Tax drag

The reduction in compounding caused by paying tax earlier than necessary - the tax itself plus everything that tax would have earned had it stayed invested.

Example

10,000 at 7.00% for 25 years with gains taxed at 25% leaves 43,205.74 if deferred to the end and 35,937.89 if taxed every year.

Important

Both paths pay the same rate on the same gain. The whole difference is timing, which is why this is largely within an investor's control rather than a fixed cost.

Related terms

• Fee drag — The compounding cost of fees over time, which is far larger than the fee's annual percentage suggests on its own.
• Tax deferral — Postponing a tax liability rather than removing it, so the money that would have gone in tax keeps compounding in the meantime.
• Portfolio turnover — The proportion of a portfolio bought and sold within a year. Zero means nothing was sold; one means roughly the whole portfolio changed hands.

Lessons that explain it

• Four risks, an invisible dealing cost, and why interest is often the worst-taxed return — Credit, rates, inflation and liquidity are four separate risks that a single word - safe - is routinely used to dismiss. The tax treatment of interest is the one most holders never price at all. (12 min)
• What it costs to own: drawdowns, fees, spreads and the tax on turnover — The risks and the costs of public equity are different in kind. One is mostly survivable; the other is certain, compounding, and largely within your control. (13 min)
• Three sources: employer money, tax saved, and compounding left alone — Returns inside a retirement account come from the investments, plus two things outside the market: employer contributions and the tax that is not taken each year. (11 min)
• Turnover, the taxable event, and the cost of selling — In most systems a gain is taxed when it is realised, not when it happens. That single rule means how often you trade changes your return even when every trade is correct. (11 min)
• The same investment can keep very different amounts depending on which account holds it — Asset location means putting heavily taxed investments inside tax-advantaged accounts where available, and lightly taxed ones in taxable accounts. The effect compounds over decades. (12 min)

All 578 terms in the Investing glossary