White paper: Direct indexing tax efficiency extends into retirement and withdrawals
In our previous white paper, we explored the tax benefits of direct indexing through tax-loss harvesting and the ability to defer taxes. This white paper builds on that foundation and provides a more comprehensive analysis of how direct indexing can offer additional tax efficiency during the withdrawals phase from a direct indexing portfolio.
By examining a scenario involving gradual withdrawals and a final liquidation from the portfolio, we aim to provide investors with a more holistic understanding of the potential tax benefits associated with a direct indexing strategy. At a high level, we expect a tax-loss harvesting strategy to significantly defer tax payments. During the withdrawal phase, the strategy can first utilize losses harvested in the early years, and then strategically liquidate stocks with a high-cost basis to further delay tax obligations.
Summary of results
Our findings show that direct indexing provides significant tax advantages over traditional ETF investments, primarily through tax deferral. This benefit applies whether the investor has external capital gains to offset using harvested losses or, in the absence of such gains, can carry forward the losses to offset gains incurred during the withdrawal phase of the direct indexing portfolio. In the latter case, investors can use harvested losses from the early years to defer tax payments during the initial withdrawal period.
Methodology
To analyze the tax implications of direct indexing after withdrawals begin, we consider the following scenario:
An investor with $1 million in cash invests in the S&P 500©. After five years of growth without withdrawals or additional deposits, the investor retires in year six and begins withdrawing $10,000 monthly from the investment account to supplement their living expenses. The investor is subject to a long-term capital gains tax rate of 28.1% and a short-term capital gains tax rate of 42.3%1.
We evaluate the after-tax financial implications of two investment strategies over the course of 15 years—10 years after withdrawals commence:
- The investor invests in an ETF, specifically SPY.
- The investor invests in a Frec S&P 500 direct indexing account.
Frec applies its tax-loss harvesting strategy to regularly rebalance the account and harvest losses. It also enables tax-efficient withdrawals during the withdrawal phase from the direct indexing account.
The tax implications for the ETF account are straightforward: if the ETF appreciates in value, capital gains taxes are due when the investor begins withdrawing funds2. In contrast, the tax implications of a direct indexing account depend on how the investor utilizes the harvested losses. The economic value of these losses varies based on the type of gains they offset— losses applied to short-term gains yield a greater tax benefit than those offsetting long-term gains due to a higher tax treatment given to short-term gains. In this paper, all of the carried forward losses are assumed to offset long-term capital gains during the withdrawal period.
This white paper describes a real-world scenario where investors are uncertain whether they will have outside capital gains to offset with harvested losses. In this case, losses are carried forward and used to offset capital gains during withdrawals, which are typically long-term3. This represents a worst-case scenario in terms of the economic value of harvested losses, but as this paper shows, still represents a significant tax deferral benefit.
Deferring tax payments provides significant value by enabling the reinvestment of tax savings within the same tax year. However, this white paper does not delve into the time value of reinvested tax savings. You can read about the value of reinvesting tax savings in our earlier white paper, here.
Simulations
This study is based on historical backtesting simulations using Frec’s current direct indexing algorithm conducted over multiple overlapping 15-year periods. The simulations begin at 90-day intervals from December 2003 to February 2009. For example:
- The first simulation spanned from December 17, 2003, to December 7, 2018, with the first withdrawal occurring on January 20, 2009.
- The second simulation ran from March 16, 2004, to March 8, 2019, with the first withdrawal on April 21, 2009.
- The final simulation covered the period from February 18, 2009, to February 14, 2024, with the first withdrawal on March 25, 2014.
In total, 22 simulations were conducted. Across all simulations, accounts maintained sufficient assets to cover withdrawals, even through adverse market events such as the 2008 financial crisis.
For direct indexing simulations, a 0.1% AUM fee was applied based on Frec’s pricing as of January 28, 2025. No additional management fees were assessed for the ETF account, as the ETF management fee is incorporated into its market pricing.
Results
The figure below illustrates the potential tax implications of direct indexing and ETF accounts. It showcases the average taxable losses and gains from tax-loss harvesting and withdrawals at year-end and after full liquidation, along with unrealized portfolio gains and losses across 22 simulation runs.
The direct indexing account accumulates realized losses during the first five years when no withdrawals occur. These losses are sufficient to offset all realized gains from withdrawals until year 13. In contrast, the ETF account begins accumulating realized gains as soon as withdrawals start in year 6.
