Tax Advantages and Risks of Direct Indexing

Index exchange-traded funds (ETFs) and mutual funds are popular low-cost choices for building a diversified portfolio, providing access to dozens or hundreds of securities within a single investment. But for investors with larger portfolios, these funds leave something on the table when it comes to taxes—namely, losses within the fund's holdings cannot be used to offset realized capital gains (a strategy known as tax-loss harvesting).

In contrast to this limitation in index funds, direct indexing combines the hands-off approach of index investing with the opportunity to strategically realize losses over time—the better to manage your tax exposure.

With direct indexing, rather than holding a single pooled fund that invests in the securities that make up an index, you hold the individual securities themselves. As a result, portfolio managers who oversee the account on your behalf can choose to sell the laggards that inevitably occur—even in an otherwise banner year—to offset gains elsewhere in your portfolio.

For example, in 2024—a year in which the Schwab 1000 Index^® returned almost 25%—433 stocks in the index lost value, each one an opportunity to potentially lower your tax burden.

What's more, losses realized through tax-loss harvesting can be used to offset up to $3,000 a year in ordinary income, with any surplus losses carried forward to offset gains or income in future tax years until the loss is fully accounted for. If you anticipate a large capital gain—say, from the future sale of an investment property—you might even choose to strategically realize and "bank" extra losses in the years leading up to the gain in order to partially or fully offset it.

According to the Schwab Center for Financial Research, tax-loss harvesting could generate an additional 1 to 2 percentage points of after-tax returns, depending on your situation.

Those who could stand to benefit most from tax-loss harvesting include:

• High-net-worth investors: Individuals in the top federal tax brackets could face short-term capital gains rates as high as 40.8% and long-term capital gains rates as high as 23.8%. Those who live in states that tax capital gains at the same rate as ordinary income—such as California, Minnesota, New York, and Oregon—could see an added tax advantage from tax-loss harvesting.
• Investors with ample capital gains: These include longtime investors who own highly appreciated assets that will potentially generate significant capital gains when sold—as well as those who regularly realize profits from other parts of their portfolio, such as active traders or company executives who periodically liquidate their stock allotments.

Philanthropically minded investors may also find direct indexing attractive. Because they own the individual securities, they can selectively donate those that have appreciated the most, thus maximizing both their donation and the potential tax deduction while also avoiding any capital gains taxes that might have resulted from a sale.

Those who want to avoid overconcentration in or exposure to a particular stock or industry may also benefit, since another feature of direct indexing is the ability to exclude a certain number of stocks from a given index.

While the tax benefits are compelling, there are potential downsides. Tax-loss harvesting involves certain risks, including unintended tax implications. In addition:

• Higher costs: The fees for direct indexing typically run between 0.30% and 0.40%—as opposed to 0.20%, on average, for garden-variety ETFs and mutual funds.
• Higher minimums: While traditional ETFs and mutual funds typically have no or very low minimum investments, most direct indexing solutions have a capital requirement of $100,000 or more.
• Diminishing tax benefits: The potential for tax-loss harvesting can decline over time as portfolios mature and stock values rise. In a portfolio that's been held for years and has appreciated significantly, most stocks will likely have gains, which limits the ability to harvest losses.

That said, if you're comfortable with the added complexity and cost, direct indexing could be a smart way to elevate your investment strategy and achieve more-tailored, tax-efficient returns.