When Does Direct Indexing Actually Lower Your Taxes?

Direct indexing has become increasingly popular as a way to combine index investing with tax-loss harvesting.

Instead of owning an index through a single ETF, you own many of the individual stocks that make up the index. When some of those stocks decline, they can potentially be sold at a loss and replaced with similar investments while maintaining broad market exposure.

Those losses can then help offset capital gains elsewhere in your portfolio.

That sounds compelling.

But there is an important distinction:

Tax-loss harvesting often creates tax deferral, not permanent tax savings.

The benefit depends heavily on your tax situation, how your portfolio is funded, and what ultimately happens to the investments.

Three questions can help you evaluate the potential benefit.

1. Do You Have Taxable Gains Worth Offsetting?

This is the most important place to start.

Direct indexing can generate capital losses. But a capital loss is only valuable if you can put it to use.

Consider an investor whose direct-indexing portfolio generates $50,000 of harvested losses during the year.

That may sound like a significant tax benefit.

But what will those losses actually offset?

The investor may be:

• Gradually selling a concentrated company stock position
• Realizing gains from individual stock trading
• Selling appreciated investments to fund spending
• Receiving gains from other taxable investments
• Rebalancing a large taxable portfolio

In those situations, harvested losses may have an immediate use.

Now consider another investor who primarily owns broad-market ETFs, rarely sells anything, and doesn't regularly generate taxable capital gains.

Direct indexing may still generate losses.

But those losses may be much less valuable to that investor.

If total capital losses exceed capital gains, federal rules generally allow an individual to deduct up to $3,000 of net capital losses against other income each year, with unused losses carried forward to future years.

So generating a large capital-loss carryforward is not necessarily the same thing as receiving an immediate tax benefit.

Short-Term vs. Long-Term Gains Matter

The next question is what kind of capital gains you typically realize.

For federal tax purposes, gains and losses on investments held for one year or less are generally short-term, while those held for more than one year are generally long-term. Short-term and long-term gains and losses are calculated separately before being combined under the Schedule D rules.

This distinction matters because short-term capital gains are generally taxed at ordinary federal income-tax rates, while long-term capital gains may qualify for preferential federal rates.

That can make losses particularly valuable for an investor who regularly generates highly taxed short-term gains.

Morningstar identified the presence of Schedule D capital gains, and particularly short-term gains, as two factors that can increase the potential value of direct indexing.

Long-term gains can still be a very legitimate use case.

An investor who is gradually diversifying a highly appreciated concentrated stock position, for example, may have significant long-term gains every year. Harvested losses elsewhere in the portfolio can still reduce or defer some of the resulting tax.

For investors in states such as California, the benefit can also remain meaningful because state taxation may add materially to the cost of realizing capital gains.

But all else equal, deferring tax that would otherwise be imposed at a higher rate is more valuable than deferring tax at a lower rate.

Remember: Much of the Benefit Is Tax Deferral

This is an important concept that can be obscured by the phrase tax savings.

Suppose you purchased a stock for $100 and it falls to $80.

You sell it and realize a $20 capital loss.

You then reinvest the $80 into another investment so you remain exposed to the market.

You have created a $20 tax loss.

That loss may offset a gain elsewhere in your portfolio and reduce your current tax bill.

But you have also established a new investment with a new cost basis.

If that replacement investment subsequently appreciates and you eventually sell it, you may realize a larger taxable gain later.

The tax hasn't necessarily disappeared.

You may have moved it into the future.

That still has real economic value.

If you can defer a tax bill for many years, the money you didn't pay in taxes today can remain invested and potentially compound.

But when evaluating a direct-indexing proposal, it is important to distinguish:

Taxes avoided permanently

from

Taxes deferred until later.

That distinction becomes even more important when we get to the third question.

2. Will the Portfolio Continue Creating New Tax-Loss Harvesting Opportunities?

Direct indexing tends to have plenty of harvesting opportunities when investments are relatively new.

