Index exchange-traded funds (ETFs) and mutual funds are popular low-cost choices for building a diversified portfolio, providing access to dozens or hundreds of securities within a single investment. But for investors with larger portfolios, these funds leave something on the table when it comes to taxes—namely, losses within the fund's holdings cannot be used to offset realized capital gains (a strategy known as tax-loss harvesting).
In contrast to this limitation in index funds, direct indexing combines the hands-off approach of index investing with the opportunity to strategically realize losses over time—the better to manage your tax exposure.
How does it work?
With direct indexing, rather than holding a single pooled fund that invests in the securities that make up an index, you hold the individual securities themselves. As a result, portfolio managers who oversee the account on your behalf can choose to sell the laggards that inevitably occur—even in an otherwise banner year—to offset gains elsewhere in your portfolio.
For example, in 2024—a year in which the Schwab 1000 Index® returned almost 25%—433 stocks in the index lost value, each one an opportunity to potentially lower your tax burden.
Weeds among the roses
With direct indexing, even when an index as a whole is up, individual stocks that are down can be sold to help offset realized gains.
Source: Bloomberg.
Information taken from the Schwab 1000 Index and represents holdings as of the last trading day in December of each year. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly.
What's more, losses realized through tax-loss harvesting can be used to offset up to $3,000 a year in ordinary income, with any surplus losses carried forward to offset gains or income in future tax years until the loss is fully accounted for. If you anticipate a large capital gain—say, from the future sale of an investment property—you might even choose to strategically realize and "bank" extra losses in the years leading up to the gain in order to partially or fully offset it.
Lemonade out of lemons
A hypothetical investor who realized $25,000 in short-term capital gains and $40,000 in capital losses could use tax-loss harvesting to cut down their tax bill—this year and in future years.
Source: Schwab Center for Financial Research.
Assumes a 32% combined federal/state marginal income tax bracket, with short-term capital gains taxed at ordinary income tax rates. The example is hypothetical and only for illustrative purposes. It is not intended to represent a specific investment product and the example does not reflect the effects of fees.
Who could benefit?
According to the Schwab Center for Financial Research, tax-loss harvesting could generate an additional 1 to 2 percentage points of after-tax returns, depending on your situation.
Those who could stand to benefit most from tax-loss harvesting include:
- High-net-worth investors: Individuals in the top federal tax brackets could face short-term capital gains rates as high as 40.8% and long-term capital gains rates as high as 23.8%. Those who live in states that tax capital gains at the same rate as ordinary income—such as California, Minnesota, New York, and Oregon—could see an added tax advantage from tax-loss harvesting.
- Investors with ample capital gains: These include longtime investors who own highly appreciated assets that will potentially generate significant capital gains when sold—as well as those who regularly realize profits from other parts of their portfolio, such as active traders or company executives who periodically liquidate their stock allotments.
Philanthropically minded investors may also find direct indexing attractive. Because they own the individual securities, they can selectively donate those that have appreciated the most, thus maximizing both their donation and the potential tax deduction while also avoiding any capital gains taxes that might have resulted from a sale.
Those who want to avoid overconcentration in or exposure to a particular stock or industry may also benefit, since another feature of direct indexing is the ability to exclude a certain number of stocks from a given index.
What are the drawbacks?
While the tax benefits are compelling, there are potential downsides. Tax-loss harvesting involves certain risks, including unintended tax implications. In addition:
- Higher costs: The fees for direct indexing typically run between 0.30% and 0.40%—as opposed to 0.20%, on average, for garden-variety ETFs and mutual funds.
- Higher minimums: While traditional ETFs and mutual funds typically have no or very low minimum investments, most direct indexing solutions have a capital requirement of $100,000 or more.
- Diminishing tax benefits: The potential for tax-loss harvesting can decline over time as portfolios mature and stock values rise. In a portfolio that's been held for years and has appreciated significantly, most stocks will likely have gains, which limits the ability to harvest losses.
That said, if you're comfortable with the added complexity and cost, direct indexing could be a smart way to elevate your investment strategy and achieve more-tailored, tax-efficient returns.
Direct indexing at Schwab
Like many direct indexing solutions, Schwab Personalized Indexing™ requires a minimum investment of $100,000; however, its fee of 0.40% is generally lower than the industry average. Here's how it works:
- Choose from a variety of index-based strategies that meet your investing goals: domestic equities, international equities, or a focus on environmental, social, and corporate governance (ESG) issues.
- Exclude individual stocks or industries that don't align with your goals or personal preferences.
- Realize potentially greater after-tax returns thanks to automatic tax-loss harvesting, which strategically sells securities at a loss to offset taxable gains from the sale of appreciated assets.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice.
Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and Charles Schwab & Co., Inc. does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager and refer to Internal Revenue Service ("IRS") www.irs.gov about the consequences of tax-loss harvesting.
Opportunities for tax management, such as gain/loss matching and loss harvesting, are more plentiful in the first several years of a portfolio's life than they are in later years.
Investors' actual tax rates, current or future capital loss carry forwards, and other tax circumstances will cause investors' actual after-tax performance to vary from the estimates presented here and the results shown on their individual account statements.
Actual after-tax returns achieved may vary and could be lower than reported due to the investor's specific tax circumstances during the time period shown. Clients who do not pay the assumed tax rates or client-specified rates or clients who do not have offsetting capital gains and income would not achieve the after-tax returns reported.
Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
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There are risks associated with any investment approach, and each Schwab Personalized Indexing strategy and equity market segment has their own set of risks based on client strategy selection and further customization.
Schwab Personalized Indexing is available through Schwab's Managed Account Connection® program ("Connection"). Please read Schwab's disclosure brochure for important information and disclosures relating to Connection and Schwab Managed Account Services.