Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Tax Drag

What it is:

Tax drag is the reduction in returns attributable to taxes.

How it works (Example):

For example, let's assume that John owns 100 shares of Company XYZ stock. He bought the stock at $10 per share, for a total of $1,000. The stock takes off, and he sells his shares for $15 per share, for a total of $1,500. John has made a $500 profit, or a 50% gain.

However, that's not quite the whole story. John has to pay capital gains tax on that investment. Assume the capital gains tax is 15% of $500, or $75. That means his actual return is not 50% but:

($500 - $75)/$1,000 = 42.5%

The tax drag is 50% - 42.5% = 7.5%

Why it Matters:

Tax drag is important to consider for many reasons, not the least of which is that investment gurus and stock promoters are very happy to tout their returns, but rarely do they include the tax consequences of those returns (mostly because every investor's tax circumstances vary).

As important is the fact that many investors reinvest their returns. And when taxes eat into those returns year after year, that leaves less to reinvest, and less to grow and compound over time. Over a long time, this can make a big difference in the size of a person's portfolio. As a result, avoiding tax drag is what makes tax-free investments such as municipal bonds so compelling for many investors.

Related Terms View All
  • Auction Market
    Though most of the trading is done via computer, auction markets can also be operated via...
  • Best Execution
    Let's assume you place an order to buy 100 shares of Company XYZ stock. The current quote...
  • Book-Entry Savings Bond
    Savings bonds are bonds issued by the U.S. government at face values ranging from $50 to...
  • Break-Even Point
    The basic idea behind break-even point is to calculate the point at which revenues begin...
  • Calendar Year
    If Company XYZ starts its fiscal year on January 1 and ends its fiscal year on December...