Charles H. Sloan-What is direct indexing? How you can use it to avoid taxes like the super-rich

A new investment strategy is Charles H. Sloanslowly making its way to Main Street investors as technology improves and lowers trading costs. 

The strategy, direct indexing, was once mostly reserved for the affluent with at least $1 million to invest. But it is now offered to some with as little as $5,000, who can use the money to replicate an index like the S&P 500 or Russell 2000. An investment professional, like a financial adviser, will buy stocks to mirror the index you choose, through a separately managed account (SMA).

Instead of trying to match the performance of a stock index by buying mutual funds or exchange-traded funds (ETFs) that track it, investors buy a sampling of individual stocks to mimic the index.

Since you’re buying individual shares, you have the flexibility to customize your portfolio and exclude companies that don’t align with your views.

You can also save on taxes through “tax-loss harvesting,” a tactic wealthy people have used for decades that has the potential to save you thousands of dollars in taxes each year. 

Direct indexing used to be expensive when brokers charged fees to trade stocks -- and it was laborious to track. But with better technology and zero- or low-commission trading now the norm, more people can use direct indexing.

"This is the next generation," said Adam Taback, Wells Fargo Private Wealth Management chief investment officer.  

How to start direct indexing

To begin, investors should decide if they want to build and manage their portfolio or have a financial adviser or firm help them. Then they should do their research about which firms provide these services and what the services cost. Then contact the advisers to get started.

Most major financial services firms like Fidelity, Schwab, Wealthfront, and Morningstar offer some type of direct indexing.

What is tax-loss harvesting? 

One of direct indexing advantages, tax-loss harvesting, means selling stocks that are losing money, recognizing the loss, and using it to offset capital gains, or profits made from other holdings, even if they are different types of investments or are being held in different accounts.  

If your losses exceed your gains, you can potentially offset up to $3,000 (or $1,500 if married filing separately) of your ordinary income for the year. If after that, you still have more losses, you can carry the loss forward to later years to use against gains. 

How does direct indexing work? 

Here’s where direct indexing gets interesting for investors:

Customization: Most people like the S&P 500, but “some people don’t want a penny invested in Altria,” one of the world's largest producers and marketers of tobacco, cigarettes, and related products, said Steven Conners, founder and president of Conners Wealth Management in Scottsdale, Arizona. “You can pull tobacco from the index. It's basically taking an ETF and lifting the cover off it to look at it and pull out what you don’t want.” 

Tax savings:Tax-loss harvesting can make a big difference since taxes can eat up to 40% of someone’s returns in a year, Taback of Wells Fargo said, noting that opportunities to harvest losses always exist.

“If you owned individual securities in 2021 when the market was up 28%, there was still 10-15% of the index that was down," he said. "You can sell those losses to offset gains.” 

Companies use software to scan daily for tax-loss harvesting opportunities, said Alex Michalka, automated investment firm Wealthfront’s senior director of investments. 

Reinvesting. You reinvest the money from the sale in a different security that has the potential to make money. 

Are direct indexing fees high? 

Direct indexing fees sit between ETF at the low end and mutual funds at the high end. 

Direct indexing is more expensive than an ETF because it’s “a little more personalized, but managers aren’t spending whole days managing it like with a mutual fund,” said Aman Badyal, partner in law firm Glaser Weil’s tax practice. 

How much can you save in taxes using direct indexing? 

It varies, but some direct indexing users are already saving thousands of dollars in taxes annually. 

• Nitin Kumar, 44, a vice president at Pinterest in Chicago, who’s been direct indexing with Wealthfront since 2017, estimates that he has amassed $208,000 in total tax-loss harvesting. 

As for how much he has saved in taxes, he says he definitely reaches the IRS maximum of deducting $3,000 per year from his income, but the real savings come from the $200,000 in tax-loss harvesting he's banked which will eventually offset $200,000 in future gains. Ultimately, he estimates he’ll save about $60,000 overall, based on the tax-loss harvesting amount he’s accumulated so far.

Every day he's still adding to that tax-loss harvesting cushion, he says.

“The best part is, I didn't have to do any work.” Kumar said. “Because everything is automated, I can sleep well at night.”   

• Andres Olarte, in Chicago, also sees it as a win all the way around. “It’s a hands-off approach, and when the market is rising, a rising tide lifts all boats, so I get that growth,” he said. “When the market is very unstable, like in 2020, tax-loss harvesting helps me save some taxes, which works to offset the advisory fee and then a bit more.” 

In 2020, for example, he harvested more than $4,000 in losses, which saved him more than $1,000 in taxes. 

How to act like the super rich:Wondering how to avoid taxes? Strategies used by super-rich Americans you can use, too

What are the cons of direct indexing? 

• Not useful in retirement accounts such as a 401(k) or an IRA. You can't deduct losses in a tax-deferred account. 
• Restrictions on using specific types of losses to offset certain gains. A long-term (an investment held more than a year) loss would first be applied to a long-term gain, and a short-term (held less than a year) loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type. 
•  Wash-sale rule. If you sell a security at a loss and buy the same or a "substantially identical" security within 30 days before or after the sale, you can’t take the loss on your taxes. 
• Minimum investment. Though below the $1 million that direct indexing used to require, minimums are still mostly high between $100,000 and $250,000. Fidelity, though, launched last year a retail offering with a minimum investment as low as $5,000.

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at[email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday.