Built Right, Taxed Hard
“Buy a diversified index fund and hold it forever.” That’s a common piece of advice. And for many investors, it has proven to be an effective approach. Own the best companies in the world, don’t try to outsmart them, and give it time. If you’ve internalized that and actually followed through, you’ve had the opportunity to win the most important battle in investing. Many people never get that far.
But here’s what that advice doesn’t address. It tells you how to build the wealth. It doesn’t tell you how to keep more of it. For high-income investors, taxes might be the single largest expense of a lifetime, larger than everything else combined. Every dollar of growth in a taxable account is a dollar the IRS will eventually want a piece of when you sell.
There’s a way to own the exact same diversified basket of companies, with the exact same expected return, while systematically reducing that future tax bill along the way. It’s called direct indexing.
What You Will Learn From This Post
- For high-income investors, taxes may be your single largest lifetime expense. Standard index funds offer limited tools to manage them.
- Direct indexing lets you own the same diversified basket of stocks as an index fund, but as individual positions in a separately managed account – giving you access to losses (and gains) at the stock level, not just the fund level.
- Tax-loss harvesting through direct indexing works even in strong markets because individual stocks may decline within a rising index every year.
- Harvested losses accumulate as a capital loss carryforward on your tax return, ready to offset future capital gains from business sales, real estate transactions, or sales of concentrated stock positions dollar-for-dollar.
- The strategy also enables strategic charitable giving, allowing you to donate your most appreciated individual lots, which can reset the cost basis and create new harvesting opportunities.
- Direct indexing is most valuable for investors in taxable accounts who are committed to index investing and expect future taxable events. It is not relevant for tax-deferred accounts or very small taxable balances.
- Fees may run roughly 0.20–0.35% above those of a standard ETF, but the annual tax value generated typically exceeds that cost by a significant margin, and fees are likely declining.
Marcus is a good example of why this matters. He’s in his mid-40s and owns a regional logistics company that he built over 15 years. He and his business partner are selling the company in stages. The first tranche closed last year for $3.2 million in pre-tax proceeds. The remaining two tranches, expected to total another $5.5 million over the next seven to eight years, will look similar on paper and identical on his tax return. Marcus started this company with a pickup truck and a $40,000 SBA loan. He reinvested in the business every year, which raised his cost basis somewhat. Even so, fifteen years of growth means the vast majority of the sale price is gain.
Marcus took $2.5 million of the after-tax proceeds and invested it in a total market index strategy. Six months later, he’s up 8%, which feels great. But Marcus has a decade of known capital gains events ahead of him from the remaining business sale tranches. His index fund is doing exactly what it should. It’s growing. But it’s also building an embedded gain of its own, with no mechanism to capture it.
In a down year, his advisor harvests at the fund level by selling one fund and buying a similar one to capture the loss. That’s real value. But in the years when the market is up, and that’s most years, there’s no way to reach inside the fund and find the individual stocks that fell while everything else was rising. Those losses existed. They just weren’t accessible.
Marcus is a long-term equity investor, passively owning the market. What he doesn’t know is that the same philosophy, index, and long-term conviction, executed through a different structure, could have been building a tax asset for him from day one. In every market environment.
When the Tax Bill is Already on Its Way
Marcus’s situation isn’t unique to business owners. The same dynamic plays out any time someone knows they’ll face a significant tax bill in the future and has no way to build up offsetting losses in advance.
Consider the engineer sitting on $800,000 worth of her employer’s stock. She knows the position is too large. She knows she should diversify. But every time she runs the numbers on selling, the capital gains tax feels like a penalty for loyalty. She held because she believed in the company, and the company rewarded that belief. Now the same growth that proved her right is the reason she feels locked in. So, she waits. And every month she waits, the position grows larger, the concentration risk worsens, and the eventual tax bill grows. She’s not being irrational. She’s responding to a real cost. What she doesn’t have is a mechanism to reduce that cost before she acts.
