In episode 22, I brought in Bob Dockendorff, a lawyer, tax expert, and financial planner who focuses on tax efficiency in his wealth management practice, to talk shop with us about tax loss harvesting strategies.
What you’ll learn in this episode:
- Tips for maximizing tax “alpha” in your portfolio
- Common mistakes investors make when tax loss harvesting
- How wash sales work
- Why it’s so hard to execute tax loss harvesting even when the benefit is clear and you know you should
Is tax loss harvesting a regular part of your portfolio management? Do you think direct indexing is worth the tradeoff of going through a manager or robo advisor? How much tax alpha do you aim for in your portfolio management? Let me know by leaving a comment when you’re done.
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Links mentioned in this episode:
- Robert Dockendorff
- Tax loss harvesting and tax gain harvesting step by step
- Morningstar Tax Cost Ratio
- Tickers mentioned in this episode: SPY, FCNTX, VOO, VT
- HYW private Facebook community
Read this episode as a post:
My guest today is Bob Dockendorff. Bob is an attorney with extensive experience in tax, as well as a Massachusetts-based financial planner who works with clients globally. His expertise is in cash flow-based financial planning, tax planning, and developing low-cost passive investment strategies.
Bob, thanks so much for joining us today to share insights and strategies about tax loss harvesting.
Robert Dockendorff 1:44
Thank you. I’m happy to be here.
Andrew Chen 1:45
So you have a legal and tax background. How did you get into doing personal financial planning and advisory work?
Robert Dockendorff 1:50
I went to law school right out of college. I was a philosophy major in college, and then I went right into law school.
And then out of law school, I graduated in 2009. I loved tax courses in law school.
And after a few months of taking the bar, passed the bar, was looking for a job, I ended up at one of the “Big Four” accounting firms, Ernst & Young. But studying taxes in law school was very different from being a tax associate at a “Big Four” accounting firm.
And I was there for about two years. I left. I went to a law firm in Boston and I was doing mostly corporate partnership tax.
I just didn’t like it at all. I didn’t like the lifestyle. I didn’t really like the work.
And I had an uncle who worked for Fidelity for a really long time. He was really successful there. He’s like a mentor.
And he suggested that I get into wealth management because there’s a big crossover between estate planning and tax planning in the higher end wealth management positions. So I ended up working in a really big registered investment advisor (RIA) in Boston.
I was there for three years, worked on a lot of executives’ equity compensation planning. As part of my role there, we get all of our clients’ tax returns.
And then I also learned investments while I was there. When I was there, they managed about $3 or $4 billion. But they actually manage now, I think, almost $10 billion.
And again, all real high net worth relationships. And I learned, I felt, a lot of what I needed to know to give effective advice to individuals in many different areas of their finances. I also got the entrepreneurial bug while I was there.
And at the time, I was 31 years old. I had two kids. I had a mortgage.
And I did my research and said, “I think I can build a really nice lifestyle practice offering this type of advice to people that aren’t millionaires yet.” And I did.
About four years ago, I left there. I went to Claro Advisors in Boston.
And I’m my own entity. I have my own business there. They’re like a platform that offers technology and support.
But for four years now, I’ve just been growing a client base. And I love doing it. I try to be very thorough with every single area of someone’s finances.
Traditionally, it’s an investment advisor. Unfortunately, it really just gives people advice on investments and they charge a fee on the investments. And if you don’t have $500,000 to invest, well, an advisor is not going to talk to you.
And the industry luckily is changing and there are a lot of people that look like me now in the industry. But that’s the long version of it. That’s my background.
And here I am today. And I’ve got a nice roster full of clients, and I’m growing, and I love what I do.
Andrew Chen 5:09
Beautiful. So your bio talks about, and you just also mentioned, that you cater to high earners and high net worth individuals. What is considered a high earner or a high net worth individual with respect to your client base?
Robert Dockendorff 5:26
I think for me, it’s really tough to put a number on it because of geographical differences and spending differences. It’s what I realized.
To me, someone I can help is someone that feels that they have discretionary income. And they’re saving a lot and they just don’t know what to do with those savings.
So it honestly could be two teachers that have a really manageable lifestyle, or it could be up-and-coming lawyer or someone who works at a tech company that just got a bunch of equity. You name it.
