Direct Indexing: A Strategic Approach to Tax Loss Harvesting Throughout the Year

In the ever-evolving landscape of investment strategies, direct indexing has emerged as a powerful tool for investors seeking personalized portfolios and enhanced tax efficiency. Unlike traditional index funds or ETFs, direct indexing allows you to directly own the individual securities within an index. This ownership offers a unique advantage: the ability to perform tax loss harvesting throughout the year. 

Understanding Direct Indexing 

Direct indexing involves purchasing the individual stocks that make up an index, rather than buying a fund that tracks the index. This approach provides flexibility in managing your portfolio, enabling you to customize holdings to match your financial goals, risk tolerance, and ethical considerations. 

The Power of Tax Loss Harvesting 

Tax loss harvesting is a strategy that involves selling securities at a loss to offset capital gains and potentially reduce your tax liability. By leveraging the natural fluctuations in stock prices, you can strategically realize losses while maintaining your overall investment exposure. 

Here's how direct indexing enhances this strategy: 

1. Continuous Opportunities 

Unlike mutual funds or ETFs, which typically rebalance periodically, direct indexing allows you to continuously monitor and manage individual stocks. This continuous oversight provides more opportunities to identify and realize losses, making tax loss harvesting a year-round activity rather than a year-end scramble. 

2. Customized Loss Harvesting 

With direct indexing, you can tailor your loss harvesting to your specific needs. If certain stocks in your portfolio experience a decline, you can sell those specific stocks to realize the loss. You can then reinvest the proceeds in similar, but not substantially identical, securities to maintain market exposure and avoid wash sale rules. 

3. Optimized Tax Efficiency 

By actively managing tax loss harvesting throughout the year, you can optimize your portfolio's tax efficiency. This proactive approach can significantly reduce your taxable income, enhancing your after-tax returns. 

A Real-World Example 

Consider an investor with a direct indexing portfolio modeled after the S&P 500. Throughout the year, market volatility leads to fluctuations in the prices of individual stocks. By continuously monitoring these changes, the investor can identify stocks that have declined in value. 

In March, the investor sells shares of Microsoft (MSFT) at a loss of $5,000. To maintain market exposure, they purchase shares of Apple (AAPL), which operates in a similar sector. In July, another opportunity arises with Amazon (AMZN), leading to an additional realized loss of $3,000. By December, the investor has strategically harvested $8,000 in losses, significantly offsetting capital gains and reducing their tax liability.  

The more volatility there is in the market, the more opportunity there is to realize tax losses. We’ve seen $1 million portfolios that have been able to realize almost 50% of their portfolio value in losses over the last five years while still largely keeping up with the S&P500 from a performance standpoint. This can be incredibly lucrative, particularly because tax losses can be carried forward indefinitely to offset future gains, if you are expecting to incur meaningful capital gains in the future from the sale of a business, property or concentrated stock position. 

Implementation and Considerations 

While direct indexing offers substantial benefits, it requires a disciplined approach and careful monitoring. Here are a few considerations to keep in mind: 

• Transaction Costs: Frequent buying and selling can incur transaction costs if you use a broker that charges commissions for trades, which may erode the benefits of tax loss harvesting. Using a brokerage with low or no transaction fees can help mitigate this issue. 

• Wash Sale Rule: The IRS wash sale rule disallows a tax deduction if you repurchase the same or substantially identical security within 30 days before or after the sale. Ensure that your replacement securities are not considered substantially identical to avoid this pitfall. 

• Professional Guidance: Given the complexity of tax laws and investment strategies, working with a financial advisor can help you effectively implement and manage a direct indexing strategy. 

Conclusion 

Direct indexing represents a sophisticated approach to portfolio management, offering enhanced customization and significant tax benefits through year-round tax loss harvesting. By actively managing individual securities, you can strategically realize losses, optimize tax efficiency, and ultimately improve your after-tax returns. 

At Fortis , we specialize in tailoring investment strategies to meet the unique needs of our clients. Contact us today to learn how direct indexing can be integrated into your financial plan, maximizing your wealth and minimizing your tax burden.