Ep 223: Maximizing Returns through Tax Loss Harvesting Doug English

Basically made nothing into the last 30 days. All of that has been spinning every week in the portfolio at no cost to any of our clients. Just building up these capital losses. And these capital losses can be used to offset capital gains anywhere in your life forever.

Welcome to the Next Level Income show where it's our goal to take your income, your investments and your life to the next level. I'm your host, Chris Larson. If you haven't yet, get a copy of our book for free at our website, nextlevelincome.com. that's www.nextlevelincome.com. just click on the book link and I'll even send you a copy if you put your address in. On today's show, we have my friend, Doug English. Doug is a CFP MBA and is the founder of Act Advisors. With over 20 years of experience in financial analysis and risk management for senior executives. He he specializes in optimizing executive benefits in both nonprofit and for profit sectors, handling complex compensation structures and benefits integration. Doug began his career at CUNA Mutual and later established ACT Advisors in 2006. His firm excels in investment management and financial planning, driven by a mission to help clients pursue their dreams. He also hosts the credit union focused podcast See youe on the show and is a featured expert on npr. He lives in Asheville, North Carolina with his wife Jennifer and their three children. And today Doug is going to talk about how you can use direct indexed investing and a specific tax harvesting strategy to help maximize the gains in your portfolio. Doug, welcome to the show.

Hey Chris, good to talk to you when we're not sitting on bicycles.

Well, I kind of would rather, I would rather that, but I think the wind noise wouldn't, wouldn't go over so well.

You make more wind noise than I do. You're very speedy. Those of you who don't know Chris can hammer on a bicycle, do not try to keep up with him.

Thank you. Thank you for the compliment. I've gotten slower over the years, but yeah, I wouldn't, I wouldn't drop you, Doug. So there we go. There we go. But no, I'm excited to have you on. We've known each other for going on a decade. We met about nine years ago through local angel investing network and you and I were chatting about kind of some real estate matters a few weeks ago and I said, Doug, you got a podcast I got to have you on to talk about what you guys are doing over at ACT Advisors. Before we jump into that, I'd love for you to share a little bit More about your background with the audience.

We just, I'll talk to you a little bit about my individual investing activity in the angel space. Obviously you and I have both belong to group but then as a, you know we myself and my partner own a fee only fiduciary RIA firm. A lot of work in strategic financial planning with high net worth investors and then some fairly advanced tax strategy in sort of part of our financial planning and investment management work and that's what we're going to talk about today is some ways that your can use direct indexing, which is a specific type of investing technique to off gains in other parts of their life. So that's where we'll end up but we'll, we'll start maybe talking about angel investing. So I know that's kind of where we got to meet each other. And I had the good fortune to invest in a couple of different startups over the years. One had a great, had a great experience. It was a qualified small business stock and I'm sure you've talked about that on this industry. The holy grail of investing outcomes because you put some money in there and the company is you got to always be a C corporation. You can't have been an ass. As soon as yours, you lose the opportunity and then you have to be below a certain value of company. And if you exit from before you hit that threshold, you are tax free. You know, there's no tax to the entrepreneurs that built the company or the investors that joined the company like myself. So in my first angel investing experience I got a seven times return and I didn't pay any taxes. So that was a, that was a good day. It was a good day.

Yeah. I love it. So go, just go back and explain the qualifications for that specific investment because I think some of these niche areas, Doug, investors aren't really familiar with that.

Yeah, you can look up qualified small business stock. It is you know, long established in the internal revenue code. But you know, from an entrepreneur standpoint, the greatest catch that usually stops them is most companies are not a C corporation. You know, a lot of us are. My company is a LLC filing as an S and you do that because of the double taxation and of hassle that it is. But the qualified small business stock requirement is you've got to essentially I think the language always have been a C corporation and I've seen entrepreneurs pay millions and millions of dollars in taxes that were just an S corporation for a small portion of their existence. But the, the rules are what they are. So you got to always have been a C corporation. And then I don't have the number on the top of my head what the maximum market value can be of your company. It's pretty good value, but it's, it's not hundreds of millions of dollars. So you got to be a small company. It's qualified small business stock. And, and then when that exit happens, no taxes. It's beautiful.

