How Investors Reduce Taxes with Direct Indexing and Tax Loss Harvesting

Direct indexing and tax loss harvesting are two ways investors reduce taxes in a taxable brokerage account. Both generate losses you can use to offset gains.

This article covers direct indexing, tax loss harvesting, and levered tax loss harvesting: how each works, the pros and cons, and who each tends to fit.

Why taxes drag on a taxable brokerage account

The federal long term capital gains rate is 0%, 15%, or 20% depending on income, and high earners also pay the 3.8% Net Investment Income Tax, for a top federal rate of 23.8% before state taxes. Inside a normal S&P 500 ETF, you do not get to separate the winners from the losers.

What is direct indexing?

With direct indexing, instead of owning one fund that holds all 500 stocks, you own the underlying stocks themselves in a separate account. That lets you do three things you cannot do inside a fund:

• Harvest losses at the single stock level. In a typical year, somewhere between 25 and 40% of S&P 500 stocks finish down, even when the index is up. You sell those, capture the loss, and replace them with a similar stock.
• Customize. You can exclude your employer's stock or tilt away from industries for personal reasons.
• Transition concentrated positions. You can slowly diversify around a low cost basis stock in a tax aware way.

Research from firms like Parametric and Wealthfront has shown direct indexing can add roughly 1 to 1.5% of after tax return per year for top bracket investors, especially in the first 5 to 10 years. The tradeoffs are complexity, fees of around 25 to 40 basis points compared to 3 to 10 for a plain S&P 500 ETF, and a tax benefit that decays as the portfolio builds up gains.

It tends to fit high earners in the top federal bracket with at least $250,000 to $500,000 in a taxable account, people who just had a liquidity event, and people who want to customize. If none of those describe you, a plain low cost S&P 500 ETF is probably still the right answer.

How tax loss harvesting works

When an investment is down, you sell it, realize the loss, and buy something similar but not identical to keep your market exposure and stay clear of the wash sale rule.

Say the market drops 15% and a $500,000 position in VTI is now worth $425,000. You sell, bank a $75,000 loss, and the same day buy SCHB, a similar but technically different total market ETF. Those losses can do three things:

• Offset capital gains this year, dollar for dollar.
• Offset up to $3,000 of ordinary income per year.
• Carry forward to future years indefinitely.

The risks are the wash sale rule, which is strict and easy to mess up, and tracking error from the substitute fund. Almost anyone with a taxable account and some discipline can be a fit, and the benefit scales with your tax bracket.

What is levered tax loss harvesting?

Regular direct indexing can only harvest a loss when a stock goes down, so in a strongly rising market the tax engine slowly runs out of fuel. A long short structure can create losses even when the market is going up.

The most common structure is 130/30. You start with $100. The manager borrows $30 to buy more stock, so the long side is $130, and sells $30 of borrowed stock short. Net exposure is still $100, but gross exposure is $160, which gives the manager many more chances to harvest losses. Research from AQR and Quantinno has shown these strategies can generate cumulative net capital losses exceeding 100% of the initial investment over time.

There are real tradeoffs:

• Management fees typically run 100 to 150 basis points, plus financing costs.
• Leverage adds risk. If the shorts move sharply against you, those are real economic losses.
• Most quality providers want $1 million to $2 million or more.
• The losses are a deferral. You will pay tax someday.

It fits a narrower group: people with a very large taxable event, such as a business sale or concentrated stock they must diversify, who are in the top bracket, comfortable with complexity, and have a time horizon of at least 5 years.

Which tax loss harvesting strategy fits you

Picture a ladder. The first rung is a regular index fund, which is low cost, already tax efficient, and a great fit for most people with smaller taxable accounts. The second rung is direct indexing. The third is levered tax loss harvesting. You climb based on three things: the size of your taxable account, your marginal tax bracket, and whether you have a meaningful taxable event coming.

Common questions

How much money do you need for direct indexing?

