Tax Smart Investing: Using Custom Indexing to Minimize the Impact of Taxes

Summary

• Physicians should consider adding custom indexing to their investment mix to enhance tax efficiency and portfolio customization.

  
  

• Custom indexing is a new way to invest that can help physicians lower their taxes and create a more personalized portfolio. It involves choosing specific stocks to track the performance of a particular index, like the S&P 500.*

  
  

• Owning the component stocks of an index allows for better personalization of portfolios, including the ability to incorporate a physician’s environmental, social, and governance (ESG) values.

  
  

• Custom indexing may offer potential for improved after-tax performance compared to some mutual funds and ETFs

Why common investing strategies fall short for physicians 

As high earners, physicians often have more complex financial lives. Their portfolios should reflect this reality. Yet commonly used investment strategies are often not designed to minimize taxes or allow for personalization.

For example:

1. Mutual funds are inherently tax inefficient. Investors in mutual funds inherit the embedded gains of the funds at the time of purchase, and mutual funds must distribute 98% of their calendar year income to shareholders. Such distributions translate into a tax hit for investors even if a fund generates an investment loss – not a great result for physicians who already pay a lot in taxes.

2. Exchange traded funds (ETFs) don’t often provide enough personalization options for physicians who want to customize their portfolios. ETFs pool investors' money into a basket of securities, so investors can't fully customize their portfolios by choosing which specific securities to own. For example, if a physician doesn't want to own stocks of weapon manufacturers or prefers to invest in companies with modern governance policies, ETFs that track broad market indices don't allow for this level of customization. 

3. When we review portfolios managed by others on behalf of physicians, we often find generic investments that don't consider the unique financial circumstances of physicians. Even when portfolios are personalized, they tend to be similar to other strategies. These portfolios don't reflect the individual goals, tax rates, career considerations, and other factors that are specific to each physician. To truly customize a portfolio, it needs to be tailored to these details and managed efficiently and cost-effectively using modern technology. That's where custom indexing comes in – it allows for a truly personalized investment experience for each physician.

Why physicians should consider custom indexing

Custom indexing, combined with advanced portfolio management technology, offers the following benefits for physicians:

Personalized Portfolios Enabled by Advanced Technology

At Earned Wealth, we use advanced technology to create personalized portfolios for our physician clients. Our process involves using a complex mathematical model to determine the best combination of individual stocks to track a specific investment style or asset class, while taking into account each physician's unique financial situation and tax needs. This means that your portfolio is tailored to your specific requirements and preferences, such as restrictions on certain types of investments or a need to limit capital gains taxes.

In contrast to traditional investment strategies like mutual funds and ETFs, where you have little control over what is included in the fund, our approach gives you full transparency and control over your portfolio.

Enhanced Tax Efficiency

Custom indexing allows investors to have more control over when they recognize gains and losses in their investments. When you invest in mutual funds, you don't have this level of control, since the funds have to distribute their capital gains each year.

One of the advantages of custom indexing is that it offers more opportunities for tax loss harvesting. This strategy involves selling securities at a loss to offset capital gains tax, and it can result in significant tax savings. With custom indexing, you have more chances to harvest losses because you own the underlying securities directly, rather than through a pooled investment vehicle like an ETF or mutual fund. Even if an index is positive for the year, it is likely that a number of its underlying securities had declines during the year, thereby providing more opportunities for tax loss harvesting in custom indexing portfolios.

In addition, any capital losses that you don't use to offset gains in the current year can be carried forward and used to offset gains in future years, which can provide tax savings for the rest of your life. These tax benefits, combined with other smart investing strategies, can add up to significant after-tax wealth over time.

According to a study published in the CFA Journal**, tax loss harvesting may potentially contribute to annual tax savings of up to 1.08%. When you combine this with other tax-smart investing strategies, your annual tax savings can be even higher. By using custom indexing and other tax-smart investing strategies, physicians may have the potential to  generate more after-tax wealth than they would with comparable ETFs and mutual funds.

Environmental, Social, and Governance Investing

ESG investing is an investment approach that aligns with a client's preferred environmental, social, and governance factors. It is an increasingly popular way for investors to invest in companies that reflect their values. However, traditional investment options such as ETFs and mutual funds don't give investors the ability to choose which stocks to hold, which means investors end up holding a basket of stocks that may not fully align with their values. Custom indexing enables investors to own stocks that match their values and avoid those that don't. For instance, if a physician is against investing big pharma, healthcare systems or  in gun stocks, they can easily exclude  them in their custom index.

Physicians often have unique ESG preferences that differ from the ESG factors used in these funds. Custom indexing allows physicians to restrict exposure to certain securities and industries, which helps them construct personalized portfolios that truly reflect their ESG values.

Low Cost

Although it’s impossible to control or predict market outcomes, you can control the amount you pay in investment expenses. That’s why many smart investors choose passive investing, which involves buying index mutual funds and ETFs. These investments track a market index, such as the S&P 500, and have lower fees than actively managed funds that try to beat the market. However, custom indexing takes this approach a step further. With custom indexing, you have even more control over the stocks you own, which allows you to further minimize costs and potentially increase your returns. By building a portfolio that’s tailored to your specific needs and goals, you can achieve investment success while keeping expenses low.

Custom indexing isn’t for everyone

Investing can be complicated, and it's important to understand which strategies make sense for your financial situation. Custom indexing is a tax-smart investing strategy that can help high net worth physicians with taxable assets reach their financial goals. However, it may not be appropriate for everyone, especially those who have not yet accumulated many taxable assets, such as residents, fellows, and early practicing physicians.

For those who do have taxable assets and are in higher tax brackets, custom indexing can provide significant tax benefits. By choosing specific stocks to include in your investment portfolio, you can minimize your investment expenses and increase the likelihood of investment success. At Earned Wealth, our custom indexing strategy requires a minimum investment of $100,000 in non-retirement accounts, and is typically recommended for investors with income levels of $250,000 or more.

Remember, not every investment strategy is right for every physician. It's important to work with a trusted financial advisor who can help you determine the best approach for your unique financial situation.

Should you consider custom indexing?

According to a recent study by Medscape, physicians pay an average of nearly $90,000 in federal and state income taxes. If you find yourself in a similar position, have taxable assets, and are looking to lower your tax bill, custom indexing may be an investment strategy to consider.

Custom indexing provides more control over when gains are realized and more opportunities for year-round tax loss harvesting. This can result in significant tax savings, allowing you to keep more of your earnings invested to help you achieve your financial goals. Additionally, direct indexing may be a good fit for physicians who want to align their portfolios with their values.

By not utilizing this strategy, doctors may be missing out on valuable tax savings. On the other hand, physicians who use this modern investment approach may be able to accelerate their wealth thanks to the tax and personalization benefits of custom indexing.

To learn more about custom indexing and to discover if this strategy makes sense for you, please connect with us here.

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*The S&P 500 Index is an unmanaged index containing common stocks of 500 industrial, transportation, utility and financial companies, regarded as generally representative of the U.S. stock market. The index reflects the reinvestment of dividends, if any, and capital gain distributions, if any, but does not reflect fees, brokerage commissions, or other expenses of investing. This index is used for comparison purposes. It is not possible to invest in an index.

** Source: https://www.cfainstitute.org/en/research/financial-analysts-journal/2020/empirical-evaluation-tax-loss-harvesting-alpha)