Back in 2013 when Wealthfront coined the term “direct indexing,” the strategy (which had been around for decades) was fairly exclusive. Companies like Parametric and Aperio had long offered direct indexing to wealthy clients, but Wealthfront was an early pioneer in offering the strategy for a low cost and low minimum to everyday investors. 

At Wealthfront, we believe that direct indexing is a powerful way to help maximize your after-tax returns, and that’s why we’re so passionate about making it more widely available to investors. In this post, I’ll break down how this strategy works and why it can make such a big difference in helping you keep more of what you earn. Direct indexing might seem complicated, but you should know that Wealthfront makes it incredibly simple—we design our direct indexing products, including Wealthfront’s S&P 500 Direct and Nasdaq-100 Direct, to help lower your tax bill with no extra effort on your part.

How direct indexing works

Let’s start with the basics of the strategy. Direct indexing gets its name from the fact that investors directly own the stocks that comprise an index instead of owning an index-based ETF or mutual fund. As a result, you get exposure to the stocks in the index (like you would with an ETF) but it’s also possible to conduct tax-loss harvesting (strategically selling investments at a loss and replacing them with similar investments) using those individual stocks. Conducting tax-loss harvesting with individual stocks means you could get opportunities to harvest losses even on days when the index as a whole is up, which means more chances to help lower your tax bill. In this way, direct indexing offers some of the same benefits as owning an index-based ETF plus something you can’t get just from holding a single ETF: the ability to generate future tax savings. 

Here’s an example that illustrates how this works. Let’s say you use a direct indexing product to hold the 200 largest market cap stocks that make up an imaginary index. On a day when the index is up 1%, Coca-Cola (which we’ll say is part of that imaginary index) might have announced poor earnings and declined 10%. If you only held an index-based ETF, there would be no loss to harvest. But if the 10% decline in Coca-Cola brings the stock’s price below its purchase price, you can sell it at a loss and temporarily replace it with a combination of other highly correlated alternative stocks in the index (for example, stocks in the same industry like Pepsi) to keep the portfolio tracking the index closely. When you sell Coca-Cola at a loss, you “harvest” that loss and can use it to offset other gains and up to $3,000 of ordinary income each year. After 30 days, to comply with the wash sales rule, you can sell Pepsi (and any other stocks you bought) and repurchase an equivalent amount of Coke.

At the same time, the risk profile and pre-tax return of your portfolio generally remain the same with direct indexing (as compared to owning the corresponding index-based ETF) because the performance difference relative to the benchmark index should be fairly low. But your after-tax return has the potential to be better with direct indexing because you should be able to harvest losses that you can then use to lower your tax bill. And after-tax return is what really matters, because that’s what you get to keep. Saving on taxes is also valuable because it means more money to reinvest, with the potential to grow and compound in the future.

If direct indexing sounds labor-intensive, that’s because it can be. A human advisor would need to carefully track the performance of hundreds of individual stocks on a near-daily basis in order to execute this strategy successfully. Software, on the other hand, is ideally suited to this kind of rules-based task—and that’s exactly why Wealthfront automates it. 

What do you do with the losses?

Harvested losses are valuable because they can be used to lower your tax bill. You can offset capital gains and, if you still have losses left over after that, up to $3,000 of ordinary income (like money you earn as your salary) in a given year. Any losses you have left over after that can be rolled over to future years to offset future capital gains and/or ordinary income. 

Let’s illustrate this with an example. To start, imagine you harvested $4,000 of losses last year and realized $500 of capital gains. We’ll also imagine you have a salary of $150,000. Here’s what you could do with those losses:

  • Offset capital gains: At tax time, you could apply those losses to offset your capital gains completely, meaning you’d owe no taxes on that $500. 
  • Offset up to $3,000 of ordinary income: After that, you’d still have $3,500 of losses left. Each year, you can use losses to offset up to $3,000 of ordinary income, so you could apply $3,000 of your remaining losses to do that. If you would have otherwise paid a marginal federal tax rate of 24% as a single filer, the amount you’d save would be $3,000 x 0.24 or $720. The higher your marginal tax rate, the more valuable your harvested losses are to you. 
  • Roll over the extras indefinitely: The $500 of losses you still have left over after that can be carried forward indefinitely to future years.