But the minute they say, “I feel like I have money now and I don’t really know if I’m doing this right,” that’s when I think I can help.
Andrew Chen 6:15
So when it comes to saving, we’re going to talk a lot about tax harvesting today. Before we do that, I want to make sure that you have the opportunity to give the disclaimer you need because I know this can be sensitive.
Robert Dockendorff 6:32
Yeah. I think it’s a very heavily regulated industry: law, tax accounting, investment advice.
Anyone listening to this, just consider it your entree into doing some further research. Don’t do anything until you talk to your CPA. Don’t do anything until you talk to your financial advisor or whatever.
I think that covers it. Sorry for the legal mumbo jumbo.
Andrew Chen 6:58
No worries. I definitely understand.
All right. So let’s just jump into it.
A common tax strategy that high earning professionals, in particular, will use is tax loss harvesting. And then there’s a sibling strategy called tax gain harvesting, which has been written about. Can you describe for my audience what these are, just to set the stage?
Robert Dockendorff 7:20
Yeah. Tax loss harvesting is really just at the end of the year generally, or it can be anytime during the year. It’s generally done at the end of the year.
You have a portfolio of various positions that have exposure to any sort of investment area. It could be within equities, large cap, small cap, mid cap, international emerging markets. Within fixed income, there are a handful of areas as well.
Overall, your portfolio will be what it is from an economic gain standpoint, but you will have individual positions that are in a loss. And what you can do is you can capture that loss at the end of the year, and you will have a capital loss in those positions.
However, you don’t want to lose your exposure to the market during that time. So what you can do is, one, after you capture a loss, you simply purchase another investment that has similar exposure to whatever you sold out of. That way, you’re capturing a tax loss, but from an economic standpoint, you’re in the same position as before.
And the thinking is really just managing a portfolio from a tax standpoint actually does really matter over the long term. It can be looked at like any other sort of expense you’re paying on the portfolio.
So if you look at a mutual fund expense of 1% for the management fee or whatever, you should also be looking at the tax efficiency of that mutual fund.
And tax loss harvesting, it’s nothing sexy. It’s not we find the best stocks. It’s just doing things the right way year in and year out.
Tax gain harvesting is when you have a loss from whatever. Something didn’t work out. Who knows what it’s from?
And then you have maybe a bunch of positions that need to be rebalanced, but you’ve been hesitant to do that because it would incur taxes. Well, now you have a loss. You can go sell your gains.
And from a tax standpoint, it’s much more efficient that way. Does that answer your question?
Andrew Chen 9:36
Yeah. I think that’s good background.
Somebody looking at this strategy might say, “Aren’t you just deferring the taxes?” What would you say to that person?
Robert Dockendorff 9:49
No. That’s a realized event. You have to look at the tax efficiency of your portfolio as just another moving part within the machine of your personal finance.
And all you’re doing is making the taxes that your portfolio kicks out every year, you’re making them a little bit more efficient. And so you always are, in some ways, deferring taxes on a portfolio.
Andrew Chen 10:17
I guess what I mean is you’re lowering your basis. So later, when that basis eventually increases and you sell it for real, you actually realize the gain for real, you’re going to have to pay more taxes from a lower basis.
And so, how should people be thinking about taking that tax benefit now versus lowering your basis and realizing you may have to pay greater taxes in the future?
Robert Dockendorff 10:45
I don’t know. That to me sounds like the traditional versus Roth argument.
And I always tell people, “If you’re in a high tax bracket now because you’re a high earner, a bird in the hand is worth two in the bush,” as they say.
And I think there are a lot of people that would probably disagree with me there. Reasonable minds can differ. But nobody has a crystal ball as to exactly what your situations can be in 20-25 years.
We know today we can save you some money and keep the plan in place. Why wouldn’t we do it?
And specifically with tax loss harvesting strategies, they’ve proven to outperform through tax alpha. So the real direct indexing tax loss harvesting strategies seek 1% to 2% over and above the index that they mimic.
And this leads into what I think is a little bit of a higher level entree into this. When you think about investing, my opinion is most people absolutely should be able to meet their financial goals with index level returns.
And all a good tax loss harvesting strategy is doing is taking that economic return from the index, say the S&P 500, and then you if you look at the after-tax return of the S&P 500, there’s that tax cost in there that you should be looking at, like a fee. Call it 1% or 2% a year you pay in taxes on the total amount of your portfolio.