Suppose you invest $1 million into a direct-indexing portfolio today.

Some stocks rise.

Others fall.

The positions trading below their purchase prices can potentially be harvested.

But now imagine that the market appreciates significantly over the next decade.

Many of those stocks may eventually sit well above their original cost basis.

If a stock purchased for $50 is now worth $100, an ordinary 10% decline still leaves it far above its original cost.

There is no tax loss to harvest.

This is one reason the tax benefit of direct indexing can diminish as a portfolio ages.

New Contributions Can Refresh the Opportunity

Now consider someone who continually adds new money to the portfolio.

Perhaps they invest another $100,000 or $200,000 each year from compensation, bonuses, stock sales, or business income.

Every new contribution creates new tax lots at current market prices.

Those newer investments have higher and more recent cost bases.

If some of those stocks subsequently decline, there may be fresh losses available to harvest.

Morningstar identifies ongoing replenishment of the direct-indexing portfolio as an important factor in how effective the strategy can be.

That means there can be a meaningful difference between:

Investor A: Puts $2 million into a direct-indexing strategy once and leaves it there.

Investor B: Starts with $2 million but continues adding substantial new money every year.

Investor B may have a more renewable source of tax-loss harvesting opportunities.

This can make direct indexing particularly relevant for high-income investors who consistently direct new savings into taxable accounts.

Market Conditions Matter Too

Your contribution pattern isn't the only factor.

The market also needs to give you losses to harvest.

Consider a year in which the S&P 500 finishes roughly flat.

That does not mean every company in the index was flat.

Some stocks may have risen substantially while others declined.

Because direct indexing owns individual securities rather than a single ETF, the investor may potentially harvest losses from some of the declining stocks even when the overall index itself has not declined.

Periods with greater volatility and dispersion among individual stocks can therefore create more harvesting opportunities.

Long, broad bull markets can create the opposite environment.

If most of the portfolio has accumulated substantial gains, there may simply be fewer losses available.

Morningstar similarly identifies market volatility as one factor that can make direct indexing more effective for tax-loss harvesting.

So the second question is:

Will this portfolio continue receiving new money and creating meaningful losses to harvest over time?

3. What Eventually Happens to the Portfolio?

This may be the most overlooked part of the direct-indexing decision.

Suppose you use direct indexing for 20 years.

Over that period, you continually harvest losses and use those losses to offset gains elsewhere.

You have successfully deferred a significant amount of tax.

But something else may also have happened.

The stocks that performed well were generally not sold for tax losses.

Over time, those winners may accumulate substantial embedded capital gains.

Eventually, you have to ask:

What happens to those appreciated positions?

There are several possibilities.

You Eventually Sell the Portfolio

Suppose you reach retirement and gradually liquidate the portfolio to fund spending.

As appreciated securities are sold, the embedded gains become taxable.

Some of what appeared to be tax savings during the accumulation period may turn out to have been tax deferral.

Again, that does not make the strategy unsuccessful.

Deferring taxes for 10, 20, or 30 years can be valuable.

But it means that adding up all of the losses harvested over the years may substantially overstate the strategy's permanent tax benefit.

Morningstar specifically identifies whether the portfolio is measured before or after liquidation as an important variable, because tax-management strategies tend to appear more beneficial before the deferred gains are ultimately realized.

You Donate Appreciated Securities

The outcome may be different if charitable giving is part of your financial plan.

Rather than selling highly appreciated securities and donating the cash, an investor may be able to donate appreciated securities directly.

Depending on the circumstances and applicable tax rules, this can potentially avoid realizing the embedded capital gain while still providing a charitable deduction subject to the relevant limitations.

That can make some of the appreciated positions accumulated through direct indexing useful for charitable planning.

You Hold Assets for Life

The economics may also be different for assets that are held for life rather than sold.

Under current federal law, certain inherited assets may receive an adjustment to basis at death.

