Assess the tax benefits of direct indexing

Is direct indexing right for your clients?

• Direct indexing strategies can increase after-tax returns for some clients, but they aren’t right for everyone.
• Automated tax loss harvesting is a well-known feature of direct indexing, but these strategies also offer customization and flexibility.
• Before you invest in a direct indexing strategy, assess the potential tax benefits in light of the client’s individual circumstances by considering four key questions.

Assess the tax benefits of direct indexing

When wealthy individuals make investment decisions, a leading consideration beyond an asset’s risk-return expectations is capital gains tax, which might explain the growing enthusiasm for direct indexing in recent years. A goal of this strategy, which investors typically access through separately managed accounts (SMAs), is often to replicate fairly closely an equity benchmark while generating capital losses that can offset gains elsewhere in the investor’s portfolio.

While automated tax-loss harvesting is the key driver of their popularity, direct indexing SMAs can also offer customization features such as the ability to align exposures with the investor’s personal values, implement factor tilts, exclude specific stocks, or manage liquidity with more flexibility.

Some providers of direct-indexing SMAs advertise their best-case-scenario results, so be cognizant that a number you see in the headlines may not be broadly representative of an investor’s actual experience. While the strategy can offer attractive tax benefits for some individuals, it isn’t right for all situations.

As with any decision, you need to weigh the benefits against the costs and risks, and in the world of investing, taxes can have a meaningful role in that. You probably wouldn’t recommend municipal bonds for a retiree with a low tax rate, would you? In seeking equity index exposure, assess the tax benefit of a direct indexing SMA in light of the client’s personal circumstances. If it doesn’t justify the cost and risks of the investment, you might instead access the desired exposure through a pooled vehicle such as an exchange-traded fund (ETF). When making this decision, there are four questions you should ask:

1. Does the client have eligible taxable gains?

Don’t assume your client will have capital gains to offset. Individuals with higher levels of income are more likely to have capital gains, but overall, most taxpayers do not. In fact, IRS data from 2022 showed capital gains reported on tax returns for only 8% of U.S. taxpayers.

Not everyone has taxable gains
% of taxpayers reporting capital gains by income level, 2022

Losses generated by a direct indexing strategy can offset both long- and short-term gains that are reported on Schedule D of the client’s tax return. While offsetting short gains provides the greater benefit (long gains are taxed a lower rate), keep in mind that not all short gains end up on Schedule D. For example, short-term gain distributions from mutual funds do not flow through to Schedule D on a tax return, instead getting taxed as ordinary income, just like bond coupon payments.

Even though taxpayers are allowed to apply up to $3,000 of capital losses against ordinary income, that limited benefit in many cases can’t provide enough value to justify paying more in fees for direct indexing versus an indexed ETF in the absence of gains reported on Schedule D.

2. What is the client’s tax rate?

The benefits of tax loss harvesting are limited for clients in lower income tax brackets but can be substantial for very high-income clients, especially those who live in states with high income tax rates.

For example, in certain situations, a taxpayer with $150,000 of income may receive less than a quarter of the same value in higher annual returns than a taxpayer with income of $1 million. The presence of high state tax rates can also make direct indexing more attractive.

3. How will the client eventually dispose of their assets?

The tax benefits of direct indexing relative to an ETF with the same benchmark can be much higher for an investor who plans to eventually pass their assets through an estate or donate them to charity versus liquidate their portfolio at the end of the holding period.

When assets are passed through an estate or to a charity, usually no final capital gain tax is incurred because of the rules on basis step-up and donations. Given a lowered cost basis due to loss harvesting, the direct indexing SMA derives a greater benefit from the elimination of a final tax bill as compared to the ETF.

In the case of liquidation, however, the tax on unrealized gains eventually needs to be paid, reducing the benefit of tax loss harvesting.

4. What is the client’s time horizon?

The length of time your client holds a direct-indexing strategy significantly affects the potential tax benefit. Holding such an SMA for only a year or two may not add much benefit because the time value of money from deferring tax payments requires, well, time.

Learn more ways to reduce taxes for your clients

Direct indexing SMAs can provide attractive tax benefits but be sure to look before you leap. Do the math to determine whether the strategy is appropriate for your client’s specific circumstances. There are other ways you can reduce tax costs for your clients. Explore BlackRock’s suite of tools, solutions and insights to keep taxes at the forefront of your investment process all year round.

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