What Is Tax Drag?

Tax drag is the reduction of potential income due to taxes. The concept describes the loss in returns, usually on an investment, as a result of taxation. Tax drag is commonly used when describing the difference between an investment vehicle that is tax-sheltered and one that is not.

Understanding Tax Drag

Tax drag has the potential to reduce investment returns, so it is worth paying attention to regardless of income level. Tax drag can have a significant effect on overall investment performance for many individuals, and tax-efficient investing techniques are important for recognizing capital gains, transferring wealth and estate planning.

For example, suppose that an individual can invest $1 million in two securities in either Country A with a 25% withholding tax, or Country B with a 15 percent withholding tax. Both securities pay a 2.5% dividend. Security A would return $25,000 minus $6,250 in taxes, for a total of $18,750. Investment B would return $25,000 minus $3,750 in taxes, for a total of $21,250. Therefore, returns would be 1.875% for Security A and 2.125% for Security B, equating to a tax drag of 25 basis points or the difference in returns between the two securities.

Why Tax Drag Matters

Tax drag is important to consider for a variety of reasons. Investors and stock promoters often tout their returns, but rarely include the tax consequences of those returns. This is mostly because every investor's tax circumstances vary.

Many investors also reinvest their returns, so when taxes eat into those returns year after year, it leaves less money left over to reinvest and less to grow and compound over time. This can make a big difference in the size of a person’s portfolio over a long period of time. As a result, avoiding tax drag is what makes tax-free investments, such as municipal bonds, so compelling for many investors.

To minimize tax drag, individuals can take advantage of any and all of the tax-sheltered investment vehicles they have access to. For most households, that means company retirement plans like 401(k)s as well as individual retirement accounts (IRAs). Families saving for college can take advantage of 529 savings plans, and people enrolled in high-deductible health care plans should consider using health savings accounts (HSAs). Investors can also reduce the drag of taxes on their portfolios by choosing funds with dividends that are mostly or all qualified and placing international funds in a taxable account.