New Ways to Minimize Taxes on Your Investments—and Why It’s Especially Important Now

(Illustration by Josie Norton)

In an elevated market, investors need to embrace new strategies to lower taxes on portfolios.

Supreme Court Justice Oliver Wendell Holmes Jr. once said, “I like to pay taxes. With them, I buy civilization.”

He might have been the only rich person ever to feel this way. For those who don’t, there are many strategies for reducing their tax bills, and increasingly, some newer ones for harvesting capital losses to offset taxable capital gains. Below are a few to consider this tax season. You can implement some strategies yourself, while others require working with a financial advisor.

Embrace ETFs

Exchange-traded funds are inherently tax efficient and worthy options for many individual investors. For instance, the $1.5 trillion Vanguard S&P 500 ETF generally doesn’t distribute taxable capital gains because of its indexed ETF structure, although it does distribute taxable dividends.

The S&P 500 benchmark, even when tracked in the less-efficient mutual fund form, holds most of its stocks forever, so it doesn’t realize taxable capital gains on appreciated shares. Moreover, in the ETF form, fund managers can unload appreciated stock shares to financial intermediaries known as authorized participants, instead of selling those stocks’ shares and forcing a taxable distribution to occur. Thus investors avoid nondividend-related taxes as long as they hold the ETF.

But deferring a tax on a gain isn’t the same as eliminating the tax altogether. Simply buying and holding ETFs long term doesn’t spare you from taxes if you need to sell them at some point down the road, especially as the indexes many of them track have gone up so much in recent years. The Vanguard S&P 500 ETF has doubled in value in the past five years and more than tripled in value in the past 10. Investors looking to sell that appreciated ETF to fund their retirement won’t be happy with the tax bill.

Try Direct Indexing

That is where direct indexing comes in. Consider the Fidelity Managed FidFolios U.S. Total Market Index Strategy, which Fidelity offers directly to individual investors for a minimum of $5,000. It holds 396 individual large-, mid-, and small-cap stocks in each client’s account instead of a total market index ETF, and continually harvests any capital losses on individual stocks throughout the year.

The losses it generates can actually exceed the gains of the direct-indexed account itself and can be used to counteract taxable gains in other parts of the portfolio, be written off against an investor’s taxable income—up to $3,000 annually—or be carried over into future years indefinitely.

In the 12 months ended Oct. 31, FidFolios’ Total Market Index Strategy produced a 19.7% return after deducting its 0.40% management fee. This lags behind its benchmark Fidelity U.S. Total Investable Market Index’s 21.0% before taxes. But the “tax alpha” the account added via all the harvested losses increased its return. After taxes, that return was 23.8%, with the additional losses harvested usable in other parts of investor portfolios. Meanwhile, its benchmark’s return sank to 20.7% after taxes because of the taxes on its dividends.

“Around 95% of our clients had their [direct-index account] fees covered by the tax savings that we’ve generated,” says Shannon Bouchard, Fidelity’s vice president of digital separately managed accounts, or SMAs. “We see a lot of [tax-saving] value in the $5,000 [accounts] all the way up to our higher-net-worth clients.”

Perhaps the most exciting offering on the direct-to-consumer side is Wealthfront’s S&P 500 Direct account, which charges only a 0.09% expense ratio—not much more than the Vanguard ETF’s 0.03%. After employing its tax-harvesting strategy, that account’s return should easily exceed its fees to beat the benchmark for taxable clients. Although Wealthfront has been direct indexing for high-net-worth clients for over a decade, the S&P 500 Direct account only launched in December 2024 and lowered its minimum investment from $20,000 to $5,000 in June.

“Since we introduced these [direct indexing] products over a decade ago, we’ve harvested over $3.4 billion of losses, and we estimate that saved our clients over $1.19 billion of tax savings,” says Dave Myszewski, vice president of product at Wealthfront. “It’s a tremendous value relative to the fee.”

Go Deeper With Portfolio Customization

There are limits to such simplistic direct-index strategies. After enough time in a rising market, most of the individual stocks in an S&P 500 account will have gains, and losses will be harder to harvest. Additionally, the S&P 500 isn’t exactly cheap, valuation-wise, with just a handful of tech stocks driving its performance. More bespoke strategies have advantages.

BlackRock acquired one of the largest direct indexers, Aperio, in 2021 and options strategy developer SpiderRock Advisors in 2024 to develop more customized tax strategies in SMAs that require the help of an advisor. Such strategies have become increasingly popular as stock index valuations become more extreme. “We sit almost at all-time highs [in the S&P 500] as we speak,” says Eric Metz, SpiderRock’s chief investment officer. “So, one of the large demand curves here is rebalancing portfolios.”

Aperio’s direct-index strategies for advisory clients go well beyond the S&P 500 and can incorporate value indexes, foreign stocks, emerging markets, small-cap stocks, and bonds of different stripes. Outside of the basic FidFolios for retail investors, Fidelity Institutional Wealth Adviser also offers some 45 direct-indexing strategies with similar tilts through its advisor-focused custom SMA platform.

