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Choosing the Right Tax-Efficient Investment Structure (Part 1): Funds, ETFs, and Direct Indexing 

by Kevin Kroskey, CFP^®, MBA 

When it comes to building and preserving wealth, after-tax returns – not just pre-tax performance – are what truly matter. Many investors focus on asset allocation or fund selection without fully understanding how the structure of their investments can drive dramatically different tax outcomes. And for high-income households, those differences can add up to hundreds of thousands – or even millions – of dollars over time. 

This two-part series breaks down the most common investment structures, from mutual funds and ETFs to long-only direct indexing and advanced tax-aware strategies like Tax-Aware, Long-Short Investment & Tax Strategies™ (TALS™). In this first installment, we focus on the foundational building blocks: how tax-loss harvesting works, why fund structure matters, and the growing appeal of direct indexing. 

Tax-Loss Harvesting 

Tax-loss harvesting is the practice of selling investments that have declined in value to offset gains elsewhere in the portfolio. Markets are volatile and even good investments will suffer declines, potentially allowing for loss harvesting. It is helpful to think of accumulated losses as “tax assets.” 

Tax-loss harvesting sounds simple – and it is, in theory – but the benefits are often overstated and dependent on the investment structure and strategy. First, markets generally go up over time. That means the longer you hold an investment, the less likely it is to generate harvestable losses and tax assets. Second, capital losses can only offset up to $3,000 of ordinary income per year. Any excess must be carried forward to future tax years, sometimes indefinitely. 

Now let’s look at structure. 

Mutual Funds vs. ETFs 

Many investors assume that all funds behave similarly when it comes to taxes. That’s a costly misconception. 

Mutual funds are pooled investment vehicles. When other investors in the fund sell their shares, the fund manager may be forced to sell underlying securities to raise cash – triggering capital gains. Those gains are then passed through to every shareholder, whether or not they personally sold anything. This can result in receiving a large tax bill even in a year where the fund’s overall performance was flat or negative adding insult to injury. 

Consider American Funds’ 2025 projected capital gains distributions: many of their funds are expected to distribute 10% or more of its value in capital gains, which is not atypical. And according to CapGainsValet.com, several active funds are already on the “doghouse” list for large distributions in excess of 30% where a $100,000 position in the fund will yield a $30,000 capital gain. 

ETFs, by contrast, are generally far more tax-efficient. Thanks to their unique in-kind redemption mechanism, ETFs can offload appreciated securities without realizing gains. This structural advantage means that many broad-market ETFs haven’t distributed capital gains in years – even decades. 

A new development is worth noting: some mutual fund families are beginning to adopt a workaround called redemption services. Here mutual funds can hire a third party to provide liquidity to mutual funds in a way that mimics the ETF in-kind redemption process. Tax-aware firms such as Dimensional Fund Advisors have been utilizing these strategies with the intent to eliminate capital gain distributions from their mutual funds. 

The Direct Indexing SMA 

Direct indexing has emerged as a solution growing in popularity for investors seeking more tax efficiency. Instead of buying a fund that mimics an index like the S&P 500, investors own the individual stocks directly in a separately managed account (SMA). 

Individual stocks are two to three times more volatile than the overall index. Even when the market is up, some stocks will be down. This yields more frequent tax-loss harvesting opportunities. 

But direct indexing isn’t without drawbacks. Its tax benefits are significant in early years but decay quickly over time. Again, markets tend to go up over time creating unrealized capital gains. The setup and ongoing management are also more complex, often requiring technology platforms and advisor oversight to monitor wash sales, substitution rules, and rebalancing. 

Yet, for taxable investors with large portfolios, direct indexing can offer a meaningful upgrade in after-tax efficiency compared to traditional mutual funds or ETFs. 

Coming Next: TALS™ 

While direct indexing marks an improvement in tax-aware investing, it still operates within the constraints of a long-only framework. In Part 2 of this series, we’ll explore how tax-aware long-short strategies – like TALS™ – can take efficiency to a new level. By integrating both long and short exposures, and applying sophisticated tax management techniques, TALS™ strategies can generate a consistent stream of losses, even in rising markets. These losses translate into tax assets, which can be utilized to solve several key tax problems for successful investors. 

For high-income professionals and investors with more complex tax needs, these advanced structures may offer the next level of after-tax compounding. 

Stay tuned for Part 2. 

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Kevin Kroskey, CFP^®, MBA is the Founder of True Wealth Design, providing “Accounting, Tax & Wealth Solutions To Help You Plan Smarter and Live Better.” This article is for educational purposes only. The strategies referenced apply to Accredited Investors or Qualified Purchases per SEC regulations. To explore how these strategies may apply to you, call or email kkroskey@truewealthdesign.com.

Opinions and claims expressed above are those of the author and do not necessarily reflect those of ScripType Publishing.