Most investors are familiar with mutual funds or exchange-traded funds (ETFs) that allow individuals to invest in a group of stocks which often track a specific index, such as the S&P 500 index, without having to purchase each stock individually. These funds allow the average investor to efficiently diversify their portfolio and track a desired index.
One challenge that arises when purchasing mutual funds or exchange-traded funds is that the investor doesn’t have access to the underlying holdings within the fund. All decisions to buy or sell underlying holdings are made by the fund manager for the fund as a whole. This reduces the flexibility and planning options to the individual investors.
In recent years with improvements in technology and the reduction of trading costs, a new option called direct indexing can provide significant value to investors.
What is Direct Indexing?
Similar to many mutual funds or exchange-traded funds, direct indexing seeks to replicate a specific index, but instead of owning a share of a mutual fund that tracks the index, direct indexing allows the investor to own each individual stock that makes up the index in the correct proportion to the underlying index.
For example, let’s assume an investor would like to track the S&P 500 index. Instead of purchasing a mutual fund or exchange-traded fund such as the Vanguard S&P 500 ETF that tracks the index, a direct indexing approach would actually own all 500 stocks that make up the index.
Purchasing and monitoring all the stocks in an index can be a very time-consuming and costly process which is why direct indexing historically has been an option available only for investors with very significant account balances. However, as technology has improved and trading costs have declined, direct indexing is now available to many additional investors.
Key Takeaway:
Direct indexing allows the investor to own each individual stock that makes up an index in the correct proportion to the underlying index.
Why is Direct Indexing Beneficial?
Before discussing the specific benefits of direct indexing, it is important to note that the benefits of direct indexing are directly tied to tax efficiency. Because of this, direct indexing occurs in taxable accounts (i.e. regular brokerage investment accounts).
Retirement accounts such as 401(k)s, Traditional IRAs, or Roth IRAs are not a good fit for direct indexing because the underlying tax savings that direct indexing can provide are eliminated by the tax-deferred/tax-free nature of retirement accounts. Accordingly, all discussion of direct indexing assumes the strategy is implemented in a taxable account.
Within a taxable account, there are multiple strategies that direct indexing can help facilitate including tax-loss harvesting, gifting appreciated stock to charity, or achieving a stepped-up basis. Further, direct indexing can help facilitate other important goals for clients such as diversifying out of concentrated stock positions in a tax-efficient manner.
Key Takeaway:
Direct indexing within a taxable account increases an investor’s ability to implement various tax reduction strategies such as tax-loss harvesting, gifting long-term appreciated stock to charity, and achieving a stepped up basis for heirs.
Tax-Loss Harvesting with Direct Indexing:
To start, let’s consider how direct indexing facilitates tax-loss harvesting. Tax-loss harvesting is a strategy where an individual sells a position that has decreased in value, allowing them to recognize a capital loss for tax purposes.
These capital losses can then be used to offset other capital gains or up to $3,000 ($1,500 if married filing separately) of ordinary income on the taxpayer’s tax return. If the capital losses are significant enough that they offset all capital gains in a given year and still exceed the $3,000 that is allowed against ordinary income, the remaining capital loss is carried forward to future years.
While it is possible to take advantage of tax-loss harvesting with a mutual fund or ETF that has declined in value, there is much less flexibility given the position to be bought and sold is the mutual fund or ETF as a whole which represents the weighted average return of the underlying positions.
Alternatively, a direct indexing strategy will track the underlying index, but the investor still has access to each individual position. This allows each underlying position to be bought and sold as necessary to facilitate the individual’s financial needs.
In the context of a tax-loss harvesting scenario, this can generate tax losses even in years when the index performs well given some of the underlying positions will still decline in value even though, on average, the index performed well.
To demonstrate, let’s consider an example. We’ll assume a married couple has $1,000,000, and they decide they want to invest in Mutual Fund XYZ which holds ten different stocks, and each stock initially makes up 10% of the mutual fund.
In the first year of holding this mutual fund, they received a total return of 7.30%. However, even though the total return was 7.30%, the return of each stock held within the mutual fund varies as shown in the chart below.
Note: The example above is intended to demonstrate the concept of direct indexing and is not a guarantee of future returns or any assurance of gains or losses. Direct indexing overall performance and available tax-loss harvesting results will vary depending on future market returns which are unknown.
