Direct Indexing in Taxable Investment Accounts to Minimize Taxes

Written by: John Neri and Derek Melvin

When it comes to long-term investing, most conversations focus on portfolio allocation, diversification, and market returns. While those factors are certainly important, tax efficiency can be just as impactful for investors with significant assets in taxable brokerage accounts.

For high-income investors in particular, taxes can represent one of the largest drags on portfolio performance. Two strategies that can help improve after-tax returns are tax-loss harvesting and direct indexing.

These strategies are designed to help investors maintain market exposure while actively managing the tax impact of their portfolios.

Understanding Tax Loss Harvesting

Tax-loss harvesting is a strategy that involves selling investments that are temporarily down in value and replacing them with similar securities. The goal is to realize a capital loss that can be used to offset capital gains elsewhere in the portfolio.

These realized losses can:

Offset realized capital gains
Offset up to $3,000 of ordinary income per year
Be carried forward indefinitely if not used immediately

This allows investors to reduce their current tax liability while maintaining their long-term investment strategy.

For example, if an investor realizes $20,000 in capital gains during the year but harvests $15,000 in losses, only $5,000 of net gains may be taxable.

Tax management strategies can have a measurable impact over time. In one analysis of tax-managed portfolios, active tax management strategies generated an estimated tax savings of approximately 3.57% of account value in 2024 through loss harvesting and deferring gains (Source: SEI Systematic Core Strategies: 2024 year in review).

While markets often trend upward over long periods, they rarely move in a straight line. Short-term volatility can create opportunities to harvest losses even in broadly rising markets.

If you feel implementing tax-loss harvesting strategies would be beneficial in your investment portfolio, reach out to us and one of our financial advisors would be glad to connect to discuss those questions.

The Benefits of Deferring Capital Gains

In addition to harvesting losses, tax management strategies also seek to defer gains whenever possible.

This matters because of the difference between short-term and long-term capital gains rates.

Currently:

Short-term capital gains (assets held under one year) are taxed as ordinary income, with top rates reaching 40.8% including the Net Investment Income Tax
Long-term capital gains are taxed at a maximum rate of 23.8% including the NIIT

By deferring gains and extending holding periods when possible, investors can significantly reduce the tax burden on investment profits.

This is one reason why tax-aware portfolio management is especially valuable in taxable brokerage accounts.

What is Direct Indexing?

Direct indexing is an investment strategy that allows investors to own the individual securities within an index instead of buying a traditional index fund or ETF.

For example, instead of purchasing an S&P 500 ETF, a portfolio may hold many of the underlying stocks within the index directly.

This structure creates a key advantage:

It allows for tax-loss harvesting at the individual stock level.

In a traditional index fund, if the overall fund is up, there may be limited opportunities to realize losses.

But within an index composed of hundreds of stocks, some securities may decline even when the overall index is positive.

Direct indexing allows investors to harvest those individual losses while maintaining overall market exposure.

Reach out to one of our financial advisors for direct indexing options and next steps.

Why Direct Indexing Can Enhance Tax Management

Direct indexing can expand the opportunities for tax-loss harvesting because each stock position is treated individually.

This creates several advantages:

1. More Opportunities to Harvest Losses

Even in strong markets, individual stocks frequently decline.

Direct indexing allows investors to:

Harvest losses in underperforming stocks
Replace them with similar securities
Maintain broad market exposure

This creates ongoing opportunities to generate tax alpha.

2. Personalized Portfolio Construction

Direct indexing also allows for customization that traditional index funds cannot provide.

Examples may include:

ESG screens
Avoiding specific industries
Concentration management
Managing exposure to employer stock

This flexibility allows portfolios to better align with an investor’s personal preferences and tax situation.

3. Improved After-Tax Outcomes

Over time, tax-loss harvesting can create a bank of capital losses that may offset future gains.

This can be particularly valuable for investors who:

Have large taxable brokerage accounts
Receive equity compensation
Plan to sell concentrated stock positions
Are in higher tax brackets

While tax-loss harvesting does not eliminate taxes entirely, it defers them and reduces their impact over time, allowing more capital to remain invested.

When These Strategies May Make Sense

Tax-loss harvesting and direct indexing tend to be most effective for investors who:

Have meaningful assets in taxable brokerage accounts
Are in higher marginal tax brackets
Have ongoing taxable gains from portfolio activity or equity compensation
Plan to invest for many years

For smaller portfolios or tax-advantaged accounts such as IRAs and 401(k)s, the benefits are typically more limited.

The Bottom Line

Investment returns are only part of the equation when building long-term wealth. Managing taxes effectively can play a significant role in improving after-tax outcomes.

Strategies such as tax-loss harvesting and direct indexing allow investors to maintain diversified market exposure while actively managing the tax impact of their portfolios.

For investors with sizable taxable accounts, these strategies can provide an additional layer of value beyond traditional portfolio construction, helping to keep more of their investment returns working toward their long-term goals.

Feel free to get in touch with one of our advisors to see if direct indexing may be right for you!