How Direct Indexing Helps You Keep More of What You Earn

by Alex Michalka, Wealthfront VP of Investing Research

Direct indexing can be very powerful, and that’s why we’re so passionate about making it available to regular people. Let’s break down how this strategy works and why it can make such a big difference in helping you keep more of what you earn. Direct indexing might seem complicated, but you should know that Wealthfront makes it incredibly simple to invest directly in an index’s stocks—we design our direct indexing products, including Wealthfront’s S&P 500 Direct and Nasdaq-100 Direct, to lower your tax bill with no extra effort on your part.

How direct indexing works

The basics: Direct indexing gets its name from the fact that investors directly own the stocks that comprise an index instead of owning an index-based ETF or mutual fund. As a result, you get exposure to the stocks in the index (like you would with an ETF) but it’s also possible to conduct tax-loss harvesting using those individual stocks. This unlocks opportunities to harvest losses even on days when the index as a whole is up, which means more chances to help lower your tax bill. In this way, direct indexing offers some of the same benefits as owning an index-based ETF plus something ETFs can’t offer: the ability to generate future potential tax savings. 

If direct indexing sounds labor-intensive, that’s because it can be. A human advisor would need to carefully track the performance of hundreds of individual stocks on a near-daily basis in order to execute this strategy successfully. Software, on the other hand, is ideally suited to this kind of rules-based task—and that’s exactly why we automate it. 

What do you do with the losses?

Harvested losses are valuable because they can be used to help lower your tax bill. You can offset capital gains and, if you still have losses left over after that, up to $3,000 of ordinary income (like money you earn as your salary) in a given year. Here’s how it might play out in an example:

To start, imagine you harvested $4,000 of losses last year and realized $500 of capital gains. We’ll also imagine you have a salary of $150,000. Here’s what you could do with those losses:

• Offset capital gains: At tax time, you could apply those losses to offset your capital gains completely, meaning you’d owe no taxes on that $500. 
• Offset up to $3,000 of ordinary income: After that, you’d still have $3,500 of losses left. Each year, you can use losses to offset up to $3,000 of ordinary income, so you could apply $3,000 of your remaining losses to do that.
• Roll over the extras indefinitely: The $500 of losses you still have left over after that can be carried forward indefinitely to future years. 

This is a hypothetical example and not tax advice. It shows how tax-harvesting losses might be used, but individual tax situations and changing tax laws will lead to different results so it’s best to consult a tax advisor regarding your specific situation. 

Who can benefit the most from direct indexing? 

Direct indexing could be a good fit for any investor who wants exposure to a specific index and tax savings at the same time. It is most valuable for long-term investors in high tax brackets, especially those who have (or expect to have) a lot of capital gains.

Maybe your company is about to go public and you have incentive stock options (ISOs). Maybe you’re planning to sell a lot of appreciated stock for another reason. Or maybe you have large mutual fund holdings that are required to make capital gains distributions. In all of these cases, direct indexing could help you offset those gains and lower your tax bill significantly. 

Find out more about our two standalone direct indexing products: Wealthfront’s S&P 500 Direct (which contains stocks from the S&P 500® index) and Nasdaq-100 Direct (which contains stocks from the Nasdaq-100 Index®). Both give investors an opportunity to get exposure to popular indices at a low cost while also generating future tax savings through a powerful direct indexing strategy. 

Take a deeper dive into why direct indexing is so valuable on the Wealthfront Blog, and don’t forget to subscribe for more future LinkedIn newsletters.

Nothing in this communication should be construed as investment or tax advice. Investing involves risk, including loss of principal. Past performance is not a guarantee of future results. Investment management and advisory services are provided by Wealthfront Advisers LLC, an SEC-registered investment adviser. Wealthfront Advisers and affiliates do not provide legal or tax advice and are not liable for tax consequences of client transactions. Please consult a personal tax advisor. You are responsible for reporting transactions to the IRS or other taxing authorities.

Tax-Loss Harvesting benefits depend on your tax and investment profile. New securities may perform better or worse than those sold, and tracking errors could cause slight divergence from benchmarks. Unintended tax effects may occur. Wealthfront does not provide tax advice. Consult a tax professional.

Harvested losses are first used to offset capital gains of the same type. This means short-term losses offset short-term gains, and long-term losses offset long-term gains. Net losses can then be used to offset gains of the other type.

The S&P 500® index is a product of S&P Dow Jones Indices LLC (“SPDJI”) and has been licensed for use by Wealthfront Advisers LLC. Standard & Poor’s®, S&P®, S&P 500®, US 500 and The 500 are trademarks of Standard & Poor’s Financial Services LLC and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Wealthfront Advisers LLC. Wealthfront’s S&P 500 Direct Portfolio is not sponsored, endorsed, sold or promoted by SPDJI or its affiliates and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500®.

S&P 500 Direct invests in many stocks in the S&P 500®, but it may not invest in all stocks in the index. Its performance may deviate from the S&P 500® index due to tracking error, market conditions, Tax-Loss Harvesting limitations, account size, and customization options (e.g. excluding individual stocks).

Wealthfront Advisers is compensated for its advisory services by charging an annual advisory fee of 0.09% on the net market value of a Client’s S&P 500 Direct account.

Indices are not available for direct investment and their performance does not reflect the expenses associated with managing an actual portfolio.

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Nasdaq-100 Direct allows clients to hold individual stocks in the Nasdaq-100 Index®, but it may not hold all the stocks in the index. As a result, its performance may deviate from that of the Nasdaq-100 Index® due to tracking error, market conditions, and the limitations of Tax-Loss Harvesting. Account size and customization options, such as excluding individual stocks, may affect the portfolio’s ability to track the Nasdaq-100 Index®

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