Tax drag: how taxes can reduce investment returns

Taxes can mean the difference between a portfolio that looks strong on paper and one that actually lives up to its potential. After all, what your reported return shows and what you actually keep after taxes on dividends, interest, realized gains, and fund distributions can be a meaningfully smaller figure.

That difference is known as tax drag.

It refers to the way taxes can reduce investment returns as a portfolio generates taxable events along the way. For investors with taxable accounts, tax drag is a quiet but persistent issue that can have a real impact on the amount of money available to fund your goals.

What is tax drag?

Tax drag is the effect that taxes have on investment returns over time. Each time a portfolio generates a taxable event – like a dividend, a realized capital gain, an interest payment, or a fund distribution – a portion of that return may be lost to taxes in that year. That loss reduces the amount of capital that stays invested and continues to compound.

The concept matters most when evaluating after-tax outcomes. A pre-tax return tells you what the portfolio earned, while the after-tax return tells you what you kept. Tax drag is the gap between the two.

For example, in a simplified scenario, an investment with a 7% pre-tax return and a 1.5% tax impact would leave an after-tax return closer to 5.5%. Repeated over many years, that difference compounds because the money paid in taxes can no longer grow.

Where tax drag comes from

Tax drag can come from several sources, each of which can generate a tax liability in a given year.

Dividends: Dividends paid by stocks and funds are generally taxable in the year received, whether or not they are reinvested.

Interest: Interest from bonds, money market funds, and similar holdings is generally taxed as ordinary income, often at your highest marginal rate.

Realized gains: When an appreciated investment is sold, the gain is generally taxable. Selling within a year produces a short-term gain taxed at ordinary income rates, while holding longer may qualify for lower long-term rates.

Fund distributions: Mutual funds and some other investments distribute capital gains to shareholders, leaving you owing tax on these distributions.

Portfolio turnover: A portfolio or fund that trades frequently realizes gains more often, generating more taxable events than a low-turnover approach.

Short-term gains: Gains on assets held a year or less are generally taxed at ordinary income rates, which are higher than long-term capital gains rates.

Poor asset location: Holding tax-inefficient investments in a taxable account, instead of a tax-advantaged account, can increase the overall tax drag on a portfolio.

Why taxable accounts need extra attention

In tax-advantaged accounts, such as IRAs and 401(k)s, gains are generally either tax-deferred or tax-exempt, so the annual taxable events that create drag have little or no immediate effect. Taxable brokerage accounts are different.

In a taxable account, dividends, interest, realized gains, and fund distributions can each create a tax event in the year they occur. Those events are reported on a Form 1099, and the tax is owed regardless of whether you sell anything or not.

Rebalancing adds another layer. Bringing a portfolio back to its target allocation often requires selling appreciated positions, which can realize gains and generate tax drag.

Fund activity matters, too. A fund’s turnover and its distribution history affect how much tax an investor in a taxable account will owe, separate from the investor’s own decisions.

Tax drag vs. fees and inflation

Tax drag is one of several forces that reduce what an investor actually keeps. Advisory fees, fund expense ratios, and inflation all work in the same direction, lowering net outcomes over time.

What sets tax drag apart is its visibility, or lack thereof.

• Advisory fees are disclosed
• Fund expense ratios are published
• Inflation is widely reported

Tax drag, on the other hand, does not appear as a line item on any statement and it varies from year to year based on portfolio activity and your tax situation.

That fact is part of why tax drag can go unmanaged. An investor who scrutinizes a fund’s expense ratio may never examine how much that same fund costs them in taxes each year. Viewing tax drag as one component of net returns, alongside fees and inflation, gives a more complete picture of what your portfolio is actually delivering.

Ways investors can review tax drag

Tax drag cannot be eliminated entirely in a taxable account, but several tax-aware approaches may help reduce it.

Asset location: Placing tax-inefficient investments, such as those that generate ordinary income, in tax-advantaged accounts, and holding tax-efficient investments in taxable accounts, can reduce the overall tax drag on a portfolio.

Tax-loss harvesting: Selling positions at a loss to offset realized gains elsewhere may reduce the tax owed in a given year, depending on the investor’s broader tax situation.

Tax-aware rebalancing: Rebalancing with attention to tax consequences, by directing new contributions to underweight positions or selecting lots carefully, can keep portfolio adjustments from generating additional gains.

Direct indexing: Owning the individual securities in an index can create more opportunities to harvest losses and manage gains.

Gain planning: Being deliberate about when gains are realized, spreading sales across tax years, and managing holding periods can affect the tax owed.

Charitable giving: Donating appreciated securities can allow you to give while potentially avoiding the gains that selling might trigger.

When tax drag may be worth deeper planning

The effort of managing tax drag is more justified in some situations than others. Investors who may have more reason to review tax drag include those with:

• Higher income: The higher your marginal tax rate, the more important it may be to understand how taxable events affect after-tax results.
• Large taxable accounts: The more assets held in taxable accounts, the larger the impact of tax drag and the more there is to manage.
• Concentrated stock position: A large position in a single stock can increase both concentration risk and embedded gains.
• Upcoming liquidity events: A business sale, IPO, or another event that could generate a large gain creates a year where tax-aware decisions can have an outsized effect.
• Charitable giving goals: Investors who plan to give can often coordinate that giving with appreciated positions to reduce tax drag over time.
• Near-term retirement plans: For those closing in on retirement, the order in which accounts are drawn down and the timing of gains can affect the after-tax income a portfolio produces.

FAQ

What does tax drag mean?

Tax drag refers to the way taxes can reduce investment returns. It comes from taxable events such as dividends, interest, realized capital gains, and fund distributions.

How do I calculate tax drag?

Calculating tax drag precisely requires accounting for the tax owed on dividends, interest, realized gains, and distributions at the investor’s applicable tax rates. Because those rates and the portfolio’s activity vary by individual and by year, the calculation is specific to each individual and a tax professional or advisor can help quantify it accurately.

Can tax drag be avoided?

In a taxable account, no. Taxable events are a normal part of investing. It may be possible to reduce tax drag through tax-aware approaches such as asset location, tax-loss harvesting, tax-aware rebalancing, and gain planning, depending on the account, holdings, and investor’s tax situation.

Which investments create tax drag?

Any investments that generate frequent or significant taxable events tend to create the most tax drag. These include holdings that pay ordinary dividends or interest, funds with high turnover or large capital gains distributions, and any position that produces short-term gains when sold.

Why does tax drag matter in taxable accounts?

In tax-advantaged accounts, such as IRAs and 401(k)s, growth is generally tax-deferred or tax-exempt, so the taxable events that create drag have little or no immediate effect. In taxable brokerage accounts, those events create a tax liability in the year they occur, reported on a Form 1099, regardless of whether the investor sold anything intentionally.