Direct Indexing is one of the investing strategies that the wealthy are increasingly turning to. If I had heard of direct indexing before my 2024 fintech startup consulting gig, I would have assumed it meant investing directly in index funds, which is what most of us already do.
Buying individual stocks that comprise an index, as opposed to traditional index funds or exchange-traded funds (ETFs), is what is meant by “direct indexing,” though, as it is an investment strategy that gives investors more control over the composition and tax management of their customized portfolios by allowing them to directly own the actual securities that comprise the index.
To gain a better idea of what direct indexing is, let’s examine its advantages and disadvantages. Direct indexing is really just a fresh approach to client-facing packaging and marketing of investment management services.
For Whom Is Direct Indexing Appropriate?
High net worth people, those in higher tax brackets, or investors desiring more control over their portfolios and prepared to pay for the customization and tax benefits that come with it are the ideal candidates for direct indexing.
For instance, you may have strong preferences for your assets if you have a net worth of $20 million, are subject to a 20% long-term capital gains tax, and are in the 37% marginal income tax band. If both of your parents had a tobacco addiction and passed away from lung cancer before the age of sixty, you would never want to hold tobacco stocks.
Your portfolio might be tailored by an investment manager to closely track the S&P 500 index, with tobacco and tobacco-related stocks excluded. In order to reduce your capital gains tax obligation, they might also engage in tax-loss harvesting on a regular basis.
Direct indexing might not be worth the extra expense, though, if you are in a tax bracket where you pay no capital gains tax and you have no particular preferences for your assets.
This situation is comparable to the past, prior to the SALT cap being implemented in 2018, when the mortgage interest deduction was more beneficial for individuals in higher tax brackets. It is unclear if the $10,000 deduction maximum will be raised or removed from the SALT cap, especially considering how much it affects people who live in high-tax, high-cost areas.
Further Over Time, More People Will Have Access to Direct Indexing
Fortunately, the Direct Indexing approach is not exclusive to those with a $20 million net worth. You already have enough if you belong to the mass affluent class and have between $250,000 and $2 million in investable assets. More investors will have access to Direct Indexing as more fintech businesses increase the range of products they provide.
Direct indexing will soon be freely accessible to everybody who is interested, much as trading commissions gradually decreased to nothing. If only real estate commissions could move faster and more sensibly, too.
Investment Managers Who Provide Direct Indexing
You wish to participate because you think direct indexing has advantages. The several companies that provide Direct Indexing services are listed below, along with the starting charge and the minimal requirement to get started.
You can see that starting with as little as $100,000 at Fidelity and Charles Schwab, you can invest as little as $250,000 at J.P. Morgan, Morgan Stanley, and other classic wealth managers.
In the meantime, the initial charge, which varies from 0.20% to 0.4%, can be offset by the predicted increase in investment return from direct indexing tax management. Typically, the charge is added to the least cost of holding an index fund, exchange-traded fund (ETF), or stock ($0).
Having learned about the range of companies that provide Direct Indexing, let’s examine the tax management component in more detail. The advantages of customization and command are obvious: you establish your investing criteria, and your investment advisors will make every effort to adhere to them.
Comprehending Harvesting of Tax Losses
By offsetting capital gains with capital losses, tax-loss harvesting is a way to lower your taxes. Generally speaking, your tax liability increases with your income and wealth. We all want to rationally retain more of our hard-earned money rather than give it to the government. Furthermore, our desire to reduce taxes will increase in proportion to our disagreement with government policy.
It is possible to perform basic tax-loss harvesting on your own and it is quite easy. More sophisticated strategies become accessible as your income rises, resulting in capital gains taxes; these strategies frequently call for a portfolio management fee.
When to Apply Harvesting Tax Losses
In the aforementioned scenario, you would have to sell stocks at a loss during the same calendar year in order to offset $50,000 in capital gains. December 31st is the deadline for recognizing these losses, so they can be deducted from capital gains for that particular year.
For example, if you sold stocks in 2024 and lost $50,000, your 2023 gains would still be there even though you gained $50,000 in capital gains in 2023. When you file your taxes for 2023, the capital gains tax will still be applicable. You would have needed to sell equities in 2023 with losses of $50,000 in order to balance the gains in 2023.
Let us assume, however, that in 2024, you sold stock and realized a capital gain of $50,000. You might utilize capital losses from prior years to offset any gains, even if you had no capital losses in 2024. It is imperative that you keep precise records of these losses, particularly if you are handling your own investments. An investment manager you employ will keep track of and apply these losses on your behalf.
Important Tip: Capital Losses Are Carryoverable Forever
To put it another way, if capital losses haven’t previously been utilized to offset gains or lower taxable income in previous years, they can be carried forward indefinitely to offset future capital gains.
That was something I didn’t know for a while in my twenties. Erroneously, I thought that the annual carryover loss I could exclude from my income was limited to $3,000. I consequently paid hundreds of dollars in unnecessary capital gains taxes. I would have made substantial savings if I had a financial manager to help me with my assets.
Even though holding stocks for an extended period of time may be preferable, selling them periodically can assist in financing your intended spending. The goal of tax-loss harvesting is to reduce capital gains taxes, which will increase your total return and post-tax purchasing power. The benefits of tax-loss harvesting increase with your income tax bracket. Impact of Tax Brackets.
Impact of Tax Brackets and Direct Indexing
Your tax liability is directly impacted by your marginal federal income tax bracket. As you go into higher tax brackets, it becomes more profitable to shield your capital gains from taxes.
For example, if you are in the 37% federal marginal income tax rate and your household income is $800,000 (top 1% income), then a $50,000 short-term capital gain from selling Google stock would result in a $18,500 tax liability. On the other hand, a $50,000 long-term capital gain would include a $10,000 tax burden due to the 20% tax rate.
Let us now assume that you and your spouse have a middle-class salary of $80,000, which puts you in the federal marginal income tax rate of 12%. Selling Google stock would result in a $50,000 short-term capital gain and a $11,000 tax liability, which is $7,500 less than the $800,000 annual tax liability. A $50,000 long-term capital gain, on the other hand,would be subject to a 15% tax, or $7,500.
If you want to benefit from the lower long-term capital gains tax rate, try to hang onto your securities for more than a year. The examples show that direct indexing and its tax management solutions are more advantageous because your income increases with your tax liability.
Limitations and Guidelines for Harvesting Tax Losses
I think my examples make clear why tax-loss harvesting is advantageous. Tax-loss harvesting makes a lot of sense to increase returns for significant capital gains and losses. My memories of investing heavily and leveraging those losses to offset any future capital gains will never fade.
However, if you participate in a lot of transactions over the years, tax-loss harvesting can become quite difficult very quickly. You must choose which underperforming equities to sell before December 31st in order to reduce taxes and offset capital gains. At this point, it is more advantageous to have a wealth advisor handle your money.
The difficulty for do-it-yourself investors is having the time, expertise, and information necessary for successful investing. Let’s go over the essentials again to make sure you understand everything if you intend to participate in tax-loss harvesting.