If the couple had implemented a direct indexing strategy tracking these same 10 companies instead of purchasing Mutual Fund XYZ, they would have the flexibility to tax-loss harvest the positions that declined in value (Stock 2, 4, 6, and 8) and realize a capital loss of $100,000 while still achieving the same overall positive 7.3% return of the index.
Assuming they have capital gains from other investments, the $100,000 capital loss from direct indexing can reduce their other capital gains by $100,000. Assuming their capital gains are long-term, they are in the top federal capital gains tax bracket of 20%, and also owe the net investment income tax as well as 5% in state taxes, these capital losses would reduce their tax bill by $28,800.
If they don’t have other capital gains, they can use $3,000 of the loss against their ordinary income and carry forward the rest until they do have capital gains to offset.
While tax-loss harvesting can create significant savings by itself, it is extremely powerful when paired together with additional strategies such as tax-efficiently exiting a concentrated stock position, facilitating charitable giving, or implementing a stepped-up basis strategy.
Let’s first consider how direct indexing can be used to help diversify out of highly appreciated, concentrated stock positions. Imagine an individual who has a significant equity position in their employer’s stock through stock awards or employee share purchase plans.
Typically after a long career, the stock is highly appreciated and would result in significant capital gains if sold. With a direct indexing strategy, an individual can generate significant tax losses (while still receiving the overall index return) and use those losses to offset the capital gains generated from liquidating the highly appreciated position.
A similar example where direct indexing often makes sense is an individual who has a highly appreciated asset such as a closely held business or a piece of real estate with a low tax basis.
Assuming they plan to sell the asset at some point in the future, they could begin a direct indexing approach to start banking up tax losses (i.e. unused tax losses can be carried forward to future tax years) to be used against the capital gain in the future.
Key Takeaway:
Tax-loss harvesting is a strategy where an individual sells a position that has decreased in value allowing them to recognize a capital loss for tax purposes.
Wash Sale Rule: Important Consideration
One nuance to consider with tax-loss harvesting is the wash sale rule. The wash sale rule states that if an individual sells a security at a loss and purchases the same security or a substantially identical security within 30 days before or after selling the security, the capital loss will be disallowed.
The IRS has provided minimal guidance on what is considered a substantially identical security, but they do give some insight in IRS Publication 550:
“Ordinarily, stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation.”
However, before this statement they also state:
“In determining whether stock or securities are substantially identical, you must consider all the facts and circumstances in your particular case.”
While the wash sale rule must be evaluated on a case-by-case basis, generally selling the stock of one corporation and purchasing the stock of another corporation should avoid the wash sale restrictions.
With this in mind, a direct indexing approach will typically tax-loss harvest one position and buy a similar position (i.e. sell Coca-Cola Co and buy PepsiCo Inc) to ensure the investor remains in the market until the 30-day wash sale requirement passes and the original security can be repurchased.
While holding a different position to satisfy the 30-day wash sale requirement can result in a small amount of tracking error, generally across the entire portfolio it is possible to still closely track the overall index.
Key Takeaway:
The wash sale rule must be closely followed to ensure harvested losses are not disallowed on the investor’s tax return.
Gifting Appreciated Stock to Charity:
While tax-loss harvesting is one of the major benefits of direct indexing, another benefit for individuals who are charitable is the ability to gift long-term appreciated positions directly to charity and avoid tax on the appreciation.
Often individuals facilitate their charitable contributions by giving cash or writing a check to the charity. However, a more tax-efficient method to facilitate charitable giving is by gifting appreciated stock that has been held for more than one year.
When gifting appreciated stock to charity, the individual gifting the stock avoids paying any capital gains tax on the appreciation that occurred while they owned the stock. In addition to not paying any capital gains tax, the individual is also allowed to claim the full fair market value of the gift as an itemized deduction.
Similar to tax-loss harvesting where having access to the underlying positions that declined in value provided flexibility to lock in tax losses, individuals who are charitable have the added benefit of having direct access to the positions with the largest increases in value which they can gift directly to charity without having to pay taxes on the gains.
To show the value and tax savings of giving appreciated stock to charity, let’s assume a married taxpayer wants to make a $20,000 charitable contribution in 2025 and a long-term position within their direct indexing account has increased in value from $10,000 to $20,000.
