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Most physicians know the standard playbook: max out retirement accounts, then invest in low-cost index funds, typically exchange-traded funds (ETFs) to mirror broad market performance in a simple and efficient way.
This approach has delivered solid results, with the S&P 500 returning roughly 9% for the last 30 years and 10% annually all time. But for physicians with substantial taxable portfolios or upcoming capital gains taxes, direct indexing offers a more tax-efficient alternative to traditional ETF investing.
What is Direct Indexing?
Direct indexing means owning individual stocks that comprise an index rather than buying a single fund. Instead of purchasing shares of SPY or VOO, you own fractional shares of all 500+ companies in the S&P 500 or whichever index you’re tracking in their proper weights, which unlocks greater flexibility.
Because you own each stock individually, this unlocks a few key benefits index funds can’t provide:
- Tax loss harvesting at the individual stock level: When specific stocks decline (even while the overall index rises), losses can be captured to offset capital gains elsewhere or in the future. Traditional index funds only allow tax loss harvesting when the entire fund drops in value.
- Portfolio customization: Direct ownership allows you to exclude specific companies or sectors to align with your personal goals and values.
Certain platforms, like Frec, automate portfolio construction, rebalancing, tax loss harvesting, and dividend reinvestment to make direct indexing as easy as investing in ETFs.
Harvested tax losses don’t expire. You can accumulate them and carry them forward for years until you have realized capital gains to offset. You can also use up to $3000 in losses each year to offset ordinary income
How The Tax Efficiency Beats ETFs
Many roboadvisors, such as Wealthfront and Betterment, offer ETF-to-ETF level tax loss harvesting, but direct indexing creates 2-3x more opportunities to capture losses. In the ETF scenario, you can only capture a tax loss when the entire fund declines.
With direct indexing platforms like Frec, we are continuously scanning for individual stocks underperforming, so you can capture losses even while the index rises. The fees used to make this “juice” not worth the squeeze, but now you can direct index for as low as just 0.09% without a financial advisor, compared to 0.25% for many robo advisors.
Key Considerations
Wash Sales
The IRS disallows a tax loss if you repurchase the same or a substantially identical security within 30 days of selling it. This makes direct indexing difficult to self-manage. It is important to use a low-cost platform like Frec, which ensures wash sale compliance.
Tracking Error
Direct indexing does not perfectly replicate index performance. Quality platforms typically maintain tracking error within +/- 1% annually versus the underlying index. This can represent a small performance deviation in exchange for tax benefits.
Concentration Risk
ETFs provide instant diversification across hundreds of positions. Direct indexing requires sufficient capital to achieve proper diversification. Most platforms require $20,000-$50,000 minimums. These minimums used to be much higher and required an expensive wealth advisor, but now with platforms like Frec, it is easier than ever before.
Tax Complexity
Direct indexing can generate significantly more tax reporting than ETFs. Instead of simple ETF gains/losses, investors receive detailed 1099 forms listing hundreds of individual stock transactions. While platforms provide consolidated summaries, year-end tax preparation can be more complex. Frec manages wash sales within your account and provides one consolidated 1099 to make things easy.
Transaction Costs
Frequent rebalancing and loss harvesting generate trading costs. Analysis shows these costs average less than 0.02% annually, but still exceed zero-cost ETF holdings.
Diminishing Returns
As cost basis increases through appreciation, fewer loss harvesting opportunities exist. The strategy becomes less effective over time without regular fresh contributions. Continuing to add new cash to a direct indexing account extends the tax loss harvesting abilities.
Physician-Specific Applications
Healthcare Sector Concentration
Many physicians receive equity compensation (RSUs) from healthcare employers. Direct indexing allows for removing individual positions or sectors to reduce concentration risk without sacrificing broad market exposure.
Practice Sale Planning
Physicians anticipating practice sales can accumulate tax losses beforehand. A radiologist expecting a $400,000 capital gain from a practice sale could use harvested losses to offset a significant portion of the tax liability, saving thousands.
Retirement Planning
Many physicians will utilize their taxable accounts to fund retirement. By stacking up tax losses, you can extend your tax-free withdrawal period.
When Direct Indexing Makes Sense
Good Candidates:
- Have significant taxable investment accounts
- Have capital gains to offset, now or in the future
- Want the ability to customize
- Fall into a high tax bracket
- Will take taxable distributions during retirement
Poor Fit:
- Aren’t yet maxing out their retirement accounts
- Will never have capital gains
- Actively trades individual stocks that overlap index exposure (could cause wash sales)
Platform Considerations
Multiple providers offer direct indexing, including Frec, Schwab, Fidelity, Wealthfront, and specialized firms. Evaluation criteria include:
- Tax optimization: Daily vs. periodic loss harvesting
- Fees: Annual management fees (0.09%-0.4%)
- Minimums: Account thresholds ($5,000-$250,000)
- Customization: Exclusion capabilities and weighting options
- Reporting: Tax form consolidation
Frec specializes in direct indexing and looks for tax loss harvesting opportunities daily. In addition, Frec offers:
- Fees starting at just 0.09%
- 16 different indices to choose from
- A low-cost portfolio line of credit to access cash as needed
- A high-yield treasury account to earn interest on cash
- The ability to customize your index
- Zero commission self-directed trading
For high-earning physicians with substantial taxable portfolios, direct indexing can deliver meaningful tax savings that compound over decades. Modern platforms have made the strategy as simple as ETF investing while unlocking significantly better tax efficiency.
As your taxable assets grow the additional tax benefits become increasingly compelling.
Ready to explore how direct indexing could impact your specific situation? Schedule a consultation with Frec to review your portfolio or create an account here.
Disclaimer: Physician on Fire is not a Frec client. Frec did not pay for this post, but paid to partner Physician on Fire on other advertising initiatives. Investing involves risk, including the risk of loss. Borrowing can add to this risk, including losing more than invested. Frec aum fees range from 0.10%-0.35% depending on the index strategy. Treasury yield will vary. Frec has commission fee trading, but other fees may apply. Visit Frec.com to learn more.