Direct Indexing for High-Income Physicians
How Tax-Efficient Investing and Tax-Loss Harvesting Can Help W-2 Doctors Reduce Taxes
Quick Overview
Direct indexing is a tax-efficient investment strategy that allows investors to directly own the individual stocks within an index such as the S&P 500. For high-income physicians with taxable investment accounts, this structure can allow for tax-loss harvesting, portfolio customization, and improved after-tax returns over time.
Because many physicians are high W-2 earners with limited tax deductions, strategies that improve tax efficiency inside investment portfolios can play an important role in long-term wealth building.
Why High-Income Physicians Often Explore Direct Indexing
Springtime. For some, the snow has melted away and it’s time to start decluttering the entire house once again. For others, they will be waiting a while longer until it gets warm enough to flush winter away fully. In Ohio, I’m guessing it will take until May. For everyone however, it’s tax season. Don’t worry, this is not going to be a last-minute guide on every exploit that can save you a few pennies at the finish line. While pennies do have some power, I want to discuss something a great deal more consistent and that can save you thousands on that final tax bill: direct indexing.
As a physician with the experience you have, you’re most likely in the stage of your career where your earnings are at a pretty high point. You’ve finally crossed over the hill and all those years of training start to reflect in both your skill level and your assets. While it may be a far cry from what you were earning while you were training, this higher income level does attract a pretty large thorn in your financial side: your taxable income. Unless you have the soul of a true altruist, most of us are inclined to try to keep said funds in our own bank accounts rather than Uncle Sam’s pockets. After all, it's not what you make, it’s what you keep.
In the spirit of trying to bolster what you are keeping, there are quite a few methods and routes to maximize your monetary assets. Rather than list every option with a short explanatory blurb attached, I wanted to shine a spotlight onto one particular example that can greatly mitigate your tax bill as well as be custom tailored to you and your lifestyle. While I have discussed direct indexing before, I want to give the subject the time it deserves and provide a fuller, richer picture of the opportunity that many are ignoring. I also want to take the time to explain that direct indexing is not the one-size-fits-all, silver bullet, magic pill that some advisors like to claim it to be. Everyone’s situation is different, and different problems require different solutions.
Sounds a tad like healthcare, doesn’t it?
So What Is Direct Indexing?
In a way, direct indexing is pretty similar to some of the best dishes found in high-end restaurants: something simplistic fine-tuned to its highest potential. In essence, you are building out your own investment portfolio by holding individual stocks and bonds. This portfolio is something that is incredibly personalized, allowing a range of options for you to pick and choose from. Your new portfolio can be designed around certain themes, which might range from everything like pure Tax-Efficiency, Environmental Investments, to Religious Compliance (Sharia Law portfolios is one example). Rather than buying into a pre-selected “barrel of stocks” with a mutual fund or ETF, you are able to fine tune and choose exactly what you are investing in. Direct indexing is a tool that offers an incredible amount of freedom within it, whatever the end goal may be. A large portion of direct indexing’s popularity in recent years has been due to that freedom, as it allows for techniques that result in a reduced tax bill come this time of the year. The key here is that the portfolio is able to be designed around your personal goals and beliefs, rather than a fund that is based solely on performance.
In order to get a better understanding on how Direct Indexing models compare to other investment strategies and methods, I want to briefly touch upon the alternatives in order to provide some context.
Direct Indexing vs Mutual Funds and ETFs
First off are actively managed mutual funds. This type of investment tool is a collection of individual stocks, chosen beforehand by a team of professional money managers. These managers then measure the performance of said collection against an index, often one internally designed.
Mutual funds are an incredibly common investment platform, known for (relative) simplicity as the selection of stocks is handled only by the investment manager. They have a long-standing history in the financial world and were great when first created, even being considered as “bread and butter” to some advisors. However, they are not the most efficient or effective investment product.
Mutual funds are some of the most tax-inefficient investments on the market with nearly all of them lagging behind the long-term performance of their respective indexes, and are quite expensive. If you have invested in mutual funds via a taxable account in recent years, chances are that you received quite a large surprise tax bill at the end of the respective year. Additionally, the fact that these funds are made up of pre-picked stocks also removes a massive amount of personalization from the investment equation.
