk about the players, but talk to me about the strategy at a high level. Let me talk about like industry innovation 1.0. That was, you know, years ago, probably maybe 12 to 15 years ago, investing philosophy called direct indexing came about. If you think about what an index-based investment is, is you buy the S&P 500 and ETF, mutual fund, you're just passive. You just want to own the market, get the exposure. No more, no less. But let's say you own the S&P 500 ETF, and the market is flat at the end of the year. If you looked under the hood, you've got stocks that shot up 20%, 50%. You have stocks that shot down. But if you just own the ETF, you don't really have an opportunity at that time. Direct indexing, which has been very quickly growing.
One of us from Strategy is saying, I don't want to take the active manager stock risk. Picking Apple versus Google, give me all of them, just like when I buy the ETF. Do it in my own account. That way, I can take advantage of tax loss at an individual security level.
When you think about investing, how do taxes play into your strategy? There's a famous saying, it's not what you make, it's what you keep. As someone who's helping taxable investors invest, we always have to be thinking about taxes and how to have the most tax efficient. And how do you quantify that? How much do taxes actually play an effect on your client's returns? There's a lot of factors. First, what state do they live in, right? If you're in New York, Hawaii, California. Taxes become a much bigger issue, but, you know, still federal income taxes on ordinary income, you know, north of 37%. Capital gains north of 20%, you know, once you factor in state and some other stuff. It absolutely reduces the net return to a client once you start.
So how do you then build a portfolio that pays attention to taxes? Another saying people say is don't let the tax tail wag the dog. You still have to make sound investment decisions, but you should absolutely be aware of what those tax rates are.
What is direct indexing and how does it work?
I've seen a lot of very smart, very wealthy people make these almost emotional decisions, putting in their money into investments that they shouldn't have just to minimize taxes. The worst outcomes that we've seen over time and you've heard these stories going back to the dot-com bubble, is people would take a company public, have huge amounts of net worth, but they don't want to pay the taxes. And then they sit there and watch it go down and down and down. And I don't want to name specific examples. There's a lot of companies that had great stock prices at one point, and they went down by a lot. So letting the tax tail wag the dog sometimes makes sense, but generally you really have to be thinking both investment return plus taxes when you're making decisions.
Let's say that I start a startup. I'm the founder and CEO. I own 20% of that company goes public. It's worth $2 billion. What's the right way to think about what to do in terms of your stake, in terms of tax strategy. Walk me through how a founder should think about their holding. This is an interesting question because we deal with this a lot. We're financial advisors. We are risk managers. To us, you may have the best company in the world, but 99% of your net worth is tied up in one company. You should absolutely be diversifying. But We don't know nearly as much about that founder's company. It's not just the tax thing. It's also this dynamic of someone wanting the exposure and risk to that company where we are not wanting concentrated exposure to anything. First, it's about having that conversation so that when I tell them, I think you should diversify, they know it's not because I think your stock is junk. It's because I think you should diversify because it's not worth that risk. But you start talking about...
Let's say we just pay the taxes. Where are we? Right. And is that a good decision? Then you start looking at things like exchange funds, tax loss harvesting. You can do options overlays to help reduce concentration risk. So I would say it's like a two part thing of making sure they understand where we're coming from and then helping them kind of get to that point. of saying, okay, I get it.
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Chapters
3 chaptersSpeakers
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