Definition
Tax drag is the reduction in investment returns caused by taxes paid along the way on income and gains.
How It Works
Dividends, interest, and realized gains each create tax that reduces the amount left to compound. Over long periods, even a modest annual tax drag can meaningfully lower the final value of a portfolio compared with a tax-efficient approach.
Example
Two identical portfolios diverge over decades because one generates frequent taxable distributions while the other defers gains, leaving less to compound in the first.
When It Works Best
Reducing tax drag matters most for long horizons and large taxable balances.
Who It Applies To
Investors with taxable accounts.
Watch-Outs
Strategies that reduce tax drag, such as low-turnover funds, asset location, and direct indexing, must be weighed against their own costs and complexity.