The same logic applies to anyone preparing to sell appreciated real estate, or an investor approaching retirement who will eventually need to liquidate a taxable portfolio to fund spending. The pattern holds across all of them. Future taxable events are coming, and a standard index fund portfolio can only do so much to soften the impact.
An index fund bundles hundreds or thousands of stocks into a single security. That bundling is what makes it simple and accessible. It’s also what prevents you from doing anything with the individual pieces inside it.
What is Direct Indexing and How Does It Work?
Direct indexing has been around for decades, but until recently, it was cost-prohibitive for most investors. Technology and competition have changed that.
So, what is direct indexing? The easiest way to understand it is to start with what you already own. If you hold an S&P 500 index fund like VOO, you open your statement and see one line: VOO. But VOO isn’t one thing. It’s a wrapper around 500 individual companies. Pull up the fact sheet, and you’ll see what’s actually inside: Nvidia, Meta, Amazon, Apple, and on down the list, weighted by size. When you own VOO, you own all those companies. You just can’t see them or touch them individually.
Now imagine you got rid of VOO and instead purchased those same 500 companies, in the same proportions, shown as individual lines on your account statement. Same exposure. Same diversification. Same expected return. But now you own each company directly. That’s direct indexing.
The natural question is whether owning 500 individual stocks is more complicated than owning one ETF. It isn’t. The individual stocks are held in a Separately Managed Account (SMA). You own them directly, not as shares of a fund. The SMA manager handles the trading, rebalancing, and tax optimization. The investor doesn’t pick stocks, make trading decisions, or monitor individual positions. You still own the market. The added capability is entirely behind the scenes.
Direct Indexing and Tax Loss Harvesting
To understand what that added capability is, it helps to see tax-loss harvesting as a spectrum. Tax-loss harvesting is the practice of deliberately selling an investment at a loss to offset taxes on gains elsewhere.
At one end of the spectrum is the investor who holds through everything and never harvests. This is the most common approach among self-directed investors without advisory guidance. Losses come and go, and no one captures them.
In the middle is fund-level harvesting with a good advisor. When a fund or an entire asset class is down, the advisor sells it and buys a similar fund to maintain exposure while capturing the loss. This is real, valuable work. The limitation is that fund-level harvesting depends on entire funds or market segments being down, which limits the opportunities in years when markets are broadly positive.
At the other end of the spectrum is stock-level harvesting through direct indexing. Because the investor owns the individual stocks, the SMA manager can harvest losses from specific companies that are down even when the index as a whole is up. Same principle as fund-level harvesting, applied at a finer resolution.
How Loss Carryforwards Work and What It’s Worth
Systematic Tax-Loss Harvesting
In any given year, even a strong one, individual stocks within an index will decline. The SMA manager’s job is to find them. When a position drops, the manager sells it to realize the loss and immediately replaces it with a similar company to maintain the portfolio’s overall market exposure.
The investor is never out of the market. The portfolio still tracks the index. But a realized loss is now sitting on the investor’s tax return, waiting to offset a future gain.
This works because of the wash sale rule. If you sell a stock at a loss and repurchase the same or a substantially identical security within 30 days, the IRS disallows the loss. So, the SMA manager does something different. Instead of selling Lowe’s and buying Lowe’s back, they sell Lowe’s and buy Home Depot. Both are home improvement retailers with similar risk profiles. The portfolio’s exposure barely changes, but in the eyes of the IRS, those are two different securities. The loss counts.
Within a diversified index, replacement candidates are always available. And tracking 30-day windows for every lot, maintaining the portfolio’s overall index characteristics while swapping individual names, is exactly why this strategy lives inside a separately managed account with daily monitoring.