I love that. Well, and that's why I wanted to have you on because you don't have experience just in, in traditional stocks, bonds, those sorts of things. You have personal experience investing in things like startups, real estate. And you know, this isn't, unfortunately this isn't something you always see in the financial planning space. You know, my MBA is in portfolio management and more I learned about it when I was in school and afterward, the more I learned that not that many people are like you. Doug. You know, one of the things. Can you explain what an RIA is to our listeners?

RIA stands for registered Investment Advisor. I guess the key differentiator is a full time fiduciary. There's never this change of hats. Most financial people that you talk to are going to be either in the dual role or exclusively in the broker role. The dual role is where depending on what the person sells, you will define the nature of the relationship. So if I'm a traditional broker at you name it firm that you imagine, basically all of them. If I sell you a fee based account, I am a fiduciary for the discussion associated with that account. If I sell you a commission based product like an annuity, I'm a broker and I only have to act in a, in a duty that is reasonable for you. As a fiduciary, I have to put your interest first at all times. I have to disclose any conflicts of interest and I can only be compensated on a fee basis that's completely disclosed to you. As a broker, I, I just have to make sure that the thing that I'm suggesting is suitable and I don't have to disclose my comp. So interesting. Very different standards and it depends on what the person sells you that defines what they are. So a ria, any ria, is fee only fiduciary at all times.

So it, it seems to me like if you're an investor, that's, that's who you would want to be working with. And that's not only do most investors not know the distinction between those, but I don't even know that they know to ask those questions. So if you're an investor out there and you say, well, how do I know if my advisor is a fiduciary or an ria? What's a simple way or what are a few simple questions that investors can ask or look up on a website to determine if that's the case or not?

Yeah, probably one of the best resources is napfa. N A P. It is a, the largest organization of fee only advisors and all the folks that are associated with that are going to be going to meet all those criterion. So napfa, the NAPFA organization anyone is a member of NAPFA is a true ria. Because one of the things that NAPFA requires is that you can't just be the only fee only person in a firm because if your partners receive commissions, there could be some sort of sharing going on behind the scenes or something. So the whole firm has to be fee only fiduciary in order to be a part of napa. So that's how I would look.

Yeah, Nap fa. Napa. We'll put that in the, in the show notes as well. And I remember looking, looking this up because I was like, this is what I want to do if I'm going to go down this route. 25 years ago there was, there was not a lot of just fee based RIAs that are out there. Why do you think that this, this part, part of the business has grown so much over the last couple decades?

Well, I know it's what people are looking for. I mean we, when, when we were a traditional brokerage firm or a hybrid firm, there was not a lot of people like calling, asking us, hey, will you take our business? Well, now that we're fee only, it's the total opposite. It's almost daily incoming calls where folks are looking for a fee only fiduciary. And there's, there's only, there's only so many of us around. The demand is, is substantial and I think it's because people want to have somebody on their side in the discussions where they don't have to be jaded about complex.

Yeah, yeah. And it's that, that's the big thing. I think a lot of people are jaded with the financial services industry in this country. They're jaded with the health, health, I'll say health care industry. It's not even really fair to say that we're gonna, we're gonna be seeing that here. We're recording this the, the day of, of the upcoming debate. So I'm sure that'll, that'll kind of pop up as we've seen RFK Jr jump in and, and talk about, you know, bringing, you know, health care back in this country. But no, it's, it's, it's really interesting. Kind of the rise of, the rise that are out there. And you know, one other thing I want to ask you, Doug. So if you talk to most financial advisors and say, hey, I'm interested in this, this real estate private placement, most of your standard brokers, they, they can't, not only can they not advise you on that or advise you to invest in something like that, but they may even have restrictions on investing in those things themselves. Is that, is that right?

Yeah. Oh, very much so. If you are a, if you're associated with a broker dealer firm. The broker dealer firm. So yeah, the biggest one there is is lpl and we have a relationship with them as a custodian. So it's a, they basically print the statements and do the trades. That's all they are for us.