For Wealthfront clients, using the losses at tax time is easy. We’ll automatically include this information for your Wealthfront accounts on your Consolidated 1099. If you use tax preparation software like TurboTax (which many Wealthfront clients do), that information will be automatically imported when you upload your forms. If you’re rolling over losses to a future year, an accountant or software like TurboTax can track this for you. Just keep in mind that if you switch to a new accountant or tax preparation software, you should just make sure your leftover losses get entered into Schedule D of your 1040.

Who can benefit the most from direct indexing?

Direct indexing could be a good fit for any investor who wants exposure to a specific index and future tax savings at the same time. It is most valuable for long-term investors in high tax brackets, especially those who have (or expect to have) a lot of capital gains.

Let’s imagine you’ve banked a significant quantity of harvested losses, and your company is about to go public and you have incentive stock options (ISOs). Or maybe you’re planning to sell a lot of appreciated stock for another reason. Or maybe you have large mutual fund holdings that are required to make capital gains distributions. In all of these cases, direct indexing (paired with tax-loss harvesting, like what Wealthfront offers) could help you offset those gains and lower your tax bill significantly. 

Keep more of what you earn

Our investment philosophy at Wealthfront is based on the belief that investors should focus on three things within their control: lowering taxes, lowering fees, and managing risk. We build products that make it easy to do all three, and our direct indexing products are no different. 

We currently offer a direct indexing within our Automated Investing Account, the Direct Indexing Portfolio, as well as two standalone direct indexing products: Wealthfront’s S&P 500 Direct (which contains stocks from the S&P 500® index) and Nasdaq-100 Direct (which contains stocks from the Nasdaq-100 Index®). Both give investors an opportunity to get exposure to popular indices at a low cost while also generating future tax savings through a powerful direct indexing strategy. And, because it’s Wealthfront, both are fully automated and effortless for you. 

Learn more about our products
Subscribe to our blog
Please fill out this field.
You've successfully subscribed to our blog.

Disclosure

The information contained in this blog is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as a solicitation, offer or recommendation to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers, Wealthfront Brokerage or any affiliate endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.

The effectiveness of the tax-loss harvesting strategy to reduce the tax liability of the client will depend on the client’s entire tax and investment profile, including purchases and dispositions in a client’s (or client’s spouse’s) accounts outside of Wealthfront Advisers and type of investments (e.g., taxable or nontaxable) or holding period (e.g., short- term or long-term). Additionally, the frequency of deposits can affect our ability to harvest losses. Tax-Loss Harvesting tends to provide greater value for clients who make regular deposits, compared to those who make a single initial deposit and no subsequent ones. This is because follow-on deposits typically have a higher starting cost basis (Since over the long term, indexes on average trend up), which helps facilitate tax-loss harvesting and increases the harvesting yield of the account. However, very frequent deposits (e.g., less than 30 days apart) can decrease the ability to harvest losses in the short-term. More frequent deposits can result in multiple tax lots in the same stock, which can prevent tax-loss harvesting due to our attempt to avoid wash sales.

Keep in mind, any harvested losses are first used to offset capital gains of the same type. This means short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other type of gain.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and the strategy could introduce portfolio tracking error into your account. Tracking error is a measure of financial performance that determines the difference between the return fluctuations of an investment portfolio and the return fluctuations of a chosen benchmark. There may also be unintended tax implications. 

Wealthfront Advisers’ investment strategies, including portfolio rebalancing and tax loss harvesting, can lead to high levels of trading. High levels of trading could result in (a) bid-ask spread expense; (b) trade executions that may occur at prices beyond the bid ask spread (if quantity demanded exceeds quantity available at the bid or ask); (c) trading that may adversely move prices, such that subsequent transactions occur at worse prices; (d) trading that may disqualify some dividends from qualified dividend treatment; (e) unfulfilled orders or portfolio drift, in the event that markets are disorderly or trading halts altogether; and (f) unforeseen trading errors. The performance of the new securities purchased through the tax-loss harvesting service may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes.

