Tax management

Tax drag: What it is and ways to potentially reduce it

January 22, 2026 - 5 min

Tax drag happens when taxes on dividends, interest, and realized gains diminish an investor’s after-tax returns, highlighting the need for tax-efficient investing strategies. Even small annual tax costs can compound into significant long-term performance deviations, especially for high-income investors in taxable accounts. By understanding how tax drag works and using strategies designed to minimize it, investors can improve their after-tax returns and potentially build wealth more efficiently over time.

Key takeaways

Tax drag applies mainly to taxable accounts where ongoing taxes reduce returns.
Tax drag reduces compounding by shrinking the amount of money available to reinvest each year.
Small annual reductions in return can produce large, long-term performance gaps.
Tax-efficient approaches such as tax loss harvesting, direct indexing, investment vehicle selection, and strategic asset placement (asset location) can help reduce the impact of taxes.
Long holding periods and lower turnover help minimize avoidable tax costs.

What is tax drag?

Tax drag is the reduction in investment returns caused by taxes on dividends, interest, and realized capital gains. It represents the gap between what a portfolio earns before taxes and what an investor actually keeps after taxes are paid. Because taxable accounts are subject to ongoing taxation, these costs steadily chip away at returns and limit the power of long-term compounding.

A helpful way to visualize tax drag is to imagine adding money into a piggy bank while a small portion is removed each time you make a deposit. Those small, repeated reductions add up. For instance, if a portfolio earns 10% but taxes reduce the return to 8%, that difference may seem modest for a single year, yet it can create a sizable shortfall in wealth over decades. Tax drag is especially important for investors in higher tax brackets or those with frequent trading activity, where even small, recurring tax costs can meaningfully reduce overall performance.

Ultimately, understanding tax drag highlights why tax-efficient portfolio construction matters. Managing distributions, controlling turnover, and planning around taxable events can help preserve more of what an investor earns and strengthens long-term outcomes.

Here are a few key points about tax drag:

Tax drag reduces the amount of money you get to keep from your investments. For example, if your investment earns a 10% return but you have to pay 20% in taxes, the maximum rate on long-term gains and qualified dividends, your actual return is 2% less, or only 8%.
Over time, the impact of tax drag can be significant. The more you pay in taxes, the less money you have to reinvest and grow. This can slow down the growth of your investment portfolio.
In aiming to minimize tax drag, investors can use tax-efficient strategies such as tax loss harvesting, gains deferral to take advantage of lower tax rates on long-term capital gains (held over a year), or using tax-advantaged accounts such as IRAs and 401(k)s where investments can grow tax-deferred.

How to calculate tax drag

Tax drag is typically expressed as the difference between pretax and after-tax returns.

Tax drag (%) = (pretax return) – (after-tax return)

Let’s say your portfolio earns 10% before taxes and 8% after taxes. Tax drag would be 10% – 8% = 2%.

This calculation helps investors quantify the impact of taxes on their portfolio performance. It’s particularly useful when comparing investment vehicles or strategies, such as mutual funds vs. separately managed accounts (SMAs), or index funds vs. direct indexing.

For the S&P 500^®, the tax drag has been about 0.3%–0.4% annualized. For the average active large-cap core mutual fund it’s consistently higher than 1%. This shows how even modest tax drag can compound over time, significantly reducing long-term returns.

Quantifying the cost of taxes

Pretax vs. after-tax performance difference

Source: https://www.spglobal.com/spdji/en/spiva/article/spiva-after-tax-scorecard, Natixis, data as of 12/31/2024.
Past performance is no guarantee of future results.

How to potentially reduce tax drag

Reducing tax drag starts with building a tax-efficient portfolio and making intentional decisions about where assets are held and when gains or losses are realized. Thoughtful asset placement, disciplined holding-period management, and strategic trade execution can help investors keep more of their returns while maintaining desired market exposure.