But broker, I've seen that on your sign when I've written by. Actually, I remember that. Yeah.

For a broker, they, the broker dealer firm has to monitor any activity they do in their client accounts or in their personal accounts that might create a conflict. And so were that broker to invest in the private placements, there is the possibility of them getting a discount on that because they refer some clients in there. That's a very, very big no, no called selling away. It is terminable instantly by the broker dealer firms. So you're correct. Most of the folks in the broker dealer world cannot be involved in any way with any kind of private placement activity.

Yeah. And that's again, I think, you know, I talk to investors and they're like, my advisor doesn't think I should invest in this. And my next question is, you know, are they, are they a broker dealer or they're an ria? You know, because again, to your point, Doug, they may actually be required to tell you no according to what they're doing. And I equate it to when I was in the medical device space, you know, if I'm working, representing a company, you know, say Medtronic, who I worked for, and the doctor says, oh, should I use this Johnson and Johnson product I have? I can't say, yeah, go use that. Like my company is going to say, what are you doing? You're not doing your job. You know, so when, when, when a surgeon would ask me, what do you think I should use for this, Chris? I'd say, you see the name on my badge, right? So you know, you know, now there was, there was, you know, from time to time there was kind of niche, niche areas where we didn't have a product that would fit that. And I may say, oh, you could, you can maybe go check this out. But again, I think if you're working with a broker, dealer and you're asking for advice, you have to be cognizant, you have to understand the rules that they're playing by and that you, you may not be getting unbiased advice when it comes to that. So yeah, I'm a big fan of kind of the niche you fall in here as an ra also as a fiduciary, which is what I set my father up, my stepfather with up about 15 years ago, which I think can, can be, be a big deal. Also the thing you also mentioned, Doug, was being, being fee based only versus you know, charging a commission when you trade or sell things for investors. And in general, the data shows that advisors make their clients more money than they charge. But there's also a strong correlation between their, the, the return an investor gets and the inverse of the fees that are charged. So basically their fees come off, come off of their returns. Can you speak, you know, a little bit more towards that and how investors may benefit from lowering their fees, but also getting advice.

Are you referencing, you're probably referencing the Vanguard study. There was a great study that Vanguard did, which is kind of funny because they're kind of the mecca of do it yourself. But they recognize that the value the advisor can bring with many things, the sort of identifying sort of things that are not in the mainstream yet and kind of getting you into them a bit early. But tax management is a very big deal and that's what we're going to talk about today. And then the most important one is behavior modification.

Yes.

In other words, stopping you from making bad things, from doing bad things, from getting scared out from what your brother in law said or what your, what you saw on television. Like, you know, I'd say that we, we push out so much content to our clients that that doesn't happen almost all for us. But just getting you to not sell in 2021 would be a humongous value add. And if we could get you to actually buy in 2021. Wow, that was a really good, that was a really good value add. So modifying behavior is the most impactful thing that a financial advisor can help you to do. And then followed by tax strategy, followed by finding sort of new things.

Yeah, no, I love it. Thank you for Sharing that. Yeah. And it was, I forget all these, all these studies I've read over the years, but I think that was the vanguard study. And I equated it to somebody that hires, you know, a coach at the gym or a trainer and saying, hey, like you should do this today or just keeping you consistent, getting to the gym every day, writing a training program for your bike, you know, making sure that you, you stick to the financial plan that you laid out with the advisor you're working with. So you know, Doug, you just touched on this. But you know, you find, you find a fiduciary, it's a fee based advisor that's a good fit for you. You keep your fees low, you go through the diversification process. I know there's all these, you know, direct invest, direct indexing options, you know, that are out there. But as you mentioned, one of the next big pieces is as you've lined all that stuff up is managing the tax side. Because, you know, we've said it many times, it's not what you take home, it's what you keep. And that applies the same for your investment. So share a little bit about, you know, how you have developed the strategy that you guys have, why it's unique and kind of how it all works together with this.