The math works best with at least $250,000 to $500,000 in a taxable brokerage account and a high marginal tax rate.

What is the wash sale rule?

If you buy the same or a substantially identical security within 30 days before or after selling at a loss, the loss is disallowed. That is why you swap into something close but legally distinct.

Does tax loss harvesting eliminate taxes?

No. It defers taxes you would otherwise have paid. With the levered version, the bet is that the deferral, plus the savings reinvested in the meantime, outweighs the eventual bill.

VDB Wealth is a registered investment adviser. Information presented is for educational purposes only and is not intended to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Past performance is not indicative of future performance.

If you own stocks in a taxable brokerage account, there is a very good chance the IRS is quietly taking one to two percent off your returns every single year. Not because you did anything wrong. Just because of how a normal portfolio works.

Now picture this. Compound an extra one percent a year for the next 20 years on a one million dollar portfolio. That is close to 800,000 dollars of additional wealth. Same investments. Same risk. Just smarter tax mechanics.

In the next 15 minutes I am going to plainly explain three strategies that can help you capture that. Direct Indexing. Tax Loss Harvesting. And the newest evolution of both, which is called Levered Tax Loss Harvesting.

Here is the deal. These strategies sound technical, but the core idea behind all three is simple. They take a normal index fund experience and add a tax engine on top of it. That tax engine generates losses you can use to offset gains, lower your tax bill, and keep more of your money compounding for you.

For each strategy I will cover four things in plain English. What it is. How it works. The pros and the cons. And the type of person who is actually a good fit.

This matters because most investors are still parked in plain old ETFs and mutual funds. That is fine. It is also potentially leaving real money on the table, especially if you are in a high tax bracket or expect a big taxable event in the next few years.

Quick intro for those who do not know me. I am Andy VandenBerg, founder of VDB Wealth, a boutique wealth management firm focused on helping a small number of clients build, preserve, and grow their wealth. My background spans trading at Deutsche Bank, helping manage a billion dollar portfolio for a single family at Ocean Road Advisors, and being a founder and operator myself, so the lens I bring to tax strategy is practical, not theoretical.

Here is the core problem. In a taxable brokerage account, when you sell a winning investment, you owe capital gains tax. For long term gains, the federal rate is 0, 15, or 20 percent depending on your income. Most viewers of this channel are probably at 15 or 20 percent. If you are a high earner, you also pay an extra 3.8 percent Net Investment Income Tax. That puts your top federal rate at 23.8 percent, before state taxes.

In California or New York, you can easily push past 35 percent total on a single gain. That is the tax headwind. And here is the thing most people miss. Inside a normal S&P 500 ETF, when you sell shares to rebalance or pull money out, the whole basket gets taxed. You do not get to separate the winners from the losers.

What if you could? What if every time a stock inside your index dropped, you could harvest that loss, use it against your gains, and still stay fully invested in the index? That is the entire premise of what we are about to walk through.

Let me start with Direct Indexing.

In a normal S&P 500 fund, you own one ticker that holds all 500 stocks. With direct indexing, instead of owning the fund, you actually own those 500 underlying stocks themselves, in a separate account, customized to you.

So you still get S&P 500 exposure, but now you have control at the individual stock level. Why does that matter? Because it lets you do three things you simply cannot do inside a fund.

First, you can harvest losses at the single stock level. Even in years when the index is up, many individual stocks inside it finish the year down. In a typical year, somewhere between 25 and 40 percent of S&P 500 stocks end up red. Direct indexing lets you spot those, sell them, capture the loss, and replace them with a similar stock so your overall exposure stays intact.

Second, you can customize. You do not want exposure to your employer's stock because you already have plenty in your equity comp? Excluded. You want to tilt away from tobacco or fossil fuels for personal reasons? Done. You cannot do that inside a fund.

Third, you can transition concentrated positions. If you have a low cost basis in a stock you cannot just dump, direct indexing helps you slowly diversify around it in a tax aware way.