A tax loss harvesting strategy can either erase that expense or actually give you money back. So it’s adding on to the benefit of your portfolio.
And it’s something that isn’t very sexy. It’s not that piece of your portfolio that you can stare at and say, “Wow, look at this one. It’s a ten bagger.”
But over 20 or 30 years of having equity exposure, it’s going to make a huge difference. And I think a lot of the managers have shown that it does.
Andrew Chen 12:57
You mentioned a moment ago that this is a strategy you typically execute at the end of the year. And I was just curious. Should one harvest no more frequently than that?
Or are there times during the year, if you’re seeing the markets are volatile, that it may make sense to harvest, say, in the middle of the year? Balancing, of course, the administrative work that’s required.
Robert Dockendorff 13:24
Yeah. Traditionally, tax loss selling, I think, happens towards the end of the year. And that’s also when mutual fund capital gain distributions are announced, which is another tax impact on portfolios. And so there’s always something that you’re doing that deep analysis.
But absolutely, depending on the situation, there could be a time during the year where it makes way more sense, like the market dips, for whatever reason, really low in March or April, and new money had been invested in February. That money still has a 20-year time horizon. But for whatever reason, you’re sitting at 5% or 6% losses.
I’m sure there are plenty of situations like that where it would make sense to harvest your losses.
Andrew Chen 14:17
Okay, cool. So you mentioned a moment ago also this notion of direct indexing. Can you explain exactly what that is and how that plays into tax harvesting?
Robert Dockendorff 14:27
Sure. I’m a very big proponent of ETFs. I think they’re perfectly fine for many investors.
Just use the S&P 500 again as an example. S&P 500 is 500 of the largest U.S. companies. So you can go out and buy SPY or whatever.
That’s just going to mimic those 500 positions. You get, hopefully, index level returns. You pay a very low fee for that.
Direct indexing is having a manager go in and essentially build you your own personal ETF.
So you open your account. You don’t have SPY. You have maybe 100 positions and they mimic the S&P 500.
Out of those 100 positions, you can probably guarantee that at any point, especially if you continue to invest in this strategy over the year, you’re contributing to it every year, there’s going to be 10, 20 positions that are in a loss.
So you don’t just have one holding of SPY. You have 100 holdings. And out of those 100 holdings, you have 10 or 20 opportunities to tax loss sell.
And overall, your account still mimics the economic return of the S&P 500. But by having the individual positions, you have much more flexibility and tax loss sell.
And so there are managers who have been doing this and they can mimic any number of indexes or equity styles. And they’ve been around for a long time and they have really good track records. And they’re showing you that their tax efficiency is worth their fee, not simply from overall performance but from tax alpha.
And you do need probably $100,000 or more in a non-retirement account specifically earmarked for equity to do one of these. Robo-advisors have them available, but I think their minimum is $500,000, which is not an insubstantial sum of money there. $500,000 outside of a retirement account specifically for equities.
But in my opinion, if you are an indexer, which I am with equities, it makes all the sense in the world to do.
And the issue again with ETFs, you can have one ETF and that can be 100% of your equity exposure. And you could buy something like ACWI or Vanguard’s VT.
And it’s all global. It’s global equity in one holding.
The problem is you have one holding. And over time, that’s never going to be in a loss position as the years go on, so you won’t be able to tax loss sell it.
And the ETF itself is not tax loss selling. It’s very tax efficient, but it’s not doing that at the ETF level. So direct indexing is a way for you to benefit from holding the individual securities yourself.
Andrew Chen 17:36
Got it. If somebody does have a taxable account and the available capital to choose between a robo-advisor versus a manager who would do this direct indexing, are there pros and cons they should be thinking about with respect to the robo versus human advisor?
Robert Dockendorff 18:00
It’s all based on the individual. An advisor is really going to help you make sure everything is totally efficient from a quantitative standpoint, makes sense for your goals. They’re also going to keep you from shooting yourself in the foot and freaking out.
And if you have a good advisor that isn’t going to make the behavioral investment errors of market timing or trying to pick the best asset class based on the last three months’ news or market performance, then you can gain a lot of help on the investment side from an advisor.
If you’re someone who truly is very disciplined, you do it yourself or you’ve done your homework, you have a long track record of being very neutral from an emotional standpoint on what the market is doing, then you probably don’t need an advisor to manage your money.