So first place, we have two methods of working and this, that we have the traditional assets under management approach where we, you know, charge everybody a percentage of what we manage and generally those folks tend to be a million plus. Then we also have a flat fee model where it's, you just pay a flat fee, you get all the financial planning, all the strategy, and then we tell you what to do with your investments, with your taxes, with your insurance. We tell you what to do and you do it so you don't have to have assets under management with us to get all the advice. Now.

Okay, just, just to clarify, so you can actually just pay basically that coaching fee like you mentioned for the advisory if you want to do it yourself. Like, like there's a lot of investment.

Out there and that's.

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That's blowing up for us. It's just personal. Yeah, that's, that's. We have a lot of demand in that area. It's going really well.

Awesome.

So what caused the direct indexing came result of our research into trying to reduce costs portfolio. Now in the portfolios we run, the internal cost of the portfolio might be 25 or 30 basis points. So it's pretty cheap.

So a basis point just for listeners is, is 1/100th of a percent. So 25 basis points would be a quarter of a percent. And that's. Yeah, that's quite low.

That's. But you know, we're always, we're constantly looking at everything in a client's life, all the insurance. So anything that causes a drag in their return, we're looking to see if there's a way to reduce that cost. So the holy grail, of course is to not have an instrument, an ETF or a mutual fund or a trust to have nothing between, between the investor and the creation of value. And isn't that essentially what you do Right. In the real estate? If you, if you buy a piece of real estate yourself, there is nothing. It's you and that piece of real estate. There's no loss of revenue in between. And that's kind of the same out way we think about that's what we want for our clients in the investing world. So we can get rid of that 25 or 30 basis points. Points. We just increase their return 25 or 30 basis points.

Yeah.

So the hard part about it is that that requires that you are able to identify the securities that are going to outperform the market. Right. That's what you normally would have to say is I've got this brilliant wisdom and outperform the market. But a few years ago there was a price war. And the price war was Schwab vs. TD vs. Fidelity. And the war was about the trading, the price to trade and the price. The trade used to be $60 a trade and then it went to eight or nine dollars. And then I'm sure, as you remember, it went to zero for all of them.

Yeah, you got Robin Hood now and all the. Yeah, it's just continued.

So when it went zero, then the software companies got involved. And what the software companies figured out is there's, there's many data points around security. It's something like 16 or 18 data points about the way it behaves, what it's correlated to positively and negatively, and all kinds of details that are way beyond me. But you, you can get a lot of data points around each security. And so then I can buy software, allow me to construct any index that I want, and I can make it with its components. So, for example, let's say that Chris is a fan of the S P. And the S P makes sense in Chris's personal portfolio. Well, you can go to Vanguard and you can buy the S e for like 10 basis points or whatever it is, and you will almost perfectly track the result of that index. It's got a great track record, it's super low cost, and it doesn't really create much of any tax impact on you except for the dividends. Right. So if you just own it, it's a little bit of a dividend you paid and very little else.

Yeah.

So that's what investors would historically do. Well, when the software companies got all these data points, they created way where we can create the index. So if I've got a platform and I have two of them, if I've got a platform with free trading, I can go on that platform and say I want to track the index for Chris and that platform is going to let me trade as much as I want for free and that I will, I'll tell our software, let's track the S P. How many positions do I need? I know because we do it all the time. It's going to take me about 300 position to have Chris perfectly track the behavior of the S and P. Okay, that's interesting.

So you can get, you can get the behavior of 500 stocks with the ownership of 300.

Yeah, with a tracking error of about 1%. So very tight, Very tight. And of course, now I've eliminated that 25 or 30 basis points. Right. It's gone. It's just Chris and the individual holdings. But then the magic comes in what we can do with tax loss harvesting.

So the harvesting, that's what I was waiting for you to say. Yep.