How much opportunity is there, even in strong markets? In 2021, the S&P 500 returned nearly 29%. A great year by any measure. But during that same year, 72 of those 500 companies were negative for the full period, and 91% of the index experienced a 10% or greater drawdown at some point before recovering. The losses were there. In VOO, you couldn’t get to them. In a direct-indexing portfolio, every one of them was a harvesting opportunity.
What Do Harvested Losses Actually Do?
Capital losses first offset capital gains dollar-for-dollar. That’s the most powerful application, because capital gains on a business sale, a stock liquidation, or a real estate transaction can be enormous. Losses beyond your gains in a given year can offset up to $3,000 of ordinary income, but that’s almost incidental. What matters is what happens to the remaining losses.
Unused losses don’t expire. They become a capital loss carryforward, a running balance on your tax return that grows every year the strategy is harvesting. The losses wait there, ready to offset future capital gains the moment they arrive.
If Marcus had used a direct indexing strategy, he wouldn’t just be reducing his tax bill in the years when his portfolio generated losses. He would be building a stockpile. When tranche two of his business sale closes, and he faces another seven-figure gain, that carryforward would be waiting to absorb it, dollar for dollar, before the IRS sees a cent.
There’s one more planning layer to understand. Those carryforwards die with the taxpayer. The direct-indexing portfolio’s appreciated positions, by contrast, receive a step-up in basis at death, meaning heirs inherit them at fair market value with no embedded gain. For investors thinking about their estate alongside their tax plan, that asymmetry matters. Use the losses while alive and let the appreciated positions pass to heirs with a clean basis.
Let’s go back to Marcus and what could have happened with a direct indexing strategy.
Marcus’s Loss Carryforward
| Portfolio: $2.5 million, invested in a direct indexing strategy |
| Annual growth rate: 8% |
| Annual harvested losses: 1.5% of portfolio value (conservative midpoint of the 1–2% range consistent with industry research across direct indexing providers). |
| Tax rate: 23.8% (20% federal long-term capital gains + 3.8% net investment income tax) |
| After 5 years: ~$220,000 in cumulative harvested losses. Tax value: ~$52,000. |
| After 10 years: ~$543,000 in cumulative harvested losses. Tax value: ~$129,000. |
Note: These figures assume no state capital gains tax. Investors in states with capital gains taxes see substantially higher value from the same harvested losses. In some states, the combined rate approaches or exceeds 30%, which means the same loss carryforward is worth meaningfully more.
Those aren’t hypothetical losses Marcus needs to manufacture. They’re the product of normal stock-level dispersion within a rising market. His portfolio still tracks the index. His expected return hasn’t changed. But over a decade, he’s accumulated more than half a million dollars in realized losses on his tax return, ready to absorb the capital gains from his next two business sale tranches dollar-for-dollar.
That $129,000 in tax savings didn’t require Marcus to do anything differently. He owns the same companies, in the same proportions, with the same expected return. The index investing philosophy didn’t change. The structure did.
In an up year, a standard index fund does one thing: it grows. In Marcus’s portfolio, those same years did two things: his balance grew, and so did his loss carryforward. That’s the scenario where direct indexing is doing something a standard index fund structurally cannot.
Now consider the engineer from earlier, sitting on $800,000 in employer stock she knows she should diversify. If she’s been building a loss carryforward in a direct-indexing portfolio alongside that concentrated position, the calculus on selling changes. The harvested losses absorb the gains from the sale, so the tax cost is no longer the reason she keeps holding a position she knows is too large. The loss carryforward doesn’t just save her money. It removes the barrier that was keeping her from making the right decision.
Tax-Efficient Charitable Giving
Because the investor owns individual stocks, each purchased at different times and prices, the portfolio contains a range of cost bases across hundreds of positions. Some lots have barely moved. Others have appreciated significantly. When the investor wants to give to charity or contribute to a donor-advised fund, they can strategically donate the most appreciated lots.