Next, we have Exchange Traded Funds, better known as ETFs. These are stripped down, more bare-bones versions of mutual funds. These funds have no active management or team monitoring the fund’s performance, are designed to replicate their respective indexes, and have amplified tax efficiency with a reduced price tag attached.
Their performance is going to be consistent with the outcome of the correlating index. While ETFs have a smaller chance of outperforming at the pace that mutual funds do, they also have a decreased chance of underperforming the index as consistently as mutual funds do on a 10-year basis. In similar fashion to mutual funds, the majority of ETFs are pre-selected and thus remove the ability to better align your investments with your personal beliefs or financial goals.
Since it is tax season, my main focus will be on Tax-Efficient Direct Indexing models.
How Direct Indexing Uses Tax-Loss Harvesting Strategy
Before we dive directly into these portfolios, I want to share some history with you that hopefully offers some illuminating context for the overall tax-mitigation process.
In 2020, the S&P 500 had total returns of just over 16%. Roughly 60% of the holdings had positive years, while 40% finished the year down.
Wouldn’t it be nice if you could sell some of those poorly performing companies and grab some tax losses without impeding the positive performance of the other companies?
If you were relying on mutual funds or ETFs, there would be no chance of making this happen. But with direct indexing, you can.
A Direct Index model replicates a traditional market index but with individual stocks and bonds at the forefront.
Let’s focus on an example portfolio that is designed to replicate the S&P 500. This example portfolio has about 150 stocks within it, with said stocks still having a high correlation to the overall index.
In order to more effectively mitigate your overall tax bill, you would be aiming to sell off under-performing stocks and use this tax loss to offset a portion of that final bill.
At the same time as these sales, you would be purchasing stocks of a similar nature from a different company that is performing more desirably.
The example I prefer to use is if you are holding Lowe’s and it is down for the year, you can sell those shares of Lowe’s and instead buy into Home Depot.
This maintains the integrity of your portfolio while capturing tax losses.
This process is referred to as tax-loss harvesting strategy.
Direct Indexing Providers and Platforms
As the costs of entry have come down and technology has served as an equalizer, Direct Indexing and its accessibility has become a hot button topic within the financial world. Rather than overwhelm with the full laundry list of who you should be discussing Direct Indexing with, I wanted to briefly highlight some of the more popular options available to you. I also want to emphasize that the pricing information I reference for said options was found online, and is liable to change between specific clients and situations. These numbers are not set in stone and should not be treated as such.
Wealthfront
Wealthfront is a California based company with one of the lowest cost of entries on the market, making it a very attractive offer to investors looking to start optimizing their taxes. Their cost is 9bps (9 basis points), which equates to $900 annually to manage a $1 million portfolio. If it seems too good to be true, it’s because it might just be. Wealthfront’s default method is to try to hold onto all 500 stocks in the S&P 500, which drags down tax efficiency along with nixing any personalization the index might regularly hold. This option is a relatively recent addition from 2024, but the company has been Direct Indexing for over a decade. You do have the ability to retroactively exclude specific stocks from your portfolio, but this and other tax optimizing methods seem to be afterthoughts or need to be repeatedly requested before they're implemented.
Vanguard
Vanguard is based out of Pennsylvania with a website that is about as clear as mud, and just about as tough to wade through. The actual cost of their Direct Indexing is nowhere to be found on their site. After talking with a Vanguard rep a few years ago I found out that it was about 20bps, coming to $2,000 on a $1 million account. I have a feeling it’s come down in recent years, but I have not reached out to confirm this. The rep also informed me that Vanguard had actually acquired an external Direct Indexing provider and simply wrapped their business directly into Vanguard’s services. This is not an uncommon practice in the finance world, but no information was ever given regarding the experience the provider had. Their version of the process does feature the more traditional personalization, but does not provide any clarification on just how many stocks they hold within the portfolio. Their website also appears to imply that the Direct Indexing service is limited to their clients with financial advisors and is not accessible to individual clients.
