You work hard to grow your investments. But hidden inside your brokerage account is a quiet, persistent force that can chip away at your returns: tax drag.
It’s not something you’ll see on your monthly statement. No one from your mutual fund management will warn you about it. Over time, tax drag can significantly dent your wealth. The good news? There’s a lot you can do to reduce it.
Let me explain tax drag, how it works, and how I help my clients keep more of what they earn.
What is tax drag?
Tax drag is the difference between what your investments earn before taxes and what you keep after paying taxes. You’re taxed on dividends, interest, and any realized capital gains in taxable accounts like your brokerage account. That tax hit reduces your effective return.
If you invest $100,000 with an average annualized return of 6% over 20 years, your investment would grow to approximately $320,711.
If your return is reduced to 4.5% after taxes, that investment would only grow to about $240,664. The difference in future value amounts to approximately $80,047, demonstrating how significantly that 1.5% annual difference can impact your total returns over time.
Why taxable accounts are more exposed
Unlike retirement accounts like IRAs or 401(k)s, brokerage accounts don’t provide tax deferrals on earnings. This means you may be liable for various taxes on your investment earnings.
Capital gains tax applies when you or the fund manager sells an asset for a profit.
Dividends earned from investments may be taxed at ordinary income rates, which can be significantly higher, or at the lower long-term capital gains rates, depending on how long the asset has been held.
Ordinary dividends are taxed at your full income rate. Qualified dividends are taxed at the lower long-term capital gains rate, but only if certain conditions are met. Your 1099 form from your broker will show how much of your dividend income was qualified.
Interest income is typically taxed at your full income tax rate, further eroding returns.
Mutual fund taxation
Mutual funds may distribute capital gains to shareholders regardless of individual sales, which is legally mandated because mutual funds must allocate any realized gains from trades they execute throughout the year.
As a result, you may unexpectedly receive a capital gains distribution from a mutual fund and wonder why you are being taxed on profits you did not personally realize through your sales, resulting in insignificant and unanticipated tax bills.
ETFs are more tax-friendly
You may have already noticed fewer taxable distributions if you’re holding exchange-traded funds (ETFs) instead of mutual funds. That’s because ETFs are structured to be more tax-efficient. They use an “in-kind redemption” process to remove appreciated securities without triggering a taxable event.
Turnover matters
Some funds trade frequently. That “turnover” creates more realized gains and more taxable distributions. I consider a fund’s “tax cost ratio” before recommending it for a taxable account. This figure tells you how much taxes reduce the fund’s return.
The Net Investment Income Tax
Another layer of tax many overlook is the Net Investment Income Tax (NIIT). If your income is over $200,000 (single) or $250,000 (married filing jointly), you may owe an extra 3.8 percent on your investment income.
How you sell matters
How you choose to sell stock can significantly impact your taxes.
When you own shares, you might have bought them at different times and prices, creating “lots.” Each lot represents a specific group of shares purchased on the same date and at the same price.
You can choose which specific lot you want to sell when you sell some of your shares. This choice can be crucial because the price you originally paid for the shares will determine your taxable gains.
Most brokers offer several methods for selecting which lots to sell. The most common methods include:
FIFO (First In, First Out): You sell the shares you bought first. If those shares were purchased at a lower price, you might have a smaller gain, or even a loss, when you sell.
LIFO (Last In, First Out): This method means you sell the shares you bought most recently. If recent prices are higher, this might result in a larger taxable gain when you sell.
Specific Lot Identification: This lets you choose precisely which shares (or lots) you want to sell. By selecting lots with higher purchase prices, you can minimize taxable gains.
I typically recommend using specific lot identification. This method gives you more control over your tax liabilities and can help reduce the amount of taxes you owe.
Tax-loss harvesting
Tax-loss harvesting allows you to sell investments at a loss to offset gains elsewhere. The IRS disallows the loss if you buy the same or a substantially identical investment within 30 days (called a “wash sale”).
Asset location matters
Asset location is about where you choose to hold your investments. It can significantly impact how much money you keep after taxes.
Not all investments are taxed the same way. Some investments, like stocks or mutual funds, might generate income or capital gains that are taxed at a higher rate. These are considered “tax-inefficient” investments.
Other assets, like bonds or fixed-income investments, generate regular income that can be taxed more heavily, making them “tax-efficient” when placed in a tax-deferred or tax-advantaged account.
A tax-efficient strategy is to place your tax-inefficient investments in tax-advantaged accounts, like retirement accounts (e.g., a 401(k) or IRA). These accounts allow your money to grow without being taxed until you withdraw it, often when you’re in a lower tax bracket after retirement.
It’s often advisable to hold tax-efficient investments in taxable accounts, where you’ll be taxed on any gains or dividends earned. By keeping these investments in taxable accounts, you can take advantage of lower long-term capital gains tax rates when you sell.
Final thoughts
Tax drag doesn’t make headlines but quietly erodes your wealth over time. The difference between gross returns and what you keep can be meaningful. Fortunately, strategies like thoughtful asset location, tax-loss harvesting, and specific lot identification give you more control.
The goal isn’t just to grow your money, it’s to keep more of it. A well-structured, tax-aware investment plan helps you do precisely that.