Tax loss harvest. What that means is when something goes down, if we don't care what the Components are, we got those 300 components that are tracking the, the index aggregate. But those 300 components were indifferent. We want to track the S P. We don't care which stocks get us there. Right, Right. So the software, every week, it looks for anything that went down. Anything that went down, it can be replaced with something else that creates the same overall behavior. And when we sell the ones that went down, we get a capital loss. That loss sort of drips out is the way I look at it. Sort of drips out of the portfolio constantly. And our returns still track the index. So if the index is up like 16 or 17% like it is this year, you're going to be up 16 or 17%. I know because many of our clients have these, including myself. I have a large capital loss this year and a 17% positive return because there's been several periods of this year where there were slight declines in the market and there were small cap, basically made nothing into the last 30 days. All of that has been spinning every week in the portfolio at no cost to any of our clients. Just building up these capital losses. And these capital losses can be used to offset capital gains anywhere in your life forever.

Not just on schedule E or really, that's interesting.

Anywhere you've got real estate, capital gains, offset it. You've got small business gains offset it. You've got another portfolio, highly appreciated stocks, you can offset it. And that's why if you're an investor and you've got, you know, you know, again, the, the angel investing that you and I both done, if you've got some holdings that are highly appreciated and you own in funds, you need to be direct indexing instead of owning index funds. You'll get the exact same return, but now you'll get these capital loss dripping out that you can use to build up and build up. And if you say I'm going to sell my business in 10 years and I'm going to have this huge capital gain, six, be direct indexing and building up the losses all the way along, you'll pay less cost and you'll pay less tax.

And I would imagine, I'm kind of thinking here as you're talking about this because you just, you just said it. So I'm trying to read between the lines. The more volatile the market is, probably the greater the losses that build up. So you know, if the market goes up, like you said, know 10, 15, 16, 17%, but it's going up and down a bunch around that mean you're getting, you're getting the, the tax loss harvesting along the way or even if it goes sideways. Yeah, yeah.

There's something going down. Like it was like 2021. I think the, we often track the Vanguard Total Stock Market Index.

Yep.

And I believe that was down about 20% for the year. And the tax loss harvesting capture was 25% for the year. And we just rode all the way through that. And of course it's been boom, boom, boom, massive gains ever since. Haven't paid a dollar in anything for capital and the losses just keep building up for whenever we need them. And that's why we lowered the cost track. The index and the folks that work with us, if they have $1 million or more in that portfolio, all of the financial planning work, which is going to add a very significant amount of additional strategic value is included.

That's wild. So, and this is this, this can be particularly valuable for investors that are not just invested in the stock market. So if you have, you know, gains in real estate or from a business that you might own or have invested in or like you were saying, angel investments or other areas, this can, this can be a significant benefit. Crypto could offset crypto as well.

As long as that be a capital gain. If I imagine a lot of crypto is probably ordinary income and we. It does not. Ordinary income does not offset.

Gotcha. So it has to be, it has to be a capital gain. Yeah. And we're not giving out specific tax advice here, but just, just in general. So that's. Yeah. So that's fascinating. And I would say this is akin to dollar cost averaging. Right. Because people, I think most people understand dollar cost averaging, which is you buy more stock when it's lower, you buy less when it's higher, and over time, your average returns are greater than the return of the market. This is doing basically a derivative of that, which is you're selling low, taking advantage of the, of the loss, replacing that. And you know, I actually use the example, I'll kind of follow up about the example of what you said, replacing it with, with a stock of, of like behavior. But so if you understand dollar cost averaging, this, this should make sense as well.

Yeah. The other thing, direct indexing is because you can control it, you can customize it in whatever way is appropriate for the investor. So let's just say that you are so fortunate that you inherited through your family. Exxon stock was super low basis, spending your family forever and you can't sell it, but it's 25% of your personal portfolio and you sure as heck don't want to buy more oil services. Well, indirect indexing, you can filter anything. So if you want nothing to do with oil services, you just say, all right, now instead of the S and P, I'm going to make the Larson index and I'm going to customize it completely to whatever Chris wants to own or wants to not own. So you've got a whole bunch of real estate exposure and maybe that's correlated with interest rates. I think there's some correlation there. You might want to not have interest rate exposures in your direct indexing portfolio. You can completely customize it to be whatever it needs to be for you.

