Meet Sarah, a product manager at a fast-growing tech company. After maxing out her 401(k) and building an emergency fund, she had $300,000 sitting in a taxable investment account, mostly in broad market index funds. Her portfolio was diversified and low-cost—exactly what conventional wisdom suggests.
But there was a problem. Every year, her index funds would distribute capital gains, creating unexpected tax bills even when she didn't sell anything. Meanwhile, she couldn't take advantage of individual stock losses to offset the gains from her RSUs when they vested. She felt trapped between wanting broad market exposure and hating the tax inefficiency.
Sound familiar? If you're a high-earner with substantial assets in taxable accounts, you've probably felt this same frustration. Enter direct indexing—a strategy that's been quietly revolutionizing how sophisticated investors approach the market.
What is direct indexing, exactly?
Direct indexing is surprisingly straightforward: instead of buying an S&P 500 index fund, you buy the actual 500 stocks that make up the S&P 500 in the same proportions as the index.
Think of it this way—when you buy an index fund, you're buying a pre-packaged fruit basket. With direct indexing, you're buying all the individual fruits yourself and arranging them in the same proportions as that basket. The end result looks similar, but you have much more control over what happens next.
This isn't exactly a new concept. Wealthy investors and institutions have been using direct indexing for decades through separately managed accounts. What's changed is technology. Advanced portfolio management software and fractional shares have made it possible to replicate major indexes with much smaller account minimums than before.
The tax game-changer: harvesting losses at scale
The biggest advantage of direct indexing lies in tax-loss harvesting—and it's a game-changer for taxable accounts.
In a traditional index fund, you can't control when the fund realizes gains or losses. If the fund manager sells Apple at a gain to rebalance the portfolio, everyone who owns the fund gets hit with that capital gain distribution, regardless of their individual tax situation.
With direct indexing, you own Apple directly. If Apple is down for the year while the overall market is up, you can sell your Apple shares to realize the loss, then immediately buy a similar technology stock to maintain your sector exposure. This loss can offset gains from other investments—including those RSUs that vested at higher prices.
Let's look at Sarah's situation. In 2022, when tech stocks were getting hammered, her direct indexing strategy allowed her to harvest over $15,000 in losses from individual positions while maintaining her overall market exposure. She used these losses to offset gains from RSUs she sold to buy a house, saving her roughly $3,600 in taxes that year alone.
Customization without complexity
Beyond tax benefits, direct indexing offers something traditional index funds can't: personalization at scale.
Maybe you work for Amazon and don't want additional exposure to your employer's stock. With direct indexing, you can simply exclude Amazon from your holdings and redistribute that weight across other stocks. Or perhaps you want to avoid tobacco companies for personal reasons, or overweight clean energy stocks. These customizations are impossible with a traditional S&P 500 fund.
This level of customization used to require extensive research and constant monitoring. Today's direct indexing platforms handle the complexity for you, automatically rebalancing your portfolio and managing corporate actions while respecting your preferences.
The ESG advantage
For investors who care about environmental, social, and governance (ESG) factors, direct indexing provides granular control that ESG funds often can't match. Instead of accepting someone else's definition of "sustainable," you can create your own criteria.
One of our clients, a software engineer passionate about climate change, used direct indexing to exclude fossil fuel companies while overweighting renewable energy and electric vehicle manufacturers. His portfolio still tracks the broad market's performance but aligns with his values in a way that no single ESG fund could replicate.
When direct indexing makes sense (and when it doesn't)
Direct indexing isn't for everyone. It works best for investors who:
Have substantial taxable accounts (typically $250,000+): The tax benefits are most meaningful when you have significant assets outside of retirement accounts.
Are in higher tax brackets: If you're paying 24% or higher in federal income taxes, the tax savings can be substantial.
Want customization: Whether for values-based investing, concentration risk management, or other personal preferences.
Have a long-term perspective: The benefits compound over time, making this ideal for investors with multi-decade time horizons.
Already max out tax-advantaged accounts: This strategy is specifically for taxable investing—your 401(k) and IRA should still be your first priority.
Direct indexing probably doesn't make sense if you're just starting to invest, have limited assets in taxable accounts, or prefer the simplicity of a few broad index funds.
The costs and considerations
Like any sophisticated strategy, direct indexing comes with trade-offs. Management fees are typically higher than rock-bottom index fund fees—usually ranging from 0.20% to 0.50% annually. However, for many investors, the tax savings more than offset these higher fees.
