What Is Tax Drag and How You Avoid It for Your Clients

Tax drag refers to the negative impact that taxes can have on the overall return of an investment or a portfolio. It's calculated as the difference between the return on an investment before taxes and the return after taxes. Tax drag is a crucial concept for financial advisors to understand and manage, as it can hinder the long-term growth potential of a client's investments and overall portfolio.

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What Is Tax Drag?

The mechanics of tax drag are straightforward. It works by reducing the total returns on an investment due to the tax liability incurred on capital gains , dividends and other forms of income.

For instance, consider a long-term investment that yields a 7% return. Since the investor owned the underlying asset for over a year before selling it, their resulting profit is taxed as a long-term capital gain . If the investor falls in the 20% capital gains tax bracket, they only get to keep a return of 5.6% after taxes (7% – 20% of 7%).

This reduction in return is the tax drag, which in this case is 1.4% annually. While this might not seem like a significant amount in the short term, it’s important to note that over time, this “silent drain” can accumulate into a substantial loss of potential earnings.

How to Calculate Tax Drag

Tax drag is primarily influenced by factors such as the tax rate, the returns on investment and the holding period. Higher tax rates and returns result in a higher tax drag. Similarly, the longer the holding period, the greater the tax drag as taxes compound over time.

To illustrate, consider an investor with a high tax rate who holds a high-return investment over a long period – the tax drag experienced would be significantly amplified. Tag drag is calculated using a simple formula:

Tax drag = (1 – After-tax return / Before-tax return) x 100.

For instance, if your client's before-tax return is 8% and the after-tax return is 6%, the tax drag would be calculated as follows: (1 – 6%/8%) x 100 = 25%. This means that taxes eat up 25% of the investment’s returns – a significant figure for long-term investors that could impact portfolio growth.

The importance of understanding and calculating tax drag cannot be overstated, as it directly impacts the long-term growth of an investment portfolio.

However, it’s crucial to recognize the limitations of tax drag calculations. Factors like changing tax laws and variable investment returns can make accurate calculations challenging. For example, new tax laws might alter tax rates or modify the tax treatment of certain investments, affecting the tax drag estimation. Similarly, fluctuating investment returns can make tax drag estimates difficult. Therefore, advisors should regularly review their tax drag calculations and adjust their clients' investment strategies accordingly.

Long-Term Impact of Tax Drag

Tax drag can erode long-term returns if not managed properly. As an example, let’s take a look at the tax drag on a $100,000-investment in bonds.

Let’s assume that you invest $100,000 in a taxable bond with an annual yield of 4%. For this example, we will also assume that you are in the 32% tax bracket. The interest income will therefore be taxed at this rate, and the bond pays interest annually.

Let’s begin by calculating the first year of this investment without considering taxes:

• Initial investment: $100,000
• Interest income (4%): $4,000
• Ending value: $104,000

Now, let’s calculate the first year of this investment with taxes:

• Interest income: $4,000
• Tax (32%): $1,280 (32% of $4,000)
• Net interest income after tax: $2,720
• Ending value after tax: $102,720

The tax drag in this example is the difference between the ending values with and without taxes: $104,000 – $102,720 = $1,280. This amount ($1,280) represents the reduction in the investment’s overall return due to taxes.

How to Reduce Tax Drag

Tax drag doesn't have to be an inevitable consequence of investing. There are several potential strategies that advisors can explore to help clients mitigate the effects of tax drag. These strategies include using tax-advantaged accounts such as Roth IRAs or 401(k)s , incorporating tax-efficient assets like index funds and strategically reinvesting dividends. We’ll delve deeper into each of these strategies below.

Use Tax-Advantaged Accounts

Tax-advantaged accounts like 401(k)s and IRAs can be a powerful tool in reducing tax drag because they allow investors to defer or eliminate taxes on their investment gains, thereby increasing their net returns. These benefits include the tax-free growth of Roth accounts as well as the tax-deductible contributions of traditional IRAs.

To reduce tax drag, advisors may leverage their clients' tax-advantaged accounts through the strategy of asset location. This approach involves placing investments that generate significant taxable income, like certain bonds , in tax-advantaged accounts, while keeping lower-taxed assets, like stocks, in taxable accounts . This strategy can optimize the tax efficiency of a portfolio and enhance after-tax returns.

Health savings accounts (HSA), which are considered triple-tax-advantaged, can also play an important role in asset location. Contributions are tax-deductible, they grow tax-free and can be withdrawn tax-free to pay for qualified medical expenses.

Incorporate Tax-Efficient Investments

Tax-efficient assets are investments that generate less tax. These include index funds , ETFs and tax-managed funds. Index funds and ETFs are considered tax-efficient because they typically generate fewer capital gains due to their passive management. Tax-managed funds, on the other hand, are actively managed with the specific goal of minimizing taxes.

By reducing the amount of taxable income generated, tax-efficient assets can help in potentially improving the net return of the portfolio. This strategy can be particularly beneficial for assets held in taxable accounts, where distributions are subject to annual taxes.

Reinvest Dividends Wisely

The reinvestment of dividends can play a significant role in potentially reducing tax drag. When dividends are reinvested, they can compound over time, which might lead to higher returns. Moreover, if these dividends are reinvested in tax-efficient investments, they can further enhance the portfolio’s after-tax returns.

Here’s a practical strategy for reinvesting dividends in a tax-efficient manner: Use a dividend reinvestment plan (DRIP). A DRIP automatically reinvests dividends back into the investment, reducing transaction costs and minimizing taxable events. This strategy is worth mentioning separately because it can be a powerful tool in an advisor's toolbox. Strategically reinvesting dividends may help them enhance the growth of a client's portfolio and mitigate the effects of tax drag.

Bottom Line

The concept of tax drag and its impact on investment returns is often overlooked but can significantly affect the long-term growth of an investor’s portfolio. Tax drag refers to the reduction in potential income or growth due to taxes on investment gains – it's essentially the silent drain on an investor's returns. The process of calculating tax drag is straightforward, yet crucial to identify potential losses. Understanding tax drag’s implications can be a game-changer, leading advisors to develop strategies that minimize its impact.

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