That's wild. And again, you know, Doug, again, this is, this is the exciting part of the conversation, which is I think the challenge that a lot of investors find is they go talk to an advisor and they say, oh, you got a house, that's real estate. You got these other real estate investments. They don't really know how to incorporate them into their stock portfolio. I remember reading some of Larry Swedro's work and talking about how you could, you could synthetically create the performance of a REIT by not owning any rates through, like you said, through other financial instruments that were related to interest rates. And, you know, the argument is kind of like, it's really not a reit. It's not really a primary investing color, so to speak. You could take red and white and make pink, which would be the REIT in that case. So, yeah. So what you're saying is you can customize your portfolio by customizing the stocks in your specific index so that you blend in your other asset classes so that it doesn't overweight you or underweight you.

You skip whatever needs to be skipped. And probably the, maybe the biggest takeaway for your listeners is this is not a, one of those things that you just do at the moment. You're going to have a capital gain, ideally portion of the, your portfolio that is taxable, that is appropriate to be invested in large company stocks is, is being direct indexed, being direct indexed for as many years as possible to just let those capital gains build up. It's, it's got to be lower cost than anything else you're doing because have any portfolio cost and let those losses build up. And then when the capital gains come, it'll off offset those gains. If you're, again, if you're an investor and you've got the appreciated things, that's going to help you whenever that occurs. If you're an entrepreneur, you've got Founder shares that are going to hopefully go big one day, it's going to offset the case for you. It's another way it's powerful is charitable giving. Right. If you, instead of owning the S P, let's say that you are brilliant like Chris Larson and you put all of your money in Nvidia two years ago. It's all there.

How did you. I didn't do that, but okay, it's all there.

It's up 2000% or whatever the number is. So you go to do your ten thousand dollar charitable giving to, to your charity this year. You don't give the S and P. You give the most appreciated in your portfolio. You say, here you go, here's 100 shares.

Oh, because you own. I see. Because you own the actual individual pieces, you can just give that one.

Yes. That's the most appreciated thing that you've owned for at least 12 months. So for charitable giving to your personal donor advised fund or your charity or choice, it is absolutely spectacular.

That is really interesting. Yeah. All these little pieces that can really add up to big things. Doug, I love that. So what? Okay, so I know some listeners are thinking, wait, I only have qualified plans, my 401k, my IRA. How does it work within qualified plans?

It doesn't, you shouldn't do direct indexing qualified plans. It doesn't add any value. You should just buy the index.

Okay, gotcha.

It's for your taxable money.

Got it. So this is for your taxable money. Okay, terrific. So, all right. So Doug, I, I got, I got a lot of questions here and we're gonna, we're gonna kind of follow up after this. But if people want to learn more about this strategy, how it may apply to them, what's the best way to get in touch with you and your firm?

On a website, act-advisors.com There is a page called are we a fit? And on the Are we a fit? Page it describes the way that we work. It describes direct indexing. It describes our flat fee versus a traditional assets under management strategies gives you everything, you know, to see if, if it makes sense for us to consider working together. And from there you can schedule a zoom call to, to, to feel it out. There's, you know, like, like I said, that's, that's kind of our first step is to give you all the information, let you see if it might fit for you. And then to start with the zoom to see, see what makes sense.

Wonderful. I will go ahead and put this in the show notes as well. If you're listening. You want to learn more about Doug ACT Advisors and if it might be a good fit for you, check them out at act-advisors advisors.com Are we a fit? Doug, thank you so much. This has been a great conversation. Always good to see you my friend.

Thanks Chris.

Hey Chris, here again. I hope you found this episode valuable. Now I have one more thing to gift you. We have a page for my coaching clients where you can get a free copy of my book as well as much more from previous guests on the show. Just check out nextlevelincome.com coaching to get a free copy of my My Book audiobook and much more. I'll send you a copy of my book and cover all the shipping costs as a thank you for listening to the podcast. Also, please like share and take just 90 seconds to give us a rating on Apple Podcasts.