If that treatment applies, some gains that were deferred during the investor's lifetime may never result in capital-gains tax for the original owner.

Tax laws can change, so a long-term financial plan should not assume that today's rules will necessarily remain in place decades from now.

But the larger planning point remains:

The ultimate destination of the portfolio can materially affect the value of tax-loss harvesting.

A portfolio that will eventually be fully liquidated is different from a portfolio in which appreciated securities may be donated or held for the long term.

So the third question is:

Do you ultimately expect to sell these assets, or could some of them be held, donated, or passed to heirs?

Two Investors Can Get Very Different Results From the Same Strategy

Consider two hypothetical investors.

Investor A

Investor A is a high-income professional with:

• A large taxable portfolio
• A concentrated company stock position being gradually diversified
• Recurring taxable capital gains
• Significant new savings added to taxable investments each year
• A long investment horizon
• Charitable or estate-planning goals

Several characteristics work in favor of direct indexing.

There are recurring gains for harvested losses to offset.

The portfolio continues receiving new capital.

And some appreciated securities may never need to be sold during the investor's lifetime.

Investor B

Investor B has:

• Most investments inside retirement accounts
• A relatively small taxable portfolio
• Few realized capital gains
• Little new money being added to taxable investments
• A plan to sell taxable assets gradually to fund retirement

The same direct-indexing strategy could still harvest losses for Investor B.

But the economic value of those losses may be substantially smaller.

This is why asking whether direct indexing is "tax efficient" is not enough.

Its value is highly investor-specific.

Then Consider the Trade-Offs

Only after answering those three questions would we compare the potential tax benefit with the additional trade-offs of direct indexing.

Cost

A broad-market index ETF can often be owned very inexpensively.

Direct indexing typically involves an additional management or advisory cost.

The relevant question is therefore not whether direct indexing generates tax benefits.

It is whether the incremental after-tax benefit exceeds the incremental cost.

Complexity

Instead of owning one ETF, you may eventually own hundreds of individual securities with many tax lots and different cost bases.

This can make the portfolio more difficult to transfer, consolidate, or unwind.

The complexity may be manageable while the strategy is operating but become more visible when your financial situation changes.

Tracking Differences

Tax-loss harvesting can also require selling one security and purchasing another investment to maintain market exposure while complying with applicable tax rules.

The replacement is not necessarily identical to the security that was sold.

Over many transactions, those substitutions can cause the portfolio's performance to differ from the index it is intended to track.

The objective should therefore not be to maximize the number of tax-loss harvesting transactions.

It should be to improve after-tax, after-fee investment results while maintaining an acceptable portfolio.

Direct Indexing vs. an Index ETF

For many investors, the real alternative to direct indexing is simply owning a low-cost, tax-efficient index ETF.

An ETF offers:

• Simplicity
• Low cost
• Easy portability
• Straightforward tax reporting
• Close index tracking

Direct indexing can add:

• Security-level tax-loss harvesting
• Greater portfolio customization
• Potential coordination with concentrated positions
• More control over realizing gains and losses

Neither structure is automatically better.

The question is whether those additional capabilities have enough value for your particular financial situation to justify the additional cost and complexity.

When Can Direct Indexing Be Most Useful?

Direct indexing may deserve a closer look when several of the following are true:

• You have a substantial taxable investment portfolio.
• You regularly realize capital gains.
• Some of those gains are short-term or otherwise taxed at relatively high rates.
• You are in a high federal and/or state tax bracket.
• You continue adding meaningful amounts of new money to taxable investments.
• You have a long investment horizon.
• You are gradually diversifying a concentrated stock position.
• You may eventually donate appreciated securities or hold some assets for the long term.

The fewer of these conditions that apply, the more important it becomes to compare the incremental tax benefit with simply owning an inexpensive index ETF.

It is valuable when those losses solve a tax problem you actually have, and when the value of solving that problem exceeds the cost and complexity of the strategy.