Wealth
Direct Indexing, Part 2: A Worked Example
A step-by-step hypothetical showing how years of tax-loss harvesting through direct indexing can offset a large capital gain.
Educational only. Not financial, tax or legal advice, and not a recommendation to buy or sell anything. Any dollar amounts or tax rules here are tied to the year they were written and change annually — verify current figures and talk to a qualified professional about your own situation.
This example continues the discussion of direct indexing from Part 1 by working through a hypothetical case in detail. To keep the math simple, it assumes the portfolio sits in a taxable account rather than a 401(k), and it simplifies the mechanics of a business sale considerably.
One of the most notable benefits of direct indexing is the opportunity to harvest tax losses, which can be used to offset taxable gains—such as those from the sale of a business.
Exactly How Direct Indexing Works for Tax Loss Harvesting
Consider an investor with about $7.5 million split between two broad index ETFs who instead uses a direct indexing strategy. Over the next 8 years, the portfolio grows at 12% annually. During this time, the investor regularly harvests tax losses, typically amounting to 3-5% of the portfolio's value each year. Over time, this accumulation of losses adds up significantly while the portfolio continues tracking the market.
Year-by-Year Breakdown of Portfolio Growth
| Year | Growth | Portfolio Value |
|---|---|---|
| 1 | $7.5 million × 1.12 | $8.4 million |
| 2 | $8.4 million × 1.12 | $9.41 million |
| 3 | $9.41 million × 1.12 | $10.54 million |
| 4 | $10.54 million × 1.12 | $11.80 million |
| 5 | $11.80 million × 1.12 | $13.22 million |
| 6 | $13.22 million × 1.12 | $14.81 million |
| 7 | $14.81 million × 1.12 | $16.59 million |
| 8 | $16.59 million × 1.12 | $18.58 million |
Tax Loss Harvesting Impact
Assume the investor harvests tax losses of 4% annually. Over the 8 years, this results in tax losses totaling $3.69 million.
Offsetting Business Sale Gains with Tax Losses
Now imagine the investor sells a business for $40 million. Capital gains taxes on such a sale would normally range between 20-30%, depending on tax brackets and other factors. Assuming a 25% tax rate on capital gains, the investor would face a tax bill of around $10 million without any tax-saving strategies.
However, by utilizing the $3.69 million in tax losses accumulated from direct indexing, the investor can offset the taxable gains from the sale. With the $3.69 million in tax losses, the taxable gain is reduced to $36.31 million, lowering the tax bill to $9.08 million.
By using direct indexing and harvesting tax losses over those 8 years, the investor effectively saved about $1 million in taxes on the sale.
Conclusion
Direct indexing is a valuable strategy for high-net-worth investors, especially those with taxable portfolios. It provides the opportunity to replicate index-like returns while also offering the ability to harvest tax losses over time. In this example, the $3.69 million in losses accumulated from direct indexing effectively allows the investor to reduce taxes on a $40 million business sale by nearly $1 million. With careful management, this approach can significantly enhance after-tax returns for those with large portfolios and substantial capital gains.