The Silver Lining: Direct Indexing & Tax-Loss Harvesting
The Silver Lining: Direct Indexing & Tax-Loss Harvesting
Stop buying ETFs. Why owning the S&P 500 directly allows you to generate “Tax Alpha” by harvesting losses even when the market is at an all-time high.
Executive Summary
- The Concept (Harvesting): When a stock drops, you sell it to realize a loss. This loss offsets your capital gains (from other winners) and up to $3,000 of ordinary income. To stay invested, you immediately buy a similar (but not identical) stock.
- The Vehicle (Direct Indexing): If you buy an S&P 500 ETF (SPY), you can only harvest losses if the entire index falls. But if you use Direct Indexing (owning all 500 stocks individually), you can harvest losses on the 150 stocks that are down, even if the index itself is up 10%.
- Tax Alpha: This micro-management creates “Tax Alpha”—an additional **1% to 2% annual after-tax return** simply by reducing your tax bill, without taking any extra market risk.
The Wash Sale Rule
The Trap: If you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale, the IRS disallows the loss.
👉 The Fix: Do not sell Coke and buy Coke back. Sell Coke and buy Pepsi. They are correlated (sector peers) but not “substantially identical.” This maintains your market exposure while banking the tax loss.
Mechanic: Unbundling the ETF
Simulation: Bull Market Scenario (S&P 500 is UP +10%)
| Feature | Mutual Funds | ETFs | Direct Indexing (SMA) |
|---|---|---|---|
| Tax Efficiency | Low (Cap Gains Distributions) | High (Creation/Redemption) | Maximum (Individual Lots) |
| Harvesting Scope | None | Index Level Only | Security Level (Granular) |
| Customization | None | None | High (e.g., Exclude ESG/Tobacco) |
Volatility is the price of admission for returns, but tax-loss harvesting turns that volatility into a tax asset. In a Direct Indexing account, a market correction is just a ‘harvesting season.'”