We also present cumulative realized gains after full liquidation. This hypothetical liquidation accounts for unrealized gains in both investment accounts, enabling a fair comparison. Additionally, it offers insight into how realized gains may evolve if withdrawals continue beyond year 15. Since realized gains are similar after the hypothetical liquidation at the end of year 15, the final tax liability for both accounts would likely remain comparable if the investor continues to withdraw and eventually fully liquidates the accounts.
Next, we’ll examine the economic impact of these realized losses and gains. The table below summarizes the average portfolio values and tax implications across 22 simulation runs.
| Direct indexing | ETF | Difference | |
| Remaining portfolio value after 15 years | $1,988,105 | $1,862,228 | 6.76% |
| Pre-tax withdrawal | $1,210,000 | $1,210,000 | 0.00% |
| Total tax liability after full liquidation | $584,542 | $582,296 | 0.39% |
| Tax paid during withdrawal period | $66,491 | $173,325 | -61.64% |
| Short-term | $0 | $0 | -% |
| Long-term | $66,491 | $173,325 | -61.64% |
| Tax owed after full liquidation | $518,051 | $408,971 | 26.67% |
During the 10-year withdrawal period, the direct indexing account pays only $66,491 in capital gains taxes, as carried-over losses are used to offset gains. In contrast, the ETF account incurs $173,325 in long-term capital gains taxes. However, the direct indexing account’s final portfolio has more unrealized gains, resulting in a total tax liability that is 0.39% higher than that of the ETF account if the investor fully liquidates the portfolio at the end of the simulation. Similar to the realized gains after full liquidation shown in the previous figure, the tax owed at liquidation is calculated to assign an economic value to unrealized gains. This allows for a fair comparison of tax implications and serves as an estimate of potential tax liability if the investor continues making withdrawals.
The primary advantage of direct indexing for investors who are uncertain they will have immediate capital gains to offset with harvested losses is the ability to significantly defer tax payments during the withdrawal period. During the first 10 years of withdrawals, the direct indexing account incurs substantially lower tax obligations compared to the ETF account. On average, there is no tax obligation until year 13—eight years after withdrawals begin. Moreover, even though the direct indexing account has greater unrealized gains and thus potential tax owed after year 15, its total tax liability isn’t significantly higher than the ETF account’s, even after complete liquidation.
Conclusion
This white paper provides an in-depth exploration of the tax implications of direct indexing accounts throughout their lifecycle—from inception to significant withdrawals, and ultimately, final liquidation. The analysis demonstrates that direct indexing can offer notable tax advantages compared to traditional ETF investments, primarily through deferred tax payments. Importantly, the benefit of deferred tax payments does not depend on the investor having capital gains to offset against harvested losses so it applies to investors who are uncertain whether they will have outside capital gains to offset harvested losses. While direct indexing presents potential tax advantages, it is crucial to consider the additional complexity associated with the strategy, as well as tracking errors. The results presented in this study are based on historical simulations and are not predictive of future performance.
If you have any questions about the details, feel free to reach out at help@frec.com or schedule a call here.
The simulations for this white paper utilized all tax losses harvested to offset withdrawals. Tax losses can be used to offset up to $3,000 in income tax annually, which was not implemented for this simulation.
This white paper describes the implementation and performance details of a Direct Indexing approach similar to that used on the Frec platform at the time of writing (01/30/2025) details may differ from the implementation used in the product now and in the future. This paper may be amended at any time to reflect new findings, improve readability, or correct inaccuracies. The results in this white paper are hypothetical, do not reflect actual investment results, and are not a guarantee of future results.
This white paper is for information purposes only and is not intended as tax advice. Frec refers to Frec Markets, Inc. and its wholly owned subsidiaries, Frec Advisers LLC and Frec Securities LLC. Frec does not provide legal or tax advice and does 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 Frec 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. Frec assumes no responsibility for tax consequences to any investor of any transaction.
The effectiveness of Frec’s 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 Frec, the type of investments (e.g., taxable or nontaxable) or holding period (e.g., short-term or long-term. The performance of the new securities purchases 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.
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 Frec Markets, Inc. S&P®, S&P 500®, US 500 and The 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Frec Markets, Inc. Frec’s direct indexing strategy 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(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500© index.
References
[1] Khang, Kevin and Cummings, Alan and Paradise, Thomas, and O’Connor, Brennan, Personalized Indexing: A Portfolio Construction Plan, (March 2022), https://corporate.vanguard.com/content/dam/corp/research/pdf/personalized_indexing_a_portfolio_construction_plan.pdf