The math is straightforward. Donating a stock with a $10,000 cost basis that is now worth $50,000 avoids recognizing $40,000 in capital gains and provides a $50,000 charitable deduction. With a standard index fund, you can donate your most appreciated lot, but your selection is limited to the number of times you purchased the fund. With a direct-indexing portfolio holding hundreds of individual positions bought and replaced at different times, the range of cost basis is far wider. The investor has more options, more appreciated lots to choose from, and more precision in matching the donation to the tax outcome they want.
Replacing what you gave away creates a second benefit. When the investor donates appreciated lots and replenishes the portfolio with cash, the new positions enter at current market prices with a fresh cost basis. That reset creates new harvesting opportunities going forward, meaning charitable giving and tax-loss harvesting aren’t competing priorities in a direct indexing portfolio. They reinforce each other.
Customization
Since the investor owns individual stocks rather than a fund, the SMA manager can exclude specific companies, sectors, or industries from the portfolio. An investor with significant employer stock exposure can remove that company from the index to avoid doubling up on a position they already hold. Investors with values-based preferences can screen out specific industries without sacrificing broad diversification. This isn’t the primary reason most people consider direct indexing, but it’s a capability the ETF wrapper doesn’t offer.
What are the Criticisms of Direct Indexing?
Direct indexing costs more than owning an ETF. The fee premium is approximately 0.20–0.35% annually above a standard index fund. On a $2.5 million portfolio, that’s roughly $5,000 to $8,750 per year. Whether that cost is justified depends entirely on how much value the strategy is producing.
As time passes and markets advance, a direct indexing portfolio that isn’t receiving new contributions will eventually run out of losses to harvest. Every position in the portfolio will be held at a gain. At that point, the investor owns a portfolio of individual stocks with no remaining tax benefits while still paying fees higher than those of a standard index fund. The harvesting has stopped, but the fee premium hasn’t.
This is a real consideration, not a theoretical one. It matters most for investors who are no longer adding to the portfolio: someone who invested a one-time windfall and never contributed again, or a retiree in drawdown mode with no new capital coming in. Without fresh contributions bringing new cost bases into the portfolio, the harvesting opportunity shrinks over time.
The case for the strategy survives this criticism on two grounds.
First, in every year the portfolio is actively harvesting, bull markets and bear markets alike, the math clearly works in the investor’s favor. In the first half of 2022, when the S&P 500 fell nearly 20%, 454 of 500 companies were negative, and 81% experienced drawdowns of 10% or more. The strategy doesn’t need favorable conditions to produce value. The tax savings and the fee cost aren’t even playing the same game. The strategy could generate roughly 1.5% in annual tax value on a portfolio that’s paying a 0.30% fee premium. The benefit is five times the cost. And that’s in a year when the market barely cooperated.
Second, fees are declining. At the Schwab Impact 2022 conference, Schwab’s CEO called bringing direct indexing fees down to ETF-level pricing a priority. The fee trajectory across the industry is downward.
For investors with ongoing charitable giving intentions, the replenishment cycle described earlier provides a structural answer. Donating appreciated lots and replacing them with cash resets cost basis across those positions, keeping the portfolio producing new harvesting opportunities well beyond what a static, contribution-free portfolio would generate.
Direct indexing’s tax benefit is front-loaded. The first several years produce the most value, and the criticism that the benefit diminishes over time is accurate. For someone like Marcus, with a decade of known capital gains events ahead and two additional sale tranches still to close, the strategy is purpose-built for his situation. For other investors, the right question is whether the cumulative value generated during the active years, combined with a declining fee environment, justifies the strategy given their time horizon and expected taxable events.
Who the Direct Indexing Strategy Is for and How to Use It
Direct indexing isn’t for everyone. Here’s who it fits, who it doesn’t, and how it works in practice.
The strategy makes the most sense for investors with significant assets in taxable accounts who are already committed to index-based investing and who expect to face taxable events in the future.