Here are a few ways to construct more tax-efficient portfolios:

Place tax-inefficient assets (e.g., corporate bonds, high turnover mutual funds, real estate investment trusts, and commodities) that generate ordinary income such as interest, nonqualified dividends, and short-term capital gains in tax-deferred accounts such as traditional IRAs and 401(k)s.
Place tax-efficient assets that generate little ordinary income or generate long-term capital gains (e.g., stocks, index mutual funds, and exchange-traded funds [ETFs], direct indexing SMAs, and municipal bonds) in taxable accounts such as brokerage and Uniform Transfers to Minors Act accounts.
Manage holding periods so more gains qualify for lower long-term capital gains rates (up to 20%) instead of short-term capital gains rates as high as 37%.
Use tax loss harvesting to offset realized gains and reduce taxable income, particularly during market volatility.
Leverage ETFs, SMAs, or direct indexing for greater control over gain and loss realization, more opportunities for customized tax loss harvesting, and sustained tax-efficient portfolio adjustments.

Sources of tax drag

Tax drag occurs when different types of taxable investment income steadily reduce what investors keep, including dividends, interest income, realized capital gains, and taxable distributions from pooled vehicles such as mutual funds. The structure of an investor’s portfolio also plays a role, since vehicles like SMAs and direct indexing accounts can offer more control over when gains and losses are realized. By understanding these sources and choosing structures that allow for more intentional tax management, investors can better limit the erosion of pretax returns.

Key factors to consider include:

Dividends, interest income, and realized gains all create recurring tax liabilities that reduce net returns.
Mutual fund distributions can trigger taxes even when investors do not sell their shares.
SMAs may allow for more deliberate timing of gains and losses to help reduce avoidable tax costs.
Direct indexing provides opportunities for systematic tax loss harvesting and finer control over taxable events.

Tax drag may be invisible, but its impact is very real. By understanding how taxes erode investment returns and implementing strategies to mitigate this effect, investors can preserve more of their gains and achieve better long-term outcomes. Whether through direct indexing, tax loss harvesting, or strategic asset location, reducing tax drag is a powerful lever for enhancing portfolio efficiency.

Direct indexing investing strategies

Direct indexing can play a valuable role in a tax-efficient investment strategy, especially for high-net-worth investors. Let us help you create portfolios that put taxes first.

Learn more

Registered investment companies, such as mutual funds and ETFs, are pooled investment vehicles offering standardized investment strategies and daily liquidity. Separately managed accounts (SMAs) are individualized portfolios managed on behalf of a single investor, allowing for greater customization, transparency, and control over holdings and tax outcomes.

Investing involves risk, including the risk of loss. Investment risk exists with mutual funds, ETFs and SMAs. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should consider the investment objectives, risks and expenses of any investment carefully before investing.

Please read the risks associated with each investment prior to investing. Detailed discussions of each investment’s risks are included in Part 2A of each firm’s respective Form ADV. The investments highlighted in this presentation may be subject to certain additional risks.

Future tax liabilities may be higher in an SMA that uses loss harvesting because it may have larger unrealized capital gains. Tax law and tax rate changes may also impact the relative value of index mutual funds, ETFs, and SMAs.

The S&P 500^® Index is a widely recognized measure of U.S. stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the U.S. equities market.

Tax liability is the total amount of tax debt owed by an individual, corporation or other entity to a taxing authority.

Tax alpha is the benefit of loss harvesting, which is assumed to be used to offset gains inside or outside the portfolio in the period they are incurred, and thus credited to the portfolio returns.

Tax loss harvesting is a strategy for selling securities that have lost value in order to offset taxes on capital gains.

Capital gain is a rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price.

This material is provided for informational purposes only and should not be construed as investment or tax advice. Investors should not make investment or tax advice choices solely on the content contained herein, nor should they rely on this information to apply to their specific situation or any specific investments under consideration. This is not a solicitation to buy or sell any specific security. Although Natixis Investment Managers Solutions believes the information provided in this material to be reliable, it does not guarantee the accuracy, adequacy, or completeness of such information.

Future tax rates and rates of return are unknown and will affect your personal outcome.

This information does not consider any investor's particular investment objectives, strategies, tax status or investment horizon.

Please consult your tax and financial advisor.

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