Unfortunately, that’s not many people. It isn’t.
And those types of people too, I think there’s all sorts of things that they don’t know that they don’t know when it comes to income taxes, employee benefits, tax location strategies, keeping tax efficient vehicles in different accounts, estate planning, and insurance.
And if you have a good advisor that will offer advice on all of these areas as part of what a normal advisor charges just to put you in an active mutual fund account, then that can make sense.
And the analogy I like to make sometimes is you could probably learn everything there is to know about your house’s heating or plumbing system and save yourself thousands of dollars over the year by doing it yourself. But most people just pay someone else to do that.
And there are those types of people everywhere, so there are plenty of great DIY investors. And for those people, robo-advisors are a great option.
Andrew Chen 20:09
So moving to the mechanics of tax harvesting, what are some key tips or strategies investors should keep in mind to maximize their tax alpha from this strategy?
Robert Dockendorff 20:21
Again, I’m not so sure the ETF portfolio is very conducive to effective tax loss harvesting over the long term simply because you’re only going to have a few securities and they’re all going to be in a gain position.
I think if you want to do a direct indexing strategy, you want to research the manager and you just want to know that you’re properly allocated. So you have what you should have into that type of exposure, and then let the manager actually go in and trade the account.
And I should disclaim too that I do not trade the accounts. I work with managers who do it. So I don’t know the nitty-gritty, exactly how to go in and do it from that standpoint.
It’s a little bit more high level for me. Sorry. I know it’s probably not very helpful.
Andrew Chen 21:21
Are there any other strategies or tips that folks should keep in mind, especially folks who are just starting to explore this strategy?
Robert Dockendorff 21:32
Yeah. I think within the realm of tax efficient investing, tax loss harvesting is only one lever to pull there.
So anyone who has an actively traded mutual fund, they should first be very aware of the tax cost of those funds.
High turnover, small cap funds, some mid cap funds, they produce really nice returns, but after taxes and capital gain distributions, it can really eat into the after-tax return of the portfolio.
At the end of the year, mutual fund companies give out estimates for what their capital gain distributions are going to be. If you bought a fund this year, you are paying capital gains on all prior year when the fund sells.
So you need to figure out, “What’s my position in the fund? What is my capital gain from this fund going to be?”
It’s totally phantom income. It increases your basis in it, but you don’t see that money. It’s phantom income.
And figure out, “Should I sell this fund before the capital gain?”
It’s like a dividend. So if you sell the fund before the capital gain hits, you won’t receive the gain. And then you could just buy it back next year.
Andrew Chen 23:03
It’s not even pro rata? It’s just like if you’re just not in the position on that day, you don’t pay?
Robert Dockendorff 23:07
Yeah. So they will announce it in October or November, “We estimate that 3% of your overall position will come through as a short term capital gain or a long term capital gain.” In order to avoid this, you must sell the fund by x date.
So if you’re a long time holder in a really nice Fidelity Contrafund or something like that, just a very nice performing large cap fund, you can’t sell your position because you’re going to incur an actual realized gain in selling the position.
But if you bought Fidelity Contrafund in September and you put in $100,000, in October it’s worth $100,500 or whatever. It’s gone up a little bit. But now you’re going to get a $4500 capital gain distribution.
Well, you should probably sell out of it and avoid the distribution and just buy it back later. But a lot of investors don’t.
That’s the tax portfolio management that does go on in the background for a lot of people. They don’t realize it.
And then a way to judge the tax efficiency if you have a mutual fund or ETF portfolio is to go on Morningstar. Morningstar has a tax cost of the fund. So you can see if your fund is tax efficient or not.
And then that way, what I like to do is I build a spreadsheet of every holding in a portfolio, and in one column, I’ll put the actual fund level expense. So if it’s an actively trading mutual fund, call it 1%. And then after that, I will put the tax cost.
And really those two things are what you’re paying to be in that fund.
And the tax cost of the fund is something that is so often overlooked. And if you look at an ETF versus a mutual fund, ETFs are significantly more tax efficient.
And then just to contrast that again to direct indexing, one, you would never have capital gain distributions because it’s not a fund. You own individual securities.
Two, you can take that tax cost. Instead of having it be a cost, it becomes a benefit.
