Tax-Loss Harvesting Through Direct Indexing

Direct indexing is an investment strategy where the underlying stocks that comprise an index, like the S&P 500, are purchased instead of an ETF or mutual fund tracking the index. Tax-loss harvesting is a strategy of selling securities at a loss. Losses can offset capital gains or be carried forward as a tax asset to future years.

Using direct indexing for tax-loss harvesting can optimize after-tax returns because losses on individual stocks can be isolated and harvested, even when the entire index has gains. Although not right for every situation and investor, in the right circumstances, tax-loss harvesting with direct indexing can be a winning strategy.

What Is Direct Indexing?

Many direct indexing strategies track the S&P 500. So instead of buying SPYSPY or another ETF or mutual fund that tracks the index, in many cases an investor would set up a separately managed account (SMA) and buy a basket of stocks in the S&P 500 that are intended to mimic the index. This may be less than 500 stocks. The custom 'basket' of securities should remain as close to the S&P 500 as possible, within an acceptable drift, called tracking error.

Aside from tax-loss harvesting, direct indexing allows investors to customize their holdings, for example, to exclude or screen specific companies or sectors.

Integration With Tax-Loss Harvesting

Tax-loss harvesting works by selling securities at a loss. So if there are no losses, there's nothing to harvest. The last few years illustrate how direct indexing can improve on a tax-loss harvesting strategy that only uses funds to harvest losses.

Consider the S&P 500's total return was 18% in 2025, 25% in 2024, and 23% in 2023. So in most cases, no opportunity to harvest losses. However, according to The Wall Street Journal using data from S&P Global, over 180 stocks within the S&P 500 were down each year on average during this time period.

When that happens, stocks that have losses can be sold and replaced with similar names. Harvesting losses can offset realized capital gains, plus up to $3,000 against ordinary income. Remaining unused losses can be carried forward indefinitely to offset capital gains.

Estimating Tax Savings

Vanguard estimates that a $1,000,000 cash investment in the S&P 500 would yield $385,000 in cumulative losses between 2015 and 2024. During this time, using the highest federal and state tax rates, they estimate the annual tax alpha generated by harvesting losses to be .85% per year in federal capital gains tax savings. For reference, in a high tax state like California, the annualized tax alpha (inclusive of federal tax savings) rises to 1.2%.

When Using Direct Indexing For Tax-Loss Harvesting Is Most Advantageous

Investors with one or more of the following factors may benefit from tax-loss harvesting with direct indexing:

• To bank losses in the years leading up to a business sale
• Early in the calendar year when expecting a large taxable windfall or liquidity event from an IPO or acquisition
• To offset gains from diversifying a concentrated stock position
• When new cash is added to the direct indexing portfolio at least annually (to buy more stocks). The best opportunity for harvesting losses is typically within the first 12 months of the initial investment. Without ongoing contributions, this strategy may only be effective for harvesting losses for a period of time
• You are in the highest tax brackets (federal and state) and expect to be for the next few years

Although not necessarily tied to harvesting losses, direct indexing can be a good strategy to reduce exposure to a concentrated holding through sector/industry screens and company exclusions.

Caveats And Other Considerations

• Fees. Unlike when you buy an ETF or a mutual fund, there is no expense ratio on the purchase of a stock. However, asset managers charge a fee to run the strategy, which could be more than the cost of an index fund tracking the index.
• Minimums. Many asset managers have account minimums for SMAs. Although this has come down in recent years, it may limit options for investors with more modest investment portfolios.
• Timing is everything. The tax savings will be different for every investor's unique circumstances. But even the same investor will have different results depending on the financial markets, especially the first year. For example, Vanguard's calculator estimates the tax alpha to be nearly 2.3% per year for an investor in the strategy between 2008 and 2017, due to the financial crisis. And that's only considering federal tax savings.
• Exit plan. Because on average, over time, we expect the stock market to produce positive returns, this strategy won't work in perpetuity without continual funding. So at some point, investors will have an account with hundreds of stocks with embedded gains. Although most platforms allow stocks to be transferred out of the SMA, without the support of an investment advisor, it may be challenging to manage so many holdings.

Is Direct Indexing Worth It?

Maybe, maybe not. It depends on many factors unique to your personal circumstances, projected situation, and goals. It’s also worth noting that the direct indexing example described here is 100% U.S. equity. So it's important that assets balance out the portfolio to maintain a diversified portfolio according to your risk profile. Consider speaking with your tax and financial advisor about the pros and cons of adding direct indexing and tax-loss harvesting to your strategy.