Business owners with upcoming sales, like Marcus, are the clearest fit. So are equity compensation holders sitting on concentrated positions they need to de-risk; investors approaching retirement who will eventually liquidate appreciated taxable assets to fund spending; anyone selling appreciated real estate at a significant gain; and investors with ongoing charitable-giving intentions who would benefit from donating their most appreciated lots. In 2024, with the S&P 500 up 25%, 172 of those 500 companies still finished the year in negative territory. The pattern holds in strong markets. For anyone in a taxable account with a future gains event on the horizon, that’s the whole argument.
The common thread: a taxable account, an index-based philosophy, and a future where capital gains are coming.
Who this doesn’t make sense for is equally important. If your investments are primarily in tax-deferred accounts like a 401(k) or IRA, there’s no tax benefit to capture.
Withdrawals from those accounts are taxed as ordinary income regardless of what happened inside them, so harvesting losses at the individual stock level doesn’t change the tax outcome. Investors with small taxable balances may not generate enough harvesting value to justify the fee premium. Most advisor-accessible solutions require a minimum of around $250,000. Finally, investors with very short time horizons in their taxable accounts won’t accumulate meaningful losses before they need the money.
One thing makes the initial step easier? Direct indexing changes the mental model for deploying capital.
Before investing, Marcus can tell himself that if the market goes up, his portfolio grows while the strategy simultaneously builds a loss carryforward from the individual stocks that didn’t participate in the rally. If the market goes down, the strategy is harvesting losses at the individual-stock level, with finer granularity than fund-level harvesting could provide.
That’s not eliminating risk. It’s giving the investor a complete story for every scenario before they act, which is often the difference between committing capital and sitting in cash for another quarter.
Implementation of Direct Indexing
Implementation is simpler than it sounds. A direct indexing provider has discretionary authority over the separately managed account to execute trades. The account is held at the investor’s existing custodian, so there’s no change to account access or reporting. The strategy monitors the portfolio daily, capturing harvesting opportunities throughout the year rather than just at year-end.
Seeing hundreds of individual positions and regular trading activity can feel unfamiliar at first, but that activity is the strategy working, handling everything entirely behind the scenes. The investor’s day-to-day experience is effectively the same as owning an index fund. And once the initial investment meets the account minimum, ongoing contributions can be dollar-cost-averaged like in any other portfolio.
Fees, as discussed, range from approximately 0.12% to 0.50% depending on provider, with the incremental cost over a standard ETF strategy running roughly 0.20–0.35%. That range is moving downward. Direct indexing makes sense when the expected tax benefit exceeds the fee difference. That calculation differs for every investor, which is why it’s worth running before committing.
Marcus’s next decade (with the direct indexing strategy in play) looks like this. Same market exposure. Same long-term expected return. Same disciplined index-investing philosophy he’s followed for a decade. But now every market year is more productive. The up years generate growth and build a loss carryforward simultaneously. The down years are harvested at the individual-stock level with finer granularity than fund-level harvesting could provide.
When tranche two of his business sale closes, he has a loss carryforward ready to absorb the gains dollar-for-dollar. Marcus is still a long-term index investor. Direct indexing just means more of what that conviction earns actually stays.
The Real Work is in the Planning
Most investors spend their energy trying to outsmart the market. The ones who build real wealth usually figure out that was the wrong place to put the effort. Passively owning the world’s best companies doesn’t require much from you. What requires attention, and where the real work actually compounds, is the planning layer.
A business sale, a retirement, a real estate transaction, an equity compensation event. None of them arrives without warning. The investors who come out ahead aren’t the ones who react when the gain lands. They’re the ones who spent the years before preparing for it, building the tax offsets before the bill arrives rather than scrambling after. Taxes are arguably the single largest expense most high-income investors will face over their lifetime. Planning around them isn’t a technical exercise. It’s how the wealth that discipline builds actually gets kept. Direct indexing is one of the most powerful tools in that effort.
