Using Direct Indexing to Maximize Charitable Giving
Direct Indexing is an investment strategy where the investor purchases the individual stocks of an index instead of the underlying index fund itself. You may be wondering why someone would go through the hassle of owning so many stocks when the cost of index funds is so low, and they can be purchased very easily. I tend to agree that in most situations, direct indexing is not the solution. However, there are some situations where they can provide a tremendous benefit. One of those is for investors with non-retirement investments who donate to charity.
Imagine an investor Jim, who donates $10,000/year to his local church. In a taxable investment account, he owns an S&P 500 index fund that has appreciated in value over time. He usually donates $10,000 of the fund to his church, taking the tax write-off and also removing the possible future capital gains from selling the fund.
However, during down years in the stock market, like what we are currently experiencing, there is less appeal for Jim to donate the index fund that is currently down. Imagine instead that he owns a direct index of stocks that closely mirrors the S&P 500. He could review all the stock holdings and donate any stocks that have gone up. While those stocks may be few and far between, there are usually parts of the market that do just fine while everything else crashes. For example, as of this writing, there are energy stocks that are up over 100% this year alone!
So, let’s assume that some of the best stocks he owns have appreciated from $4,000 to $10,000 this year and some of the worst stocks have gone from $10,000 down to $6,000.
He donates the winning stocks to his church, avoiding $6,000 in capital gains. He then replaces the stocks he gifted with the cash he would have donated to his church, and he can buy back the same stocks but at a higher cost basis. He sells the losing stocks and realizes $4,000 in capital losses than can be used to offset his income. He can then buy back similar stocks to the losers so he can take advantage of any increases if the market starts to come back.
This pattern could be repeated indefinitely, with the best-performing stocks being donated and then replaced with cash, and the worst-performing stocks always being “harvested” for their tax losses.
Thank you for reading,
Alex
This blog post is not advice. Please read disclaimers.