Go Long and Short

The newest tax strategies for investors are actively managed long/short SMAs and options overlays. Earlier this year, BlackRock launched its Long/Short Tax-Managed Dynamic Factor SMA. Although customized to the specific investor, a typical account might, via leverage, have a 130% long exposure of specific stocks and 30% short exposure betting against a different set of stocks—what is called a 130/30 strategy. In a rising market, the short side of the account will likely generate capital losses to reduce taxes, while in falling markets, the long side will lose. That is while maintaining a 100% net long equity exposure—130% long minus 30% short.

“Let’s say you started with a direct-indexing account, and after a few years, you run out of losses,” says Ran Leshem, BlackRock’s head of SMAs. “If you have a need for additional tax losses, and you’re OK taking some pretax sort of risk, then you can add margin [i.e., leverage] so [the account] is 130/30 or 140/40, and you’ve expanded the opportunities for tax outcomes.”

Another use case for this strategy is for portfolios concentrated in just a single highly appreciated stock, a common scenario for executives compensated with stock shares by their employers. If the investor works in, for instance, the semiconductor industry, the account could short a basket of other semiconductor stocks to counteract the excess exposure to the industry while adding stocks in other industries to the leveraged long side so the portfolio becomes diversified without having to realize a large gain on the company stock position. Gradually, the company stock position can be whittled down within the portfolio.

An options overlay can also work with concentrated stock positions. SpiderRock can buy a put option in the appreciated company stock that will expire worthless if the stock position continues to rise, generating a capital loss, and hedging the stock against losses in case it falls.

Doing this yourself, you could buy a defensive put option that starts to make money on an appreciated stock currently worth, say, $100 a share, only if it drops below $80 a share. If the stock stays above $80, the option will expire worthless, generating a capital loss to write off, but if the stock falls below that level, you can sell the option at a profit, albeit a much smaller taxable one than if you sold the appreciated stock outright.

Meanwhile, SpiderRock can also use options to create a “synthetic long” position to the broad market or some other benchmark to maintain the portfolio’s overall equity exposure. The firm can also add sophisticated call options strategies with the put options to generate income in a tax-sensitive way.

Don’t Neglect Income Strategies

Investors aren’t just seeking tax-free capital gains, but also tax-free income. The simplest way to achieve this is to buy municipal bonds. But there are other tax-savvy ways to own bonds.

“Assuming the same risks, the taxable corporate bond will always pay a higher yield than a municipal bond,” says advisor Gabriel Shahin of Falcon Wealth Planning in Ontario, Calif., making corporates better suited for tax-deferred accounts. Then, instead of using munis in taxable accounts, Shahin favors a combination of taxable bonds with higher yields than munis in retirement accounts and stocks in direct-index accounts.

Not all advisors agree. “Munis can make a lot of sense for people who are in high tax brackets and states with high income tax, like New York, New Jersey, or California,” says Andrew Altfest, president of Altfest Personal Wealth Management in New York. Altfest favors buying individual municipal bonds versus funds for clients because the muni bond market tends to be inefficiently priced, offering smart investors opportunities to get good deals.

A look at muni bond yields supports Altfest’s point. According to Fidelity, the median triple-A-rated muni bond yield with a 10-year maturity currently yields 2.98%, while the highest-yielding bonds of the same category pay 4.06%. By comparison, the spread on corporate bonds with comparable credit quality and maturities is much narrower—4.16% median, and 4.54% high—indicating a more efficient market with fewer opportunities for bargains.

The taxable-equivalent yield for a 4.06% muni yield for a wealthy New York City resident in the top 10.9% state tax bracket, 3.9% city tax bracket, and 37% federal tax bracket is 8.42%—tantamount to a high-yield corporate bond that would have much lower credit quality. Meanwhile, the taxable equivalent for the median 2.98% yield is 6.18%.

Instead of shopping for themselves, investors can hire a large direct-index and SMA shop such as Parametric, which can build accounts not only of the usual S&P 500-like stock portfolios, but also of individual muni bonds. These accounts can harvest bond losses just like stock accounts, to add to after-tax returns. According to Parametric’s cited research, direct-index stock SMAs historically have added 1% to 2% a year of “tax alpha” return to taxable clients’ accounts, while bond SMAs have added 0.30%.

Tax-Code Shifts

Given elevated markets and shifting tax codes, investors need to be careful today with tax management. Shahin typically advises his clients to contribute to traditional tax-deferred accounts like IRAs when markets are strong and highly valued. That way, you get the tax deduction now for the contribution, and pay taxes on the distributions later. But he recommends that clients use post-tax dollars to contribute to tax-free Roth IRAs after market crashes, so all of clients’ subsequent gains during a rebound can grow tax-free. He also converted some clients’ IRA accounts to Roth IRAs in April during the tariff-related market crash, when account values were low and the tax on conversions was thus lower.

Altfest has been paying close attention to changes in the state and local tax, or SALT, deduction this year in the One Big Beautiful Bill Act. The bill increases the deduction from $10,000 to $40,000, but the bill begins reducing the deduction when personal income exceeds $500,000 and cuts it back to $10,000 when income crosses $600,000.

Muni bond income doesn’t count toward the phaseout threshold—all the more reason munis are still popular in states like New York.

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