Frequently Asked Questions (FAQs)
An ETF like VOO holds hundreds of stocks inside a single wrapper – you see one line on your statement and can’t interact with the individual holdings. Direct indexing replicates the same exposure by purchasing each stock separately inside a Separately Managed Account (SMA). You own the same diversified market, but because each company is a distinct holding, your advisor can harvest losses from individual stocks that decline even when the overall index is rising – something structurally impossible inside a fund.
When a position in your portfolio drops in value, the SMA manager sells it to realize the loss and immediately replaces it with a closely correlated company. For example, selling Lowe’s and buying Home Depot. The portfolio’s overall market exposure barely changes, but the IRS recognizes the sale as a loss. That loss offsets capital gains elsewhere on your tax return. The key is that this opportunity exists nearly every year, even in strong ones, because individual stocks within an index regularly decline while the index as a whole advances.
When your harvested losses exceed your capital gains in a given year, the unused portion carries forward to future tax years indefinitely. It sits on your return as a running balance, ready to offset future gains dollar-for-dollar the moment they arrive. For someone who knows a large taxable event is coming (a second business sale tranche, a real estate sale, or a concentrated stock liquidation), building a loss carryforward in advance means the tax bill is already partially paid before it lands.
The direct indexing strategy is best suited for investors with meaningful assets in taxable accounts who follow an index-based philosophy and anticipate capital gains events in the future. Examples include business owners selling a company, employees diversifying out of concentrated employer stock, investors approaching retirement, or anyone selling appreciated real estate. It is generally not useful for tax-deferred accounts like IRAs or 401(k)s, where the harvesting benefit doesn’t apply, or for very small taxable balances where the fee premium isn’t justified. Most platforms require a minimum of around $250,000.
Fees typically run 0.12–0.50% annually, depending on the provider, with the incremental cost over a standard ETF strategy around 0.20–0.35%. On a $2.5 million portfolio, that’s roughly $5,000–$8,750 per year. The strategy is generally expected to generate approximately 1–2% in annual harvested losses, which, at a combined federal capital gains rate of 23.8%, translates to tax value well above the fee premium – often five times the cost or more in active harvesting years. Whether it’s worth it for your specific situation depends on your tax rate, portfolio size, and the capital gains events you expect.
Yes, and it’s one of the more overlooked benefits. Since your portfolio holds hundreds of individual positions potentially bought at different times and prices, you have a wide range of cost bases to choose from when donating. Gifting your most appreciated lots to a donor-advised fund avoids realizing the embedded gain and generates a charitable deduction at full fair market value. When you replenish those positions with cash, the new lots come in at current prices, creating a fresh cost basis and new harvesting opportunities. Charitable giving and tax-loss harvesting reinforce each other rather than compete in this structure.
Over time, if a portfolio isn’t receiving new contributions, every position will eventually be held at a gain, leaving less to harvest. This is a real limitation, particularly for investors who made a one-time investment and are no longer adding capital. That said, the strategy is front-loaded by design – the earliest years produce the most value, which is exactly when investors with near-term taxable events need it most. Ongoing charitable giving that donates appreciated lots and replaces them with cash can significantly extend the harvesting window. And as the industry likely continues to reduce fees, the bar for justifying the strategy lowers over time.
Disclosures: Golden Road Advisors LLC (“Golden Road Advisors”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Golden Road Advisors and its representatives are properly licensed or exempt from licensure.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
This information is general in nature and should not be considered tax advice. Investors should consult with a qualified tax consultant as to their particular situation.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The hypothetical examples used within this commentary are for illustrative purposes only and do not represent the performance of an actual client
Diversification does not ensure a profit or guarantee against loss. Hypothetical performance has inherent limitations and does not reflect actual trading or market conditions. Actual results may differ materially. This information is intended for financially sophisticated investors capable of evaluating the assumptions and risks involved. Additional information regarding the methodology and assumptions is available upon request.
