Direct indexing may help investors reduce their tax bill by making market downturns work in their favor.
Unlike traditional ETFs or index funds, direct indexing allows you to own the individual stocks within an index, providing opportunities that may help you harvest losses throughout the year. Those harvested losses may be used to offset capital gains elsewhere in your portfolio or reduce up to $3,000 of ordinary income (Source: IRS).
Real Example: Turning Volatility into Value
A client of ours held a big position in a single tech stock with a large capital gain. To diversify while limiting the capital gains taxes, we built a direct indexing portfolio around it. Here’s what happened:
- As some holdings dipped during market pullbacks, we harvested capital losses and reinvested the proceeds into other stocks in an effort to track the index.
- We did this by selling stocks that were down and reinvesting the proceeds into similar stocks (example: Sell Coca Cola, Buy Pepsi).
- We sold down the concentrated stock gradually, staying within the client’s preferred tax budget
By year-end, they had a more balanced portfolio and a reduced tax liability, all while remaining fully invested in the market.
(Source: First Trust Direct Indexing)
Why It Can Work:
- Year-round tax-loss harvesting
- Customized tax budgets to manage gains exposure
- Exclude company stock to help avoid overlap or trading restrictions
- Potential for improved after-tax outcomes through tax-focused management
Market downturns are inevitable, but with direct indexing, they can become a powerful tool to potentially lower your taxes and improve your long-term net returns.
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