The taxpayer can give this position to a charity of their choosing and avoid paying capital gains taxes on the $10,000 gain as shown in the graph below.
Assuming they are in the top capital gains tax bracket of 20%, have a state tax rate of 5%, and are subject to the net investment income tax of 3.8%, they would have owed $2,880 in capital gains tax if the shares were sold as shown below.
In addition to avoiding this capital gains tax, the taxpayer would also be able to claim the full charitable contribution of $20,000 as an itemized deduction. Assuming they are already itemizing their deductions and are in the 37% federal and 5% state ordinary tax brackets, they would save an additional $8,400 in taxes from the itemized deduction resulting in total tax savings of $11,280.
After all the tax savings, the $20,000 charitable gift would only cost the couple $8,720. Thus, they would save 56% of their charitable contribution in taxes, and the after-tax cost of the gift would only be 44% of the total amount given to the charity.
Key Takeaway:
Direct indexing provides the opportunity to select long-term positions with the most appreciation for charitable giving which maximizes the tax benefit of gifting appreciated stock.
Stepped-Up Basis:
In addition to gifting long-term appreciated positions to charity, direct indexing also provides the ability for individuals to implement a stepped-up basis strategy which can be a valuable tool for those interested in creating generational wealth.
A stepped-up basis strategy involves investments held in a taxable investment account. When these investments are held for life and are passed on to heirs upon the death of the owner, the tax basis of the investments are stepped up to the fair market value on the date of death. This allows heirs to sell the inherited property and pay no taxes on the appreciation that occurred during the original owner’s lifetime.
In the context of direct indexing, this provides the taxpayer with the opportunity to benefit no matter what happens. First, for individual positions that go down, the taxpayer can harvest the losses to reduce their tax burden now. Second, for individual positions that go up, the taxpayer can hold those positions for life and obtain a stepped-up basis avoiding tax on the appreciation.
To show how this works, let’s assume the couple discussed above who invested $1,000,000 implements the direct indexing strategy for the last 20 years of their lives and their investments appreciate in value by 7% per year.
If the couple sold the appreciated positions throughout their lifetime, they would have to pay capital gains tax on the growth which ultimately reduces the after-tax return they would achieve. Assuming they are in the top capital gains tax bracket of 20%, have a state tax rate of 5%, and are subject to the net investment income tax of 3.8%, their after-tax appreciation would be 4.98%.
However, as demonstrated in the table below, by implementing a stepped-up basis strategy and passing the appreciated positions on to their children, they would avoid paying any capital gains taxes allowing them to realize the full 7% annual appreciation which is an increase in the overall return of over 2% per year.
Note: This example includes the simplifying assumption that all returns are capital gains and there are no dividends. In reality, a small portion of the return would be dividends which would be taxed when received under either approach. Accordingly, the example above reflects specifically the capital gain portion of the long-term returns.
As shown in the chart below if they invested $1,000,000 and implemented the stepped-up basis strategy receiving a 7% rate of return over the last 20 years of their lives, the account would grow to $3,869,684. If they didn’t implement a stepped-up basis strategy and only achieved a 4.98% after-tax return, the account would grow to $2,645,223 after paying all the taxes due.
Thus, a stepped-up basis strategy would add over $1,200,000 of value and would allow the couple to pass this additional value on to their children.
Key Takeaway:
A stepped-up basis strategy provides the taxpayer the opportunity to pass the most highly appreciated positions on to their heirs and avoid capital gain taxes on all the appreciation that occurs during their lifetime.
Conclusion:
With technology continuing to advance and more custodians offering zero trade commissions on stocks, direct indexing is becoming a tool that is available to more investors.
Direct indexing offers the ability to invest in a particular index while providing additional flexibility that mutual funds and ETFs can’t provide. By holding each of the underlying positions of an index, individuals are able to increase their overall tax efficiency through tax-loss harvesting, gifting appreciated positions to charity, and implementing a stepped-up basis strategy for the next generation.
Combined, these opportunities can result in substantial tax savings over the course of a lifetime and can provide attractive ways to diversify out of highly concentrated positions and offset large capital gains from selling closely held businesses or real estate.
While direct indexing isn’t right for everyone, in the correct situations it can be very powerful. For individuals who are interested in learning more about direct indexing and or would like to determine the best approach for reaching their long-term goals, we would love to connect to see if what we do is right for you.