On the pro side. You get index level exposure with a built in tax engine. Research from firms like Parametric and Wealthfront has shown direct indexing can add roughly 1 to 1.5 percent of after tax return per year for top bracket investors, especially in the first 5 to 10 years. You also get full transparency since you own every position.

On the con side. It is more complex than a single ETF. You will see hundreds of line items on your statement. Fees are higher than a plain index fund. A typical direct indexing fee runs around 25 to 40 basis points, compared to 3 to 10 basis points for a plain S&P 500 ETF. And the tax benefit decays over time. Once most of your portfolio has built up gains, there are fewer losses left to harvest. Years 6 through 10 tend to deliver a small fraction of the benefit you saw in years 1 through 5.

Who is this a good fit for? Three groups in particular.

Number one. High earners in the top federal bracket with at least 250,000 to 500,000 dollars in a taxable brokerage account. The math works best when your marginal tax rate is high.

Number two. People who just had a liquidity event. You sold a business. RSUs vested. You inherited a portfolio with embedded gains. Direct indexing can absorb those gains over time using harvested losses.

Number three. People who want to customize their portfolio. Excluding employer stock. Expressing values. Or working around a legacy concentrated position.

If none of those describe you, a plain low cost S&P 500 ETF is probably still the right answer.

Now let me zoom in on Tax Loss Harvesting itself. Direct indexing is the vehicle. Tax loss harvesting is the engine that runs inside it. But you can also do tax loss harvesting at the fund level in a regular ETF portfolio, so it is worth understanding on its own.

The mechanic is simple. When an investment is down, you sell it. You realize the loss on your tax return. Then you buy something similar, but not identical, to keep your market exposure. The IRS has a rule called the wash sale rule that says if you buy the same or a substantially identical security within 30 days before or after the sale, the loss is disallowed. So you have to swap into something close, but legally distinct.

Here is a real world example with simple numbers. Say the market drops 15 percent and your 500,000 dollar Vanguard Total Market ETF, which is the ticker VTI, is now worth 425,000. You sell VTI. You bank a 75,000 dollar loss. The same day you buy SCHB, which is Schwab's similar but technically different total market ETF. You still own essentially the same market exposure. But now you have 75,000 of losses sitting on your tax return.

What can you actually do with those losses? Three things.

One. You can offset any capital gains you have this year, dollar for dollar.

Two. You can offset up to 3,000 dollars of ordinary income per year if you have leftover losses.

Three. Anything beyond that carries forward to future years. Indefinitely. You can use a loss you booked in 2026 against a gain you take in 2046.

On the pro side. This is one of the most reliable ways to add after tax return without changing your underlying investment plan. You stay in the market the whole time. The IRS effectively gives you an interest free loan by letting you defer taxes you would have otherwise paid.

On the con side. The wash sale rule is strict and easy to mess up. Especially across accounts you share with a spouse, or in accounts where dividends are reinvested automatically. You can also introduce tracking error. That just means the substitute fund does not behave exactly like the original. Over a few weeks that is usually fine. Over years, you have to manage it carefully.

Who is a good fit? Honestly, almost anyone with a taxable account and some discipline. The benefit just scales with your tax bracket. A 50,000 dollar loss is worth roughly 12,000 in real taxes saved for a top bracket investor in California, but maybe only 5,000 for someone in a lower bracket state and a moderate income.

If you want this done automatically, at the single stock level, and at scale, that is exactly when direct indexing becomes the better wrapper.

Now to the strategy most people have never heard of and which is, frankly, one of the hottest topics in high net worth planning right now. Levered Tax Loss Harvesting. Sometimes called tax aware long short investing.

Here is the plain English version. In a regular direct indexing account, you can only harvest a loss when an individual stock goes down. But in a strongly rising market, fewer stocks go down. So the tax engine slowly runs out of fuel.

