Minimizing the impact of taxes for physicians with custom indexing

Why physicians should consider custom indexing

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

Personalized Portfolios

At Forme Financial, our client portfolios are constructed using sophisticated optimization technology designed to replicate the exposures of an underlying asset class or investment style. The optimizer uses a complex mathematical process to solve for the best possible portfolio, given client-specific requirements like capital gains budgets, existing holdings, and security restrictions. The result of this portfolio construction process is a customized portfolio composed of individual equity securities designed to track a specific index, while accounting for a physician’s unique tax considerations. In contrast, traditional investment strategies such as mutual funds and ETFs lack end-investor control and full transparency. Thus, it’s hard to know exactly what you own in these funds that tend to have unclear investment mandates.

Enhanced Tax Efficiency

Custom indexing allows investors and their advisors to be in control of when gains and losses are recognized through direct ownership of the underlying securities. Such control is often not the case when investing in mutual funds given their annual capital gain distribution requirements. 

Furthermore, custom indexing provides more opportunities for tax loss harvesting – a strategy of selling securities at loss to offset capital gains tax. These opportunities to save on taxes arise because certain underlying stocks of the tracked index may be trading at a loss even if the overall index has posted a gain. Since ETFs and mutual funds are traded in baskets of securities rather than by their underlying holdings, tax loss harvesting is limited for these pooled investment vehicles. Conversely, custom indexing holds more securities that inherently have more variability than a single investment position of a fund. The raw number of securities mathematically creates more opportunities to harvest losses with direct indexing.

If capital losses exceed gains in any given year, they can be used to offset up to $3,000 of ordinary income per year. What is less widely known by physicians is that an unlimited amount of capital losses can be applied against capital gains in future years on federal tax returns for the remainder of one’s lifetime. These losses can be used to offset gains in an investment portfolio or from the sale of other assets with capital gains, such as the sale of real estate or a physician practice.

Because of better control and more opportunities for tax loss harvesting, custom indexing can generate better after-tax performance than comparable ETFs, mutual funds, and market indices.According to a study published in the CFA Journal**, tax loss harvesting can generate 108 basis points (1.08%) of annual tax savings. When combined with other tax-smart investing strategies such as asset location and tax-efficient withdrawal optimization, aggregate annual tax savings can be up to 2% or more each year. Such savings compounded over multiple years can translate into significant additional after-tax wealth for physicians as illustrated below.

Environmental, Social, and Governance  Investing

ESG investing incorporates investment holdings that score highly on a client’s preferred environmental, social and governance factors. Incorporating ESG criteria into portfolios is an increasingly popular way for clients to align their values with their investments. Yet, ETFs and mutual funds don’t enable investors to specify which stocks to own - instead, investors are forced to hold the entire basket of stocks in these funds. Custom indexing, in contrast, allows investors to choose which stocks to own and which ones to avoid. Accordingly, custom indexing lets physicians steer clear of stocks that don't align with their values. For example, if a physician doesn’t want to invest in gun stocks, they don’t have to own them in their custom index.

As ESG investing continues to gain broader market acceptance, a growing number of asset managers now integrate ESG factors into their mutual funds and ETFs. Despite having more access to these types of ESG options, physicians may have unique social preferences that differ from the ESG factors of any given mutual fund or ETF. Custom indexing allows physicians to restrict exposure to certain securities and industries, enabling the construction of truly personalized portfolios that uniquely reflect their ESG values.

Low Cost

Keeping investment costs low is a prudent strategy to help physicians reach the financial outcomes they desire. Markets are not controllable or predictable. However, investment expenses are a known factor. Minimizing these costs increases the probability of investment success. This well-researched fact has contributed to the popularity of passive investing, including the use of index mutual funds and ETFs. We believe that custom indexing is the next evolution of low-cost investing.

Custom indexing isn’t for everyone

Not every physician needs to invest in a custom indexing strategy, especially those who have not accumulated many taxable assets yet. For example, if a resident, fellow, or early practicing physician has the majority of their financial assets in retirement accounts that are tax deferred or tax free, custom indexing with its associated tax benefits may not make sense. In such cases, ETFs and mutual funds are likely the more appropriate investment vehicles.

Generally, custom indexing is a better fit for high net worth physicians who have taxable assets and are in higher tax brackets. At Forme Financial, the investment minimum for custom indexing is $100,000 in non-retirement accounts, and typically investors in these types of accounts have income levels of $250,000 or more.

Should you consider custom indexing?

According to Medscape’s 2022 Physicians and Taxes report, doctors pay on average nearly $90,000 in federal and state income taxes. Furthermore, the study found that the median physician marginal tax bracket was 35% in 2021, the second highest income tax bracket. If you find yourself near these averages or above, have taxable assets, and are looking for ways to lower your tax bill, custom indexing may be an investment strategy for you to consider. 

Owning securities directly affords you and your advisor better control of when gains are realized and provides more opportunities for year-round tax loss harvesting. These tax savings allow you to keep more of what you earn with more of your money remaining invested to help reach your financial goals. Direct indexing is also often a good fit for investors interested in aligning their portfolios with their values.

Doctors who don’t utilize this strategy likely are missing out on significant tax savings. In contrast, physicians using this modern investment approach may be able to materially accelerate their wealth via 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.

‍

*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)