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.
($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.