Tax loss harvesting may generate a higher number of trades due to attempts to capture losses. There is a chance that trading attributed to tax loss harvesting may create capital gains and wash sales and could be subject to higher transaction costs and market impacts. In addition, tax loss harvesting strategies may produce losses, which may not be offset by sufficient gains in the account and may be limited to a $3,000 deduction against income. The utilization of losses harvested through the strategy will depend upon the recognition of capital gains in the same or a future tax period, and in addition may be subject to limitations under applicable tax laws, e.g., if there are insufficient realized gains in the tax period, the use of harvested losses may be limited to a $3,000 deduction against income and distributions. Losses harvested through the strategy that are not utilized in the tax period when recognized (e.g., because of insufficient capital gains and/or significant capital loss carryforwards), generally may be carried forward to offset future capital gains, if any.

Wealthfront Advisers and its affiliates do not provide legal or tax advice and do not assume any liability for the tax consequences of any client transaction. Clients should consult with their personal tax advisors regarding the tax consequences of investing with Wealthfront Advisers and engaging in these tax strategies, based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront Advisers assumes no responsibility for the tax consequences to any investor of any transaction.

What we mean by “help improve your after-tax returns”: Tax Loss Harvesting, by making small calculated exchanges on investments that lose value, can help our clients lower their taxes when they use those losses to offset long-term, short-term, or ordinary income taxes. What’s more, clients then have the opportunity to reinvest those tax savings back into the market, potentially further increasing after-tax returns. Please note, tax loss harvesting doesn’t guarantee market outperformance, but it provides an opportunity to help improve after-tax returns.

Tax-Loss Harvesting can become more challenging over time. Reinvesting proceeds from harvested investments lowers the portfolio’s cost basis. In an upward-trending market, this lower cost basis means it can be harder to find losses to harvest in the future.

Wealthfront’s S&P 500 Direct: The S&P 500® index is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and has been licensed for use by Wealthfront Advisers LLC. Standard & Poor’s®, S&P®, S&P 500®, US 500 and The 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Wealthfront Advisers LLC. Wealthfront’s S&P 500 Direct Portfolio is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500® index.

Wealthfront’s Nasdaq-100 Direct: Nasdaq®, Nasdaq-100 Index®, NDX®, and Nasdaq-100® are registered trademarks of Nasdaq, Inc. (which with its affiliates is referred to as the “Corporations”) and are licensed for use by Wealthfront Advisers LLC. The Product(s) (“Wealthfront Nasdaq-100 Direct Index”, “Wealthfront Nasdaq-100 Direct”, “Nasdaq-100 Direct”) have not been passed on by the Corporations as to their legality or suitability. The Product(s) are not issued, endorsed, sold, or promoted by the Corporations. THE CORPORATIONS MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO THE PRODUCT(S).

Our direct indexing portfolios (S&P 500 Direct and Nasdaq-100 Direct) invest in many stocks in their respective underlying index, but they may not invest in all stocks in the index. Its performance may deviate from its associated index due to tracking error, market conditions, and limitations of Tax-Loss Harvesting. Account size and customization options, such as excluding individual stocks, may affect your portfolio’s ability to track its underlying index. Since indices are not available for direct investment, their performance does not reflect the expenses associated with the management of an actual portfolio.

All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Please see our Full Disclosure for important details.

Investment management and advisory services are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and brokerage related products, including the Cash Account, are provided by Wealthfront Brokerage LLC, a Member of FINRA/SIPC.

Wealthfront, Wealthfront Advisers and Wealthfront Brokerage are wholly owned subsidiaries of Wealthfront Corporation.

Copyright 2025 Wealthfront Corporation. All rights reserved

About the author(s)

Alex Michalka, Ph.D, has led Wealthfront’s investment research team since 2019. Prior to Wealthfront, Alex held quantitative research positions at AQR Capital Management and The Climate Corporation. Alex holds a B.A. in Applied Mathematics from the University of California, Berkeley, and a Ph.D. in Operations Research from Columbia University.