So instead of saying it’s a 1% management fee and a 1.5% tax cost, it becomes a 1% management fee and a +1.5% tax rebate. Do you follow me there?
Andrew Chen 25:39
Yeah, I get it.
Robert Dockendorff 25:40
Yeah. And again, it’s not something you’re going to see that’s tangible and immediate. That’s something that’s very much in your control.
And it matters. And so it’s what should command your attention when it comes to investments.
Andrew Chen 25:59
One thing I am curious about, though, is that if you go with a manager, whether it’s robo or human, and they’re doing direct indexing, and later you decide, “Hey, I want to exit this manager.” Maybe your priorities have just shifted or you want to go into a traditional index fund or something like that.
Are all those positions in the direct index then going to have to be liquidated all at once? Because surely you’re not going to be handed 100 positions that then you’re going to have to go and deal with. How will that work on the exit?
Robert Dockendorff 26:33
Well, similar to exiting any manager that’s invested in equities over a long period of time, there are tax transaction costs to switching your investment plan. You have to do it. It’s similar to a real estate investor that’s selling a long time holding to buy a new one.
And that being said, in real estate, you have a 1031 exchange. You can roll gains. And even now with opportunity zone funds, you can do that with equities too, which is a totally different area of tax efficient investing.
But long story short, yeah, you do. You’d have to sell everything.
You could probably tell the manager, “I want you to sell everything and then just send me the cash,” but it’s going to net gains. It’s the cost of business.
Andrew Chen 27:21
Yeah. It’s something that just to be aware of.
Robert Dockendorff 27:23
Andrew Chen 27:24
Okay, cool. What are the biggest mistakes or pitfalls you see investors make when they try to do tax harvesting?
Robert Dockendorff 27:34
Well, the wash sale rule. The wash sale rule essentially says if you capture a tax loss and you buy back a substantially similar or substantially identical security, that tax loss is washed out, so you don’t get credit for it.
There are some bright-line rules around it, and then there’s a lot of gray areas as to how to avoid wash sales. But you do see that happen.
People will sell, people will buy some sort of IPO because it’s a hot name. And three months later, it goes down and they sell it.
And then it starts to go back up again. And two weeks later, they buy it again.
And that initial loss, which you should be able to take, it gets washed out. The IRS says, “That doesn’t count. You just sold it and rebought it so you can’t capture your loss.”
And if you’re doing tax loss harvesting as part of your annual portfolio maintenance and management, there are absolutely ways that you can sell one security and purchase another that will not trigger the wash sale rules.
For instance, if you own something like a Fidelity Contrafund or something like that, and you sold out of Contrafund, which is a large cap exposure, you could probably buy just SPY to keep your market exposure.
And so you’d capture loss on Contrafund. You could then just go buy SPY. You’ve got the tax loss and you’ve also maintained the market exposure.
Andrew Chen 29:19
Got it. So that’s referring to not buying something that’s substantially identical.
Are there heuristics or guidelines that folks should keep in mind when looking at two securities and trying to decide whether they are substantially identical or not? Or is there some IRS guidance?
Robert Dockendorff 29:39
It’s tough. And I should also disclaim, I’ve never really had to make that call for a client.
I’ve read about it. I know what it is. I’ve seen it happen on accounts.
When a 1099 tax document comes through, you can see that that sales were washed out.
But I think there are some rules of thumb, definitely. I’m a little hesitant to get into them here because I don’t want to run afoul or say the wrong thing.
But I think generally, obviously, if you sold out a Coke, you can go buy Pepsi. It’s a different ticker. It’s a totally different company.
Same industry, same sector. Both large cap, both U.S.
Additionally, I think a lot of people believe that if you sell an actively traded mutual fund, you can then go buy the index, or vice versa.
Where it gets a little hairy is you sell SPY and then you immediately go buy VOO, which is the Vanguard S&P 500 fund. So they’re basically the exact same thing.
I think that there are plenty of tax practitioners that would say, “I don’t know if I’m comfortable with that one.” But again, it’s such a gray area.
When you think about the universe of available investments out there that has just happened even in the last 15 years, it used to just be everyone on individual stocks. But now with funds, it changed the game a little bit.
So I think that’s why it’s much easier with direct indexing because you are trading one stock for another, so you know you’re not going to run afoul of the wash sale rules.