You'll also need to deal with more complexity at tax time. Instead of receiving one 1099 from your index fund, you might receive dozens of 1099s from individual stock sales. This is where working with a tax professional becomes especially valuable.
There's also the risk of tracking error—your customized portfolio might not perfectly match the index's performance. If you exclude certain stocks or overweight others, your returns will deviate from the benchmark. For most investors using modest customizations, this tracking error is minimal.
Technology makes the difference
The success of modern direct indexing relies heavily on sophisticated technology. Advanced algorithms continuously monitor your portfolio for tax-loss harvesting opportunities, automatically rebalance positions, and manage corporate actions like stock splits and spin-offs.
This technology also handles the complexity of avoiding wash sale rules—regulations that prevent you from immediately repurchasing a "substantially identical" security after realizing a loss. The software automatically finds appropriate substitute securities that maintain your desired market exposure while respecting these rules.
Direct indexing and your broader wealth strategy
For many of our clients, direct indexing isn't a standalone solution—it's part of a comprehensive wealth management strategy. It works particularly well alongside:
Equity compensation planning: Use harvested losses to offset gains from RSU sales or stock option exercises.
Tax-loss harvesting coordination: Ensure your direct indexing strategy coordinates with tax-loss harvesting in other parts of your portfolio.
Charitable giving: Donate appreciated shares directly to charity to avoid capital gains while supporting causes you care about.
Estate planning: The individual stock ownership provides more flexibility for legacy planning strategies.
Getting started with direct indexing
If direct indexing sounds appealing, start by evaluating your current situation:
- Assess your taxable assets: Do you have at least $250,000 in taxable investment accounts?
- Review your tax situation: Are you in a high enough tax bracket to benefit from tax-loss harvesting?
- Consider your preferences: Do you want to customize your portfolio based on values or concentration concerns?
- Evaluate providers: Different platforms offer varying levels of customization, minimum investments, and fee structures.
- Plan for implementation: Consider tax implications of transitioning from existing investments to a direct indexing strategy.
The integration challenge
One thing we've learned from helping clients implement direct indexing is that it works best when integrated with your overall financial plan. The tax benefits are most powerful when coordinated with other tax planning strategies, and the customization options should align with your broader investment goals and risk management needs.
This is where having a Certified Financial Planner (CFP®) becomes invaluable. They can help you determine if direct indexing fits your situation, coordinate the strategy with your other investments, and ensure you're maximizing the tax benefits without taking unnecessary risks.
Looking ahead
Direct indexing represents a significant evolution in how we think about passive investing. It maintains the benefits of broad market exposure and low turnover that make index investing so attractive, while adding layers of tax efficiency and personalization that weren't previously available to individual investors.
As technology continues to improve and costs continue to decline, we expect direct indexing to become an increasingly important tool for tax-efficient wealth building. The ability to maintain broad market exposure while harvesting losses, customizing holdings, and optimizing for taxes makes it particularly attractive for high-earning professionals building wealth in taxable accounts.
Key Takeaways
Direct indexing isn't about beating the market—it's about keeping more of what the market gives you. For the right investor, it can provide meaningful tax savings, valuable customization options, and better alignment between your investments and your values.
Like any sophisticated financial strategy, direct indexing requires careful consideration of your unique situation, goals, and preferences. The technology has made implementation easier, but the strategic decisions still require expertise and ongoing management.
If you're tired of paying taxes on index fund distributions you didn't choose, frustrated by the lack of customization in traditional funds, or simply want to optimize your after-tax returns, direct indexing might be worth exploring.
Ready to explore direct indexing for your portfolio?
At Domain Money, our team of expert CFP® professionals helps high-earning individuals navigate sophisticated investment strategies like direct indexing. We'll analyze your current situation, model the potential benefits, and integrate any changes seamlessly with your broader financial plan.
Don't let tax inefficiency erode your wealth-building efforts. Schedule a free strategy session today to learn how direct indexing could enhance your investment strategy and boost your after-tax returns.
The scenarios described in this article are for illustrative purposes only and do not represent actual client situations. Individual results may vary based on personal circumstances, market conditions, and other factors. Tax-loss harvesting and other tax strategies should be implemented in consultation with qualified tax professionals. Past performance does not guarantee future results.
.jpg)