Summary

• Potential tax benefits:Direct indexing may offer tax benefits through tax loss harvesting, which can help defer - not avoid - current tax liabilities into the future.

• Not a tax silver bullet: Every strategy comes with its own risks. Direct indexing strategies may fail to track the targeted index, have diminishing tax opportunities over time, or both. Understand if the risks are worth the potential benefits.

• Common use cases: Best suited for high-income investors with significant taxable investment assets, common use cases include diversifying concentrated stock positions, offsetting gains from other investments, and expressing personal preferences within an investment strategy.

We spend a lot of time talking to clients about taxes. In our experience, most people would prefer to pay as little as legally possible. In some cases, this leads to conversations about direct indexing.

First, the primary tax benefit from a direct indexing strategy involves tax loss harvesting. This is about deferring taxes, not avoiding them altogether.

But in the right situations, the potential tax savings could be very appealing.

What is direct indexing

The goal of direct indexing is to deliver index-like returns with tax benefits and potential customization. The simplest way to understand direct indexing may be through an example. I will use the S&P 500 to help explain the strategy.

From S&P’s website: The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.

Investors can’t own an index, though. Index funds were created to mimic the performance of the index, minus management and other associated fees, by owning the investments within the index. An investor owns the fund, not the underlying investments. Historically, the performance of many index funds tracks the returns of the index very closely.

Direct indexing strategies take a different approach by owning a broad sample of the individual companies within the index. Instead of owning shares of an index fund, investors might buy shares of the underlying investments like Apple, Microsoft, Amazon.com, etc. There could be several hundred holdings. Tax loss harvesting - one of the potential advantages - is discussed below, and many direct indexing strategies give the investor an opportunity to customize the index so that it better aligns with their goals or investment preferences. Certain stocks, sectors, or industries can be avoided altogether, for example. Some investors may prefer to emphasize higher quality companies, smaller stocks, or a variety of other investment factors. Tax-sensitive investors who prefer to be more active with their investments may find this appealing.

How can it help reduce taxes

Tax loss harvesting is one of the key differentiators between direct indexing and owning an index fund. The strategy is pretty straightforward: sell investments that have fallen below the price at which they were bought to realize the capital loss.

The first $3,000 of net realized capital losses (i.e. realized losses minus realized gains) can be deducted from taxable income. To make the math simple, if someone’s tax rate is 33%, their tax savings would be $3,000 x 33%, or $1,000.

Realized long-term capital gains are typically taxed at 15%. Some high-income families and individuals may pay as much as 23.8% tax on long-term gains, including net investment income tax (NIIT). Short-term gains are taxed as ordinary income, which can be as high as 40.8% between federal income tax and NIIT. Investment losses from tax loss harvesting can be used to offset those gains.

So, how exactly could direct indexing help reduce taxes?

The investor in a direct indexing strategy owns individual investments within the index, not a fund. Some of those investments will likely fall in value.

The chart below shows how many stocks within the S&P 500 index – using the SPDR S&P 500 ETF as a proxy – rose or fell in each calendar year since 2007.

Source: Divvi Wealth Management, Morningstar Direct.

On average, 338 stocks rose each calendar year, while 182 had negative returns. For investors who own an index fund, all of this happens below the surface of the fund wrapper and they do not have the opportunity receive the benefits of tax loss harvesting.

By owning the individual securities instead of a fund, investors can potentially take advantage of those stocks whose price falls below their cost basis by selling. The loss becomes “realized” and can be used to offset gains. If realized losses exceed realized gains, those losses can be carried forward to future years. For example, if an investor has $50,000 in realized losses and $30,000 in realized gains in a calendar year, up to $20,000 of losses can carried forward to offset realized gains in future years. Finally, proceeds from the investment sales are reinvested in securities similar to those that were sold. An example might be selling Home Depot and buying Lowe’s. The account stays fully invested, attempting to track the targeted index.

Potential risks of tax loss harvesting

Every investment strategy comes with risks. Here are three potential risks of direct indexing and tax loss harvesting.

1. Tracking error. In plain English, the performance of the investments owned in the direct index will not track the performance of the index perfectly. Since investors won’t own every security in the index, and the percentage allocations can vary, returns will not be identical. Investors will need to decide what is more important – potentially realizing more losses or tracking the performance of the index more closely.

2. Tax deferral, not tax avoidance. Tax loss harvesting may be like kicking the tax can down the road. Assume 100 shares of a stock are purchased at $100 per share and then falls to $80 per share. The original cost basis is $100 per share x 100 shares, or $10,000. The investor realizes a $2,000 loss if they sell at $80, and then they reinvest the remaining $8,000 in another investment. Their new cost basis is $8,000, or $2,000 lower than the initial cost basis. If that new investment rises to $15,000 over time and they sell, they would be taxed on $7,000 of gain from that investment.

3. Fewer opportunities to realize losses over time. Stocks that go up in value within the direct indexing strategy will typically be held. Stocks that fall in value will be sold and reallocated. Over time, a larger percentage of the strategy’s investments will likely have unrealized gains, potentially reducing tax loss harvesting opportunities.

Three common use cases

Now that we have covered some of the pros and cons of direct indexing and tax loss harvesting, here are three common use cases. If you can relate to one or more of these, these strategies could be worth considering.

1. Diversify a concentrated stock position. Watching the price of a stock you own significantly rise is a wonderful feeling. Many corporate executives and employees can accumulate a considerable number of shares of their employer’s stock through their compensation plans. As the company grows, this can be an incredible way to build wealth. On the other hand, maybe you bought a bunch of Nvidia 15 years ago (and held on to it). Whatever the reason, big gains in single stock positions can create their own headache – big tax bills.

   Let’s say a corporate executive accumulated $1,000,000 worth of company stock over their career. The company performed great, and the stock is now worth $10,000,000. More than likely, that single position makes up a huge percentage of their net worth. This can be risky. Most individual companies – and stocks – go through periods where they struggle. The investor may be interested in protecting those gains. Diversifying to reduce risk can seem and protect wealth could seem prudent.

   Long-term capital gains rates for an investor like this could be 23.8%. If they were to sell all of the company stock, realizing the $9,000,000 gain, they might owe $2,142,000 in federal taxes on those gains.

   Losses from direct indexing and tax loss harvesting can help offset those gains. Every $100,000 in realized losses could save the investor over $23,000 in taxes. Sometimes a multi-year transition plan makes sense, both to spread the tax burden across several years, and to give the tax loss harvesting strategy more time to accumulate losses.

2. Expect to realize gains in other investments. Taxes on realized gains from other capital asset sales can also be offset by realized losses. Real estate and business assets are two common examples. This could work just like the concentrated stock example above.

3. Express your personal views. When an investor buys shares of an index fund, they delegate management of that investment to the company managing the fund. They have no control over what is bought or sold. A direct index can be customized to meet the investor’s preferences.

   Let’s go back to the concentrated stock example. Assume that individual works for an energy company, and the majority of their net worth is in the stock of their employer. They may not want or need more energy holdings in their investment portfolio. With a direct index, they could exclude other energy stocks from their index and instead distribute those dollars to other sectors or industries.

   Some investors have strong opinions about the types of companies in which they invest. You may have seen investments marketed as “socially responsible” or “ESG,” which stands for Environmental, Social, and Governance. Regardless of their individual views, a direct index gives them more flexibility to customize their investments in a way that aligns with their values, beliefs, or other preferences.

Finally, all these people have one thing in common: meaningful taxable assets that can be invested in strategies like this. Direct indexing and tax loss harvesting only works if the losses are realized outside of tax-sheltered accounts.

Direct indexing isn’t a one-size-fits-all solution, but for the right investor, it can be a powerful tool for managing taxes, diversifying a portfolio, and aligning investments with personal preferences. As with any investment strategy, it’s important to weigh the potential benefits against the risks and consider whether it fits within your overall financial plan. If you're curious about whether direct indexing could work for you, we are happy to have a conversation and explore your options.

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