What Is Direct Indexing? Tax Benefits and Other Considerations

While it’s been around for nearly 20 years, the investment strategy direct indexing has grown in popularity recently due to its accessibility, customization, and tax benefits. Historically reserved for ultra-high-net-worth clients, the strategy has become more affordable, attracting a wider range of investors. Let’s discuss how the plan works and how it may benefit you.

What Is Direct Indexing?

Over the past 40 years, the investment landscape has come a long way, from buying individual stocks to using mutual funds and exchange-traded funds (ETFs) for diversification. Direct indexing takes investing one step forward, offering similar collective benefits of the previous strategies while adding customization capabilities and powerful tax benefits for taxable accounts. 

How Direct Indexing Works:

• Index Modeling: Rather than buying a mutual fund or ETF, the strategy allows you to choose which stocks you own, closely emulating a benchmark index, such as the S&P 500, but with fewer positions. 
• Automatic Tax-Loss Harvesting: Throughout the year, the strategy does tax-loss harvesting automatically, replacing lower-performing stocks with comparable stocks, so your overall investment strategy stays on track; for example, swapping Home Depot stock for Lowe’s. 
• Captured Capital Losses: When selling a stock that has lost value, you will realize a capital loss on paper, which can help lower your taxes. You can apply these losses to existing and future capital gains or as a deduction of up to $3,000 against ordinary income annually.1 Unused losses can be retained and applied in the future, as they don’t expire.

While there may be significant annual paper losses, never before has there been a strategy that allows you to realize those losses without simply losing money, in addition to offering savings and managing risk.

The Benefits of Direct Indexing

The benefits of direct indexing have made the strategy attractive to a range of investors.

• Tax Advantages: Tax savings are the primary benefit of direct indexing. While you book losses on paper, they are an excellent tool for offsetting existing or future capital gains. Since these losses never expire, you can apply them in many ways, including reducing concentrated stock with significant embedded gains or offsetting future taxable events like selling a property or business. 
• Customization: You can choose stocks based on your values and other preferences. For example, you can provide parameters about avoiding certain companies and industries, such as alcohol. You can also replicate one index or a combination of indexes to form a unique index that still offers a diversified mix of U.S. and international options.
• Passive Investing: When managed by a firm, the strategy occurs automatically with minimal client involvement, so you don’t necessarily have to closely monitor your portfolio or make daily decisions about selling or buying. While happening in the background, you still have control over which stocks to keep for personal reasons, even if the value declines.
• Comparable Index-Like Performance: The strategy typically moves in line with the markets, up or down, producing returns similar to the benchmark, with minor deviations.2 You don’t have to sacrifice your stock composition or performance, which you would have had with similar indexes, and can still stay in the market.

Risks and Other Considerations of Direct Indexing

Before choosing direct indexing, consider that the strategy can be complex and may not be suitable for every financial situation. Additionally, besides customization, it adds no extra benefits for certain savings vehicles, like retirement accounts. We recommend discussing these considerations with your financial advisor:

• Minimum investment to get started
• Management fees and trading costs
• Avoiding tax penalties
• Tracking errors or performance deviations from the benchmark

Direct Indexing with Monarch Wealth Strategies

One of our firm values is nimbleness, in which we use technology and innovation, like direct indexing, to remain flexible and help you reach your goals. Today, direct indexing is more accessible and affordable than ever, allowing clients to reduce risk and manage taxes while maintaining comparable returns. Contact our team if you’d like to explore this and other investment strategies. Monarch does not provide tax advice, so please consult your CPA or tax professional for in-depth guidance. 

Sources:

1. IRS. “Topic no. 409, Capital gains and losses.” IRS.gov. https://www.irs.gov/taxtopics/tc409. 
2. Investopedia. James Chen. “Tracking Error: Definition, Factors That Affect It, and Example.” Investopedia.com. September 16, 2024. https://www.investopedia.com/terms/t/trackingerror.asp.