I would say too that, I’m sure you’re aware of this, but in 2018, Wealthfront, which is one of the robo-advisors that does offer direct indexing, were penalized because they were not monitoring wash sales on their accounts. And a bunch of their investors were dinged with wash sales when a huge value add for robo-advisors was automated tax loss harvesting.
So you can see even at that level, it’s a learning process. And it’s something that continues to be tough to manage, I think, especially over that scale.
Andrew Chen 32:24
Yeah, it’s a good point.
Robert Dockendorff 32:28
It’s really scary to think that you would sign up with them and then they could bungle that one, where if you have a professional manager who’s been doing it for 25 years and has a great track record, I think you can be pretty confident that that’s not going to happen.
Andrew Chen 32:46
Who’s the decider on whether something is a wash sale? Because it sounds like there’s gray area.
But if you run afoul, you’re going to get some statement on a 1099 that says, “No, you can’t take the tax loss harvest because of the wash sale.”
Who’s the ultimate decider?
Robert Dockendorff 33:01
Well, the easiest one is the custodian itself, so whoever is producing the 1099. And obviously, the sales where it was the identical security.
So these weren’t situations where you’re buying something, and someone at Fidelity or Charles Schwab is saying, “Well, this looks substantially…”
No. You sold Coke and you bought Coke again. And there’s a trigger on the account.
Andrew Chen 33:28
Got it. So it’s very black and white in that case.
Robert Dockendorff 33:31
Yeah. It was just mismanagement, I think.
Andrew Chen 33:34
Got it. So other than just careless buying and selling, are there other ways that one might inadvertently trigger the wash sale rule?
Robert Dockendorff 33:45
There are. It’s like you have a situation where you consistently invest in a security, like your buys and sells, and you now have several different lots.
So you’ve consistently invested in a security over a bunch of years. And you have some shares you bought for 100, some shares you bought for 30, some shares you bought for 130.
And then you’d go in and sell some shares and take a loss. And then through your consistent monthly investments, you inadvertently go in and rebuy those shares. Things like that happen all the time.
And there is another aspect of the wash sale rule which I’m not as familiar with. But there’s a 60-day window around all buys and sells to prevent that situation.
And I can send you a link to a Forbes article that I think is the best thing I’ve read around avoiding wash sale rules, just because I’m not in the nitty-gritty of trading and securities. It’s more of explaining the value of the tax benefit of tax loss harvesting to people.
Andrew Chen 34:59
Got it. Some other things that I’ve heard of. I don’t know if you’ve ever encountered them.
Definitely the consistent investing thing that you mentioned.
Also, I think folks may not realize that if they have automatic dividend reinvesting turned on, that can trigger because your dividends will pay out maybe quarterly. And if you’re in the danger time zone and your dividends hit within that 30-day before or after window, it could trigger.
And then I’ve also heard about one where even if your spouse buys or sells the security, even if you are not personally doing it, that the IRS may look at you and treat you as one entity. Have you heard about this?
Robert Dockendorff 35:37
Yeah. I was not aware of this, but apparently, it’s on a household basis. So a married filing joint, that’s one entity from the IRS standpoint.
And so there are people with multiple accounts, multiple custodians, multiple advisors. You could have somebody that says, “Well, I have Merrill Lynch do this account, and I have some private wealth manager do this other account.”
And they’re not talking to each other. And so one of them buys it, and one of them sells it. One of them buys it again.
And I don’t know how the IRS would monitor that, but technically, it does run afoul of those rules.
I think avoiding the wash sale, especially for most DIY investors, is a pretty simple thing. Because you have your account, you have 10 or 11 ETF positions, maybe fewer than that, you know what you have.
And you could earn a dividend that will wipe out a portion of that loss. But whatever the dividend comes in later.
And you mentioned that. That’s a great example. It’s like you sell out of a security, but you still receive the dividend.
It’s not going to wipe out the whole thing. It will just wipe out that portion of it.
Andrew Chen 37:02
It’s pro rata. Yeah. It’s good to keep in mind.
Robert Dockendorff 37:05
Yeah. I think that what just continues to amaze me is that I talk to so many super sophisticated smart people, they’re unbelievable at their job, they’re good with money, they’ve been investing for years, and people just don’t seem to appreciate what you can do to an account over time if you’re just mindful of taxes.
And again, tax loss selling is one of these levers. But there’s so many more.