Forward Thinking Wealth Management
For my Direct Indexing, I work with an outside advisor with over 20 years of experience to assist in running my portfolios. Those decades of experience are priceless when tax season comes around. The annual cost is 30bps, or $3,000 a year for a $1 million portfolio. Rather than just focus on tax-loss harvesting, we like to beef it up and call our tax mitigation process “Tax Alpha”, because it involves more bang for your buck and shaves quite a bit off your final bill. One of my clients actually elected to have the Direct Indexing portfolio I designed for him independently analyzed, and was elated to hear that he was getting a 3-to-1 return on his investments, shaving off about $70,000 in taxes. My S&P 500 portfolios do not try to hold onto every company within the index but rather roughly 150 of said stocks. This approach allows for greater flexibility in the realm of tax management and mitigation. Additionally, I have the ability to truly customize a profile around a concentrated position you may already own, such as a large amount of Apple stock. This streamlines the initial process rather than forcing you to sell all of said stock beforehand. Coupling this with the additional factors I involve in the process: individual tax lot analysis, incorporating wider rebalancing ranges, enhanced Gain-Loss offset, all allow me to help you keep more every year.
Why Direct Indexing Can Be Powerful for High-Income Physicians
As we’ve discussed, you are earning at quite a high level, which comes with the consequence of higher tax bills. Taking the step to be more tax-smart with your investing can add roughly 1% to a portfolio’s return, year after year. I don’t know about you, but an additional 1% a year sure can compound. This figure is also a conservative measurement, as one client had a 5% tax-savings advantage in 2022, and another client was up an additional 1% by May of last year.
I do want to caution that Direct Indexing is not a cure for everyone’s financial ails. You wouldn’t visit a dermatologist after tearing your ACL, and you wouldn’t go to a grocery store to get your car worked on. Specific tools are meant for specific situations. It is always worth discussing with your advisor about the reasoning behind investment and savings strategies. It’s your money, you deserve a say in how it’s handled. The one consistent downside that comes with Direct Indexing and tax-loss harvesting is that there will come a point in your portfolio where you will have already sold off all the failing stocks and you will be “stuck” with only higher valued (taxed) stocks. However, these can then be sold off at a lower Capital Gains rate in exchange. It is a bit of a textbook example of a first world problem to have.
Key Takeaways for Physicians Considering Direct Indexing
Direct indexing can be a powerful strategy for high-income investors because it allows for:
• Individual stock ownership
• Portfolio customization
• Ongoing tax-loss harvesting
• Potential improvements in after-tax returns
However, like any investment strategy, it should be evaluated within the context of your overall financial plan.
Frequently Asked Questions Physicians Ask About Direct Indexing - FAQ
Below are some common questions that arise during discussions about Direct Indexing.
1. What is direct indexing and how is it different from ETFs or mutual funds?
Direct indexing is an investment strategy where you directly own the individual stocks that make up an index rather than buying a mutual fund or ETF that holds them for you. This allows your portfolio to closely track an index like the S&P 500 while still giving you flexibility to customize holdings. Unlike ETFs or mutual funds, direct indexing allows for personalization and tax strategies such as selling specific losing positions to offset taxable gains.
2. How does direct indexing help reduce my tax bill?
Direct indexing allows investors to take advantage of a strategy called tax-loss harvesting. This means selling individual stocks in your portfolio that have declined in value and using those losses to offset taxable gains elsewhere. You can then replace those stocks with similar investments to maintain your portfolio’s overall exposure to the market. Over time, this strategy can meaningfully reduce the amount of taxes owed.
3. Who is direct indexing best suited for?
Direct indexing is typically most beneficial for high-income earners with taxable investment accounts, such as physicians, business owners, and executives. Investors in higher tax brackets often benefit the most from tax-loss harvesting and portfolio customization. It may be less impactful for investors whose assets are primarily held in tax-advantaged accounts like 401(k)s or IRAs.
4. Are there downsides to direct indexing?
While direct indexing offers powerful tax advantages, it isn’t the right solution for everyone. Over time, as markets rise, your portfolio may eventually hold mostly appreciated stocks, leaving fewer opportunities to harvest losses. In addition, direct indexing requires more portfolio management and may involve advisory or platform fees depending on the provider.
5. How much can tax-efficient investing with direct indexing add to returns?
Tax-efficient strategies like direct indexing can potentially add around 1% in annual after-tax returns through tax savings and improved portfolio management. In certain years with more volatility, the tax benefits may be even greater due to increased opportunities for harvesting losses.