What if you could create losses even when the market is going up? That is exactly what a long short structure lets you do.

The most common structure is called 130/30. Here is how it works. You start with 100 dollars of your own money. The manager borrows another 30 dollars and uses it to buy more stock, so the long side is now 130 dollars. On the short side, the manager borrows 30 dollars worth of stock and sells it into the market, betting it will go down. The cash from that short sale sits as collateral.

Your net exposure to the market is still 100 dollars. 130 minus 30. But your gross exposure is now 160 dollars. That extra 60 dollars of activity, on both the long and the short side, gives the manager many more positions and many more chances to harvest losses, in both rising and falling markets.

And here is the wild part. Research from AQR and Quantinno, two of the leading providers in this space, has shown these strategies can generate cumulative net capital losses exceeding 100 percent of the initial investment over time. A one million dollar account can produce more than a million dollars in usable tax losses across its life. Those losses can offset gains from your business sale, your concentrated stock, real estate, or anywhere else you have taxable gains.

Now the pros and cons. This is where you really need to pay attention.

On the pro side. This is a far more powerful tax engine than vanilla direct indexing. The losses do not dry up as quickly because the short side keeps producing opportunities regardless of market direction. For someone with a large pending taxable event, this can be the difference between writing a multi million dollar tax check and writing a much smaller one.

On the con side, there are real tradeoffs. Fees are higher. Typical management fees run 100 to 150 basis points, sometimes more, plus financing costs on the borrow. Leverage adds risk. If the shorts move sharply against you, those are real economic losses, not just paper. The tax reporting is complex. Expect mark to market accounting and far more line items at tax time. Minimums are high. Most quality providers want 1 to 2 million dollars or more allocated to this strategy. And eventually, you have to unwind the structure. The losses you generated are a deferral, not a permanent escape from taxes. You will pay tax someday. The bet is that the deferral, plus the savings reinvested in the meantime, outweighs the eventual bill.

Who is this a good fit for? A narrower group.

One. You have, or expect, a very large taxable event. A business sale. Concentrated stock you must diversify. A big inheritance. The losses generated here can shelter millions in gains.

Two. You are in the top tax bracket and plan to stay there. The benefit scales directly with your marginal tax rate.

Three. You are comfortable with complexity and a longer time horizon. Five years minimum. Ideally ten.

Four. You can clear the minimum, typically 1 to 2 million dollars allocated specifically to this strategy.

If you do not check most of those boxes, you are almost certainly better off with vanilla direct indexing, without leverage.

So how should you actually decide which of these is right for you?

Picture a ladder.

The first rung is a regular index fund. Low cost. Already tax efficient. A great fit for most people with smaller taxable accounts or who simply want simplicity.

The second rung is Direct Indexing. A good fit if you have 250 to 500 thousand or more in a taxable account, you are in a high tax bracket, and you want a meaningful tax benefit without massive complexity.

The third rung is Levered Tax Loss Harvesting. A good fit only if you have significant existing or expected gains, a very high income, and the capacity to handle complexity and high minimums.

You climb the ladder based on three things. The size of your taxable account. Your marginal tax bracket. And whether you have a meaningful taxable event coming. You do not climb it based on what sounds clever at a dinner party.

If you watched this far, here is exactly what I would do next.

Pull up your most recent year end brokerage statement. Look at the realized gain section. Look at the dividend section. Add up the tax bill on that account. If it is more than a few thousand dollars and you are still parked in plain ETFs, there is a real conversation to have about whether one of these strategies fits your situation.

If you want help thinking through which one makes sense for you, I would love to talk. You can book a call using the link in the description of this video. There is no pressure. The first conversation is just about understanding your situation and seeing if we can actually help.

If this video was useful, hit subscribe so you do not miss the next one. I have more videos coming on equity compensation, concentrated stock, and how to think about Roth conversions in your peak earning years.

Thanks for watching. I will see you in the next one.