Direct Indexing vs. ETF: Tax-Loss Harvesting Comparison

Holding ETFs in a taxable account often raises a question: can direct indexing help you harvest more tax losses? It may, since you own individual stocks in an index rather than a single fund. That extra flexibility may also come with higher fees, tracking differences and a wash sale rule you still have to manage. 

Below, we compare how each approach harvests losses, where the wash sale rule gets in the way and who may benefit most.

Key Takeaways

• Direct indexing lets you harvest losses stock by stock, which may give you more losses than an ETF.
• An ETF lets you harvest losses on shares purchased at different times, but not on individual stocks within the fund.
• The wash sale rule applies to both approaches.
• Direct indexing may cost more and track the index less closely. It generally helps most in a taxable account with gains to offset.
• Harvested losses offset gains first, then up to $3,000 of other income a year.¹

What Is Direct Indexing, and How Does It Work?

With direct indexing, you buy many or all of the stocks in an index yourself instead of buying a fund that tracks it. Your account may hold hundreds of individual positions, each with its own cost basis, which is what you paid for it. 

When an individual stock falls below what you paid for it, your account can sell it to capture the loss and replace it with a similar stock to maintain your target index mix. 

You can also tailor the portfolio. For example, you could leave out specific stocks or sectors. 

Direct Indexing vs. ETF at a Glance

How Does Tax-Loss Harvesting Work With an ETF?

With an ETF, you can only harvest losses by selling specific blocks of shares bought at higher prices. If the overall index goes up, you might not have any losses to take. 

Some investors sell an ETF at a loss and buy a similar fund to stay invested. The catch is the wash sale rule. If the new fund counts as substantially identical, you may lose the deduction. Whether the two funds are substantially identical is a question to ask your tax professional before you trade. 

How Does Tax-Loss Harvesting Work With Direct Indexing?

Even when an index goes up, some of its stocks go down. Direct indexing may let you sell the stocks that have dropped and use those losses to offset gains elsewhere. Then you buy additional stocks to keep the portfolio close to the index. 

Here is a simple, hypothetical example: Say you put $100,000 into an index, and the index ends the year up 8%. 

How much this helps depends on your situation: 

• How Much You Have in Gains to Offset. Harvested losses only save you money if you have taxable gains or income to offset.
• Your Tax Bracket. Losses may be worth more in a higher bracket.
• How Long You Hold the Account. Harvesting chances generally shrink as your holdings rise over time.

What Is the Wash Sale Rule, and How Does It Limit Both Strategies?

You generally cannot deduct a loss if you buy substantially identical stock or securities within 30 days before or after the sale². That 61-day window applies whether you hold an ETF or individual stocks. 

Two situations can trigger a wash sale unexpectedly: 

• Your other accounts count. Buying the same security in your IRA or Roth IRA can trigger a wash sale.
• Your spouse counts. A purchase by your spouse or by a corporation you control can also trigger it.

A disallowed loss isn't lost forever. It gets added to the cost basis of your replacement shares, pushing the tax benefit down the road. The holding period of the shares you sold also carries over to the new shares. However, losses disallowed due to contributions to an IRA or Roth IRA generally cannot be recovered. 

Direct indexing has one advantage here. IRS rules say the stock of one company is ordinarily not substantially identical to the stock of another company.³ That gives a direct indexing account room to sell one stock and buy another. The wash sale rule fits into your broader tax planning strategies, so trades generally need to be coordinated across every account you and your spouse own. 

What Can Harvested Losses Offset?

Capital losses offset capital gains first. If your losses are larger than your gains, you may deduct up to $3,000 a year from other income ($1,500 if married filing separately). Any remaining loss carries forward to future years.⁴

The value of your tax loss depends on the type of gain you're offsetting: 

• Short-term gains come from assets held one year or less. They are taxed as ordinary income.
• Long-term gains come from assets held more than one year.
• The 3.8% net investment income tax may also apply to gains above certain income levels.⁵

The brackets and thresholds change each year, and how capital gains are taxed depends on your income and filing status. Harvested losses must also be reported correctly. Savvy Wealth advisors can coordinate the investment side of your tax planning with your tax preparer.  

What Are the Downsides of Direct Indexing?

Direct indexing comes with a few possible drawbacks to consider: 

• Fees: You may pay more than you would for a typical passive portfolio.
• Tracking: Your returns may differ from the index and could be lower.
• The Harvest Trade-Off: A stock you sell at a loss could rally back above what you paid, and you may miss that gain.
• Market Risk: You still own stocks, and their prices still move.

The account type can also affect the math. Harvesting generally adds little to a tax-deferred account such as an IRA. 

Is Direct Indexing Worth It for You?

Direct indexing may be worth considering if you have gains to offset and plan to invest through a taxable account for several years. 

It may fit if you have: 

• Large realized gains: from selling a business, a home or other investments.
• Equity compensation: gains from selling shares acquired through RSUs or stock options. If you also hold a large position in a single company, concentrated stock position strategies may reduce that risk, alongside harvesting.
• A higher tax bracket: each dollar of loss may save you more.
• A long time horizon: the benefit generally builds over years, not months.

It may not fit if you have few gains, a short time horizon or most of your money in tax-deferred accounts. 

Questions to Ask Before You Choose a Direct Indexing Approach

Ask your advisor these questions before you start:

• What is the total fee, including the advisory fee?
• How closely has the portfolio tracked its index?
• How will the account avoid wash sales across my IRA and my spouse's accounts?
• How will losses be reported to my CPA?
• Who coordinates harvesting with my tax return?

Harvesting generally works best when your advisor and your CPA see the same picture. That is the idea behind tax-coordinated investing, where your investment decisions and your tax plan are managed together. Tax savings are only one reason investors choose direct indexing; customization, ESG screens, and charitable giving round out the benefits for high-net-worth investors.

Conclusion

Direct indexing may give you more losses to harvest than an ETF, especially in years when the index rises but some stocks fall. Whether that outweighs the higher cost depends on your gains, your tax bracket and how long you plan to invest.

If you want help deciding between an ETF and a direct indexing approach, talk to a Savvy fiduciary advisor.

Frequently Asked Questions

Are Direct Indexing Strategies Tax-Efficient?

They may be, depending on your situation. Direct indexing tends to help most when you have capital gains to offset, are in a higher tax bracket and have a taxable account you plan to hold for years.

Is Direct Indexing Better Than Holding a Broad Index ETF?

It depends on your gains, the fees and how much tracking difference you can accept. A broad index ETF is generally simpler and cheaper. Direct indexing may make sense if the extra harvested losses could outweigh the higher cost.

Can I Use Direct Indexing In an IRA?

It may be possible, depending on the provider. Harvesting generally only helps in a taxable account, and a purchase in your IRA can trigger a wash sale, resulting in a loss in your taxable account.

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