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If you're planning to retire soon, having a brokerage account is one of the biggest financial advantages you can have. It gives you flexibility, options, and control over how you spend and distribute your money in retirement. But with that flexibility comes a set of important decisions, and one of the most consequential is this: should you hold a direct index in your brokerage account, or would a simple ETF portfolio serve you better?

The honest answer, as with most financial planning questions, is that it depends. This article is going to break that down for you in a straightforward way. If you're 50 or older and within five years of retirement, this is especially relevant to you. By the end, you'll have a clear framework for thinking through whether direct indexing makes sense for your situation or whether a passive ETF approach is the smarter path.

As always, this is not personal financial, tax, or investment advice. The goal is to help you understand these concepts so you can make better informed decisions.

First, What Exactly Is a Direct Index?

Before diving into the comparison, let's define the two options clearly.

In a brokerage account, you can hold virtually anything: individual stocks, bonds, ETFs, or mutual funds. An ETF, or exchange traded fund, is essentially a basket of securities that you buy as a single investment. If you purchase an S&P 500 index ETF, your investment is designed to mirror the performance of the 500 largest companies in the United States. When the index goes up, your ETF goes up. When it goes down, your ETF goes down. It's straightforward, historically productive, and widely used.

A direct index (also called a custom index) takes a different approach. Instead of owning a single fund that represents the index, you own the individual stocks that make up that index. So rather than one ETF position, you might own 75, 100, or 150 individual stock positions that together are designed to replicate the overall performance of an index like the S&P 500.

Think of it this way. An ETF is like the Titanic. It's going to get you to your destination, and historically it has done that very well, but you don't have many options while you're on it. You can't turn it around quickly. You can't maneuver. A direct index is more like a speedboat. You can move in and out, adjust quickly, and take advantage of opportunities as they arise.

How Tax Loss Harvesting Works in a Direct Index

The core advantage of a direct index comes down to something called tax loss harvesting, and understanding this is key to everything else in this article.

The S&P 500 is a cap weighted index, meaning larger companies like Apple, Meta, and Microsoft make up a proportionally larger share of the index. In any given year, some of those individual companies will be up and some will be down, even if the overall index ends the year in positive territory.

When you own an ETF, a down year simply means your account is down. There's nothing you can do with that loss except wait and hope for a better year. You have no tax planning tools available to you.

When you own a direct index, that same down year becomes an opportunity. Because you own individual securities, you can sell the ones that have declined, harvest the loss, and then immediately reinvest in something substantially similar to maintain your market exposure. For example, if you own Coca-Cola and it's down, you could sell it, harvest that loss, and buy Pepsi (or another comparable security in the same sector). After 31 days, you can even buy back the original security if you choose. This keeps your portfolio tracking the index while generating a realized loss that you can use for tax purposes.

Those losses carry over indefinitely if you don't use them right away. They won't offset ordinary W2 income, but they can be used to offset capital gains, and that's where the real planning power comes in.

The Four Factors That Tell You Whether Direct Indexing Makes Sense

Here are the four situations where a direct index in a brokerage account can be genuinely advantageous:

Factor 1: You Have Foreseeable Capital Gains on the Horizon

If you know you're going to face significant capital gains in the next one to five years, whether from selling a concentrated stock portfolio, selling real estate, or selling a business, a direct index can be a powerful tool to help offset that tax bill.

Here's a practical example. We all remember the tariff related market volatility in April of 2025, when the S&P dropped roughly 9 to 10% in a single day. If you had a direct index at that time, you could have harvested meaningful losses during that dip, then immediately gotten back into the market and participated in the recovery. By the end of 2025, the S&P finished very positively, meaning you captured the full upside while banking losses that could be used to offset future gains.

This is the core use case for direct indexing, and it works best over a three to five year window leading up to retirement or a major liquidity event like a business sale. It is not a permanent magic bullet. Over time, the harvesting opportunities naturally slow down as your portfolio appreciates and the low hanging fruit runs out. That's why the timing matters.

Factor 2: You Have Sufficient Cash to Fund the Account Meaningfully

This is not a strategy for a $50,000 account. A meaningful starting point for a direct indexing account is several hundred thousand dollars. Below that threshold, you're almost always better served by a simple ETF portfolio.

The reason this matters goes back to how tax loss harvesting affects your cost basis. Let's say you open a direct indexing account with $300,000. Over several years of harvesting, you accumulate $50,000 in harvested losses. Even if the account has grown to $375,000 or $400,000 in market value, your cost basis may now be $250,000. That's a meaningful embedded gain that will eventually need to be managed.

If your retirement plan involves living off the 0% capital gains bracket (as described in a previous article on this topic), a lower cost basis could work against you. So before pursuing this strategy, make sure you have both the cash to fund the account properly and a clear plan for how those eventual gains will be handled.

Factor 3: You Hold Assets in an Irrevocable Trust

This is a scenario that many people overlook, but it can be incredibly powerful. Irrevocable trusts have compressed capital gains tax rates, meaning they reach higher tax brackets at much lower income thresholds than individuals do.

Consider a client who inherits an account that becomes a complex irrevocable trust. They plan to take distributions from that account over time, but they don't need the money for day to day living. In this situation, a custom index inside the trust allows you to harvest losses, offset the gains that arise from distributions, and keep the overall tax exposure at a lower rate within the trust's compressed bracket structure.

One important caution here: be careful not to mix this strategy with bond income inside the same trust. Ordinary income in a complex trust is taxed at those same compressed rates, and that can quickly erode the benefit you're trying to create on the capital gains side.

Factor 4: You're Prepared for the Planning Complexity That Comes With It

This one is often overlooked, and I think it's important to be upfront about it. When you retire with 100 individual stock positions in a direct indexing account, deciding which securities to sell and in what order becomes genuinely complicated. This isn't meant to scare you away from the strategy, but you should go in with eyes open.

The good news is that there are thoughtful solutions available when you reach that point. If you decide you don't want to manage a large number of individual positions in retirement, you have options. One is the 351 Exchange discussed in a previous article, which lets you diversify without triggering a large taxable event. Another is a gifting strategy, where you begin transferring appreciated individual securities to family members or a donor advised fund as part of your broader legacy plan.

There is also one scenario where the complexity is simply worth it, and that's if you know you're never going to spend the money yourself. If your intention is to leave this account to your children or to the next generation, the step up in basis at death essentially erases whatever embedded gains have accumulated. Let's say the account grows from $300,000 to $1,000,000 over your retirement, and you pass it on to your heirs. They inherit at the current market value. If they choose to sell, they owe virtually nothing in capital gains taxes. In that scenario, the direct index strategy becomes a win on both ends: tax efficiency during your lifetime and a clean slate for the next generation.

So Which Should You Choose?

Here's a simple way to think through it:

Direct indexing and custom indexing are not for everyone. But for the right person with the right set of circumstances, the tax savings and planning flexibility can be substantial. The key is having a clear strategy in place before you start, not after.

If you're approaching retirement and you're not sure which path fits your situation, this is exactly the kind of conversation worth having with a financial planner who can look at your full picture and help you make the call with confidence.

This article is for educational purposes only and is not intended to be personal financial, tax, or investment advice. Please consult a qualified financial professional before making any decisions based on the information presented here.

Forest Dutton, CFP®, MSFP, MBA is the owner of Brightworks Financial Planning.