What Are the Tax Benefits of Direct Indexing?

Holly Swan: Taxes are one of the biggest hidden costs of investing. You might not notice them when you glance at your portfolio, but over time, they can quietly erode your returns. Direct indexing may give you more control over when and how you pay taxes, generating what's called tax alpha. Because you directly own each individual stock in the portfolio, it's an advantage unlike anything you can get through traditional mutual funds or exchange-traded funds. The first and most important tax benefit of direct indexing is tax-loss harvesting. This means selling stocks that have dropped in value, capturing the loss for tax purposes, and reinvesting in similar securities so you stay invested in the market. Even in years when the overall stock market gains ground, many individual stocks are likely to finish lower than where they started. For example, in 2024, the S&P 500 Index posted an overall return of 25%. Yet, nearly one-third of the stocks in the index posted a negative return for the full year. In any given period, there are almost always stocks declining in value, which is an opportunity for tax-loss harvesting. Unlike strategies that only harvest losses occasionally or at year-end, direct indexing portfolios are monitored and optimized throughout the year. This means that volatility-driven opportunities are far less likely to slip through the cracks. Over time, these harvested losses can build to offset any future gains, even outside of a direct indexing account. If your losses are larger than your gains in any given year, you may even be able to apply up to $3,000 of those losses against ordinary income, and any unused losses can carry forward, creating a cushion for future tax years. At Allspring, portfolios are managed to balance tax efficiency with index alignment, so you may get after-tax benefits without straying from the market exposure you expect.

The second major tax benefit is the ability to spread out your tax liability. With mutual funds, you don't control when gains are distributed. You might even receive a tax bill without selling anything yourself. Direct indexing is more flexible. If you're transitioning out of a concentrated stock position, selling a business, or preparing for retirement, gains can be managed more gradually. Meanwhile, harvested losses from the direct indexing strategy can help offset those gains, reducing the impact of one big tax hit and spreading tax liability across multiple years.

The third benefit is charitable giving. Donating appreciated securities instead of cash means you avoid paying capital gains tax on those shares while still receiving a deduction for the full market value of the contributed asset. Because you own individual stocks in a direct indexing account, it's easy to identify and donate the most appreciated holdings. That way, you support the causes you care about while also improving your after-tax outcome. Taken together, continual tax-loss harvesting, ongoing tax management, and smarter charitable giving, direct indexing offers a powerful tool kit for tax-efficient investing. Tax laws may change, but taxes will never disappear. Working with a financial professional, direct indexing can keep you invested in markets while also helping manage your taxes thoughtfully—and who doesn't want to keep more of what they earn?

Tax alpha refers to the additional value or returns generated in an investment portfolio by incorporating strategies that minimize tax liabilities, such as tax-loss harvesting. Tax alpha is based on historical performance and does not represent future results.