It is the biggest overhead expense to every household. And you really can make a big difference through this, the mutual fund distributions, investing in muni bonds rather than a traditional fixed income to get the tax-free interest, using opportunity zone funds now if you do have a liquidity event.
There’s so many people that are sitting on all sorts of tech stock gains. And they have to get out of them to layer it into their financial plan. And the use of opportunity zone funds in the last year as a tool to minimize taxes is a game changer, and people just don’t know about them.
From an investment standpoint, they know ETFs, they know low fee, or they know that they want to find the guy who can beat the market because he’s the smartest and best stock picker of all time, but taxes is an area where you can make a huge difference if you just know how to put the effort in.
Andrew Chen 38:34
For folks who don’t have a lot of insight, what are opportunity zones? How should investors be thinking about them?
Robert Dockendorff 38:51
An opportunity zone fund, the easiest analogy, although there are a lot of differences, is it’s like the 1031 real estate exchange but you can use stock.
So you can take a gain you have in stock. It can be any capital gain.
So you buy something for $100,000. You sell it for $200,000. You take your $100,000 gain, and you put that into what’s called an opportunity zone investment.
So it has to be a real estate investment. It has to be within a certain sector that’s been designated as an opportunity zone.
There are thousands of them throughout the United States. A lot of them would surprise you. A lot of really good real estate managers have started opportunity zone funds that have a long track record of doing development projects in these areas.
So it’s like investing in a non-traded REIT. But basically, you’re able to take that $100,000 gain, which nets you $15,000 in taxes. You defer that $15,000 tax payment for seven years.
And then when the tax comes due, you actually get a 15% reduction on that. So if it’s $15,000, instead of paying $15,000 today in 2019, you pay $13,000 in 2026.
And the opportunity investment itself, any gain on that, if you hold it for 10 years, is totally tax-free. So you’re $100,000 invested in a commercial real estate fund seeking an 8% IRR. There’s a portion for that in everyone’s account, 10%-15% in something that’s non-liquid, non-correlated to equities and fixed income.
Over 10 years, you hold it as an 8% IRR. Just say it doubles in 10 years. All of that is exempt from taxes.
Andrew Chen 40:56
I see. So you only still pay tax on the original gain that you put in. But even then, there’s a 15% discount off of that.
Robert Dockendorff 41:05
Correct. And the 15% discount goes away.
So this was part of the 2017 Tax Cuts and Jobs Act. 2019 has been the first year of these. You can still invest in 2020 and beyond, but the 15% goes to 10%.
And obviously, your deferral period is shorter because the hard deferral end date is 12/31/2026.
Andrew Chen 41:32
Robert Dockendorff 41:33
Yeah. So it’s still a great opportunity for people.
Again, it’s about fit. You can find a place where this fits to help with taxes. People just don’t know about it.
Andrew Chen 41:45
The reduction in taxes, you said, in 2020 goes to 10%. Does it keep going down, or does it stay?
Robert Dockendorff 41:54
No. It stays at 10%.
Andrew Chen 41:56
Robert Dockendorff 41:57
But for instance, if you didn’t do this until 2024, your deferral is shorter. But it still makes sense.
And actually, I think the best part is not the reduction in the original gain. It’s that the new investment is tax-free.
And for a lot of people, you get to free up your basis in the original investment. So you’re only investing the gain.
So the original sale, you paid $100,000 for it. You sold it for $200,000.
In a 1031 exchange, you would have to roll the entire sale into a new property in real estate. So you don’t get your basis back.
But think about someone that’s been invested in their company stock, in the company IPOs, and now they have $250,000 in basis and $700,000 in total value. So there’s a gain of $450,000.
When they do this, assume they put it all in an opportunity zone fund, which they wouldn’t. That’s too much to put in probably.
But they now have their $250,000 back in cash. And then that can be applied to their financial goals, however that is. They don’t have to tie it up forever.
So it’s pretty flexible. I will say it’s also very new.
Tons of rules around it. Tons of regulations around it. Someone is going to run afoul of it, and it can be ugly for some people.
But again, if you find a good manager that you trust, that’s done the legal and accounting work around it, then you should be okay.
Andrew Chen 43:43
Are you getting a lot of inbound interest from this from your clients?
Robert Dockendorff 43:46
Yeah. Well, I design a lot of tax efficient investment plans for people that have liquidity events, and that’s part of it.
