Planning Considerations for a Direct Indexing Program

Trust Ownership and Planning Considerations

• Managing trust tax brackets. For those who have established irrevocable trusts, it may make sense to own a direct indexing portfolio within that trust to avoid unfavorable trust tax brackets that apply to undistributed income retained within a non-grantor trust, which is treated as a separate taxable entity for income tax purposes. For 2026, the highest trust tax brackets on ordinary income, dividends, and capital gains (including the 3.8% net investment income tax) apply once income exceeds $16,000. In contrast, individual taxpayers face the top tax bracket once income exceeds $640,600. For that reason, holding more tax-efficient assets (such as a direct indexing portfolio) within this type of trust may be a consideration if the trust is not distributing most of the income to beneficiaries, who would be subject to paying taxes.
• Taking advantage of step-up in cost basis. One potential downside of holding a direct indexing portfolio within an irrevocable trust, whether a grantor or non-grantor trust, arises when the portfolio reaches a point where most of the available tax-loss harvesting opportunities have been exhausted. The technical term for this is ossification. Unless additional cash is added to the portfolio and invested or a tax budget is implemented to proactively recognize gains, the investor is potentially left with an appreciated, albeit diversified, portfolio. If wealth transfer is an objective, owning an appreciated asset within an irrevocable trust may be problematic since that property is generally not eligible for stepped-up cost basis treatment at death. A potential solution would be to incorporate language within the trust document which allows for “swapping powers” under Internal Revenue Code (IRC) Section 675. This provision allows the trustee to substitute property of equal value within the trust. For example, swap out low-cost-basis property from the trust and replace that with higher-cost-basis property. If the low basis property is owned by the grantor outside of the trust, step-up in cost basis treatment may apply upon death.
• Planning for excess losses. While losses generated through direct indexing are generally applied to gains within the same portfolio, there may be market environments where realized losses significantly exceed gains—known as a net capital loss. The ability to apply these excess losses against ordinary income is generally limited to only $3,000 annually for individual taxpayers. Any excess must be carried forward to the next tax year. Are there opportunities to apply net losses to other investments outside of the direct indexing portfolio? If the direct indexing portfolio is owned within a trust, the type of trust will make a difference. As mentioned previously, a non-grantor trust is generally considered a separate entity for income tax purposes. In this case, net losses held inside a non-grantor trust could not be applied to realized gains on investments owned individually or jointly outside of the trust for example. However, this is not the case with a grantor trust where taxes on income retained inside the trust (i.e., not distributed to beneficiaries) essentially “flows-through” to the grantor’s own tax return, allowing for more flexibility in applying losses to other gains in this instance.

Other Planning Areas to Consider

• Sale of a business or other appreciated asset. Another important consideration is whether the tax efficiency afforded through direct indexing can be coordinated with the timing of other significant income or capital gain tax events. For example, a business owner selling a business may face a substantial tax bill in a particular year, or over several years in the case of an installment sale. A direct indexing program could potentially provide an opportunity to harvest losses that may be used to offset gains from the sale of the business or other event.
• Charitable giving. Once a direct-indexed portfolio matures to the point where the ability to harvest losses has been essentially exhausted (i.e., ossified), donating appreciated securities from the portfolio to charity may be one planning consideration to satisfy philanthropic wishes while avoiding taxes on embedded capital gains.
• Opportunities for income or liquidity. Depending on an investor’s circumstances and risk tolerance, a mature direct-indexed portfolio may also provide opportunities to explore liquidity or income strategies, such as securities-based lending or certain managed options strategies.
• Corporate executives and equity-based compensation awards. Similar to the sale of a business or other appreciated asset, losses generated through a direct indexing portfolio may provide corporate executives with an additional tool for managing the tax impact of equity compensation, including restricted stock and options. Additionally, customizations may allow the executive to eliminate or restrict a single stock, sector, or industry to limit concentration risk within their direct index.
• Highly appreciated company stock within an employer retirement plan. The tax code allows preferential tax treatment when company stock is distributed—not rolled over—from a retirement plan. This is known as the net unrealized appreciation (NUA) rule. It must be a lump-sum distribution from the plan, with the stock transferred in kind (i.e., not sold) from the plan to a brokerage account. Although the cost basis of the stock is considered ordinary income when distributed, the appreciation in the stock (the NUA) is taxed at preferential long-term capital gains rates when sold. Combining this strategy with a direct indexing program may allow the investor to diversify out of the NUA stock over time while potentially offsetting some of the capital gains associated with the sale using losses generated by the direct indexing portfolio. Also, if the former employer company stock is owned until death, the original NUA portion of the stock (the difference between the cost basis and market value when the stock was distributed from the plan) is not eligible for step-up in cost basis. Instead, the NUA portion is considered income in respect of a decedent (IRD) and would have to be reported as a long-term capital gain if eventually sold by the heir. Subsequent appreciation after the stock was distributed from the plan would be eligible for step-up in cost basis. Selling shares of the NUA stock over time in conjunction with losses generated by the direct indexing portfolio may mitigate taxes while reducing single-stock concentration risk.
• Potential improvement in tax efficiency. Direct indexing may also play a role in managing taxable income and avoiding unintended tax consequences tied to income-based thresholds. For example, realizing substantial capital gains may trigger higher Medicare premiums through the Income-Related Monthly Adjustment Amount (IRMAA) rules. As a result, direct indexing may serve not only as an investment strategy but also as a tool for managing taxable income and coordinating tax-efficient wealth planning decisions across multiple years.

Seek Guidance

As direct indexing continues to gain popularity, investors should evaluate the strategy within the context of their broader financial plan. Understanding its potential benefits while proactively addressing possible pitfalls can help investors determine how the strategy may fit within their broader financial plan. Working with financial and tax professionals is a critical part of the process.

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