A Tax-Focused Investment Strategy For More Than Just The Super-Rich

An index is a list of investments that represents a part of the market. The S&P 500, for example, is a list of the 500 leading large U.S. companies. An index fund is a single investment that mirrors that list, giving you a small stake in many companies through a single purchase. You own shares of the fund, and the fund owns the stocks. It is a convenient, often inexpensive way to spread your money around.

Direct indexing takes a different route toward a similar goal. Instead of owning one S&P 500 fund, you could own the 500 individual stocks making up that index. Both approaches would give you similar market exposure, but in one case your statement would show a single investment, the fund, and the other would show about 500 individual stocks.

When you buy a fund, which is often the simpler, more cost-effective approach, you have no choice about the underlying stocks in that fund. That's one potential advantage of direct indexing - you can choose which stocks to include upfront, and you can selectively buy and sell individual stocks rather than buying or selling the entire fund. For some investors, that flexibility can help reduce taxes or satisfy a particular investing need.

Once largely reserved for the very wealthy, this approach has become more accessible thanks to lower trading costs, software enhancements, and the ability to buy fractions of shares. Investors used to need $500,000 or more in a taxable account to access direct indexing, but these advances make direct indexing possible for accounts as small as $2,000. Whether it is worthwhile still depends on your needs and the costs involved, so let's consider the cases when it might make the most sense.

Tax Benefits

Direct indexing increases your opportunity to tax-loss harvest. Loss harvesting means intentionally selling an investment that is worth less today than you paid for it, so you can capture the capital loss. Those losses can offset capital gains, or if losses exceed gains, you can generally deduct up to $3,000 against ordinary income each year. Unused losses can be carried forward.

Imagine buying a stock for $10,000 and selling it for $8,000. The $2,000 loss can then be used to reduce your taxes, like taxes on other investment gains or even ordinary income.

To preserve the deduction, you must avoid buying the same or a substantially identical security within 30 days before or after the sale. Usually, when you sell one stock at a loss, you can buy a similar stock to replace it so your market exposure doesn't meaningfully change, even though you were able to capture a beneficial tax loss.

Oftentimes, while an entire part of the market, like the large US market represented by the S&P 500, will go up in value, it doesn't mean that every one of those 500 companies went up during that period. Owning the entire fund limits your ability to tax-loss harvest, because if the entire fund is up in value, there is no loss to harvest. Conversely, if you own the individual stocks, you can sell just the holdings that went down, capturing those individual losses.

Many direct indexing approaches are focused on harvesting as many losses as possible. Accumulating losses helps offset other taxes, which is particularly valuable if you have other investment gains, are in a high tax bracket, or have a particularly high tax year from selling an asset for a profit.

While most approaches focus on loss harvesting, a direct index portfolio also allows you to identify the holdings that have appreciated the most. You may choose to use those shares for charitable giving, which allows you to avoid the capital gain on those shares. This is another means of using direct indexing in a tax-advantaged way.

Diversification

Taxes are only part of the story. The flexibility to buy the individual stocks in an index can also help with diversification.

Let's say you already own a lot of Apple stock. Maybe you received it as compensation for work or from an inheritance. If you then buy an S&P 500 fund, you are buying even more Apple stock, because Apple is one of the companies in that index. That further increases your concentration risk by putting more eggs into the same basket.

With a direct index portfolio, you could buy the 499 other companies in the S&P 500 and leave out Apple. You would still get the broad diversification of investing in a lot of different companies, while avoiding putting more money into Apple, which you don't need.

You also may have other reasons to leave out a particular company, or entire sector from your portfolio. You may want to exclude certain companies or industries from your portfolio that don't align with your values. When you buy a fund, you can't extract these companies, but when you buy a direct index portfolio, you can specify what you want left out.

Anytime you leave an investment or sector out of the portfolio, it changes your risk profile, so it's important to consider that before making changes.

Costs

Direct indexing usually costs more than a low-cost index fund, though it is becoming more affordable all the time. It's important to weigh the additional costs against the potential tax or diversification benefits.

For example, for a portfolio of $500,000, an extra 0.25% fee for direct indexing would cost $1,250 annually. The benefits would need to be more valuable than that in order for a direct index portfolio approach to make sense.

Custodians like Altruist are offering direct indexing at costs that are more commensurate with their index fund counterparts, making it easier to overcome the costs with tax and other benefits.

Are You A Candidate for Direct Indexing?

Direct indexing deserves consideration if you have taxable investments, meaningful gains to offset, and are in a high tax bracket. It works best when you can move new money into the direct index portfolio, rather than selling investments you already own, which may generate taxable income.

It's also worth considering if you own a meaningful portion of your portfolio in one stock and want to avoid adding more money into it. Likewise, if you have important values criteria that you want reflected in your portfolio, direct indexing may be worth a look.

The case may be weaker if most of your savings are in retirement accounts, you have few taxable gains, your applicable tax rate is low, or switching would create a large tax bill. It may also be a poor fit if you need the money soon or prefer simple account management.

The useful starting question is what you need your investments to accomplish. A straightforward index fund remains a reasonable answer for many people. But if direct indexing solves a real problem in your financial life, and its potential benefits justify the costs, it can be an attractive tool to implement with a portion of your portfolio.