So it’s like “Here’s current. Here’s proposed.” And you tell them what it is, and they’re like, “Oh, yeah. That sounds great.”
And then if they’re making a lot of money and they’re a super high earner and this is all taxable money, between direct indexing for equities, muni bonds for fixed income, and an opportunity zone fund for your alternative asset class, it’s a fairly attractive strategy that just makes sense from a tax standpoint.
Andrew Chen 44:25
And I guess for the opportunity zones, you don’t have to roll in capital gain to take advantage of them, do you? Could you just invest in them with new dollars?
Robert Dockendorff 44:35
No. It has to be capital gain.
Andrew Chen 44:37
Oh, I see.
Robert Dockendorff 44:39
Yeah. And so, once you get into it, you have 180 days until after you realize the gain.
So what you could actually do is you could look at your year to date capital gains, or even your prior year capital gains starting in January. So you could get your 1099 and say, “I had $150,000 of capital gains. I didn’t expect that.”
You could still allocate that $150,000 to an opportunity zone fund. You have 180 days to do it.
So we’ll see. Again, I think it’s still the Wild West a little bit with them because the concept is very, very sound and the players that are getting into it are super high end.
Private equity real estate firms are opening these funds and raising hundreds of millions of dollars. And a lot of the funds too have really high minimums.
But if you do your research, which I have, you can find good opportunities. No pun intended. But they’re there.
Andrew Chen 45:47
Got it. Cool. That’s an interesting aside.
Cool. So just zeroing back in on tax harvesting, we talked a lot about wash sales. That’s something that folks definitely have to be mindful of.
Are there any other common mistakes that you see people make when they try to do harvesting?
Robert Dockendorff 46:11
Nothing comes to mind.
Andrew Chen 46:12
Okay. No worries. Cool.
So, one thing I wanted to also ask is I found you through a blog post that you wrote on tax loss harvesting. And in it, you said something very interesting, which is that the hard part is execution. Many advisors, whether the robo or human, will preach the value of tax harvesting, but they fail to deliver.
And I was curious to get your thoughts on why is it so hard to execute? If the tax benefit is so clear and it doesn’t seem terribly complicated, why is it so hard to execute?
Robert Dockendorff 46:41
I remember writing that line because of the Wealthfront issue. The benefit was clear. They failed to execute because something happened at the organizational level where it all slipped through the cracks.
And it’s really just a lot of things work from a conceptual standpoint. It’s about discipline and doing the process in a way that’s thorough and accountable.
As we all know, humans just let things slip through the cracks a lot. They do, and you see it all the time. So that’s where that line came from.
I think there are a lot of things with finance where, for example, right now, year end. Everyone should be going through everything they have, to say, “Did I max out my 401(k)? “Did I max out my HSA? Did I do all the things that is simply just best practices for personal finance?”
But a lot of times, it just doesn’t get done. Life gets busy.
And then specifically, the Wealthfront thing. They just dropped the ball.
Andrew Chen 47:54
Cool. Well, this has been super insightful. Thank you so much for sharing all your insights and advice with us.
Where can people find out more about you, your platform, your services?
Robert Dockendorff 48:04
They can just go to claroadvisors.com. I keep a blog there. I try to do two posts a month.
I send it out as a newsletter. It’s on a bunch of different topics relating to personal finance.
A lot of the things I write about, the questions come from real life client experiences. And I really am trying to give away the knowledge. So I’ve put a lot of work into that.
It’s all by me. There’s no content mill that I’m hitting up for the usual Roth versus traditional.
I try to make it useful. And if people if people want to know more, it’s all there for them.
Andrew Chen 48:47
All right. Thanks so much. We’ll definitely link to your blog in the show notes, and folks can find you there.
Robert Dockendorff 48:53
My newsletter isn’t annoying either. It’s once a month.
Andrew Chen 48:58
Okay, cool. Well, thanks so much again, Bob. And we’ll see you soon.
Robert Dockendorff 49:04
All right. Thank you very much.
Andrew Chen 49:05
Cheers. Take care. Bye.
All right. That’s a wrap. I hope you enjoyed today’s guest interview and got a lot of value and insights from it.
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Related: Be sure to also check out our related post to see how to do tax loss harvesting and tax gain harvesting step by step.