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- May 26, 2016
Most of us start making our first investments in tax-sheltered accounts. These accounts, which include traditional and Roth IRAs, 401(k) and similar employer-based retirement accounts, allow your investments to grow tax-free.
Hopefully, we eventually reach a point in our lives where we have filled all available tax-sheltered space, and have money left over to invest. This is where a simple brokerage account, or taxable account comes into play.
There are advantages to a “taxable” account, despite that ugly word. You can access the money at any time without penalty. Your investment choices are not limited as they are in an employer’s retirement account. You can engage in tax loss harvesting to lower your taxable income by $3,000 a year.
But we hate taxes. Remember the Boston tea party? Me neither, but I remember learning about it.
How about when Ms. Strouddelivered this cynical, butmore or less accurate line to the graduating seniors of the Lee High class of’76:
“Okay guys, one more thing, this summer when you’re being inundated with all this American bicentennial Fourth Of July brouhaha, don’t forget what you’re celebrating, and that’s the fact that a bunch of slave-owning, aristocratic, white males didn’t want to pay their taxes.”
Fortunately for me, you, and the aristocrats, ataxable account doesn’t have to be subjected to a heavy tax burden. If you earn anything close to a physician’s salary, a taxable account will be subject to “tax drag.” We will discuss exactly what that means, and what we can do to minimize it.
What is tax drag?
Simply stated, tax drag is the amount that your returns in a taxable account are decreased by taxes. It is commonly given as a percentage of the portfolio.
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How is tax drag calculated?
You must calculate your taxes paid on short and long term capital gains, and on ordinary and qualified dividends. Divide that number by the sum of your taxable investments, and you’ve got your tax drag. Wouldn’t it be nice if someone built a calculator for this?
Short-term capital gains and ordinary dividends are taxed at your marginal tax rate. At a physician’s salary, this is probably in the range of 30% to 50%.
Long-term capital gains and qualified dividends are taxed at a lower capital gains rate of 15% for most, or 20% for those in the highest federal tax bracket. On top of the 15% or 20% is state income tax for most, and a 3.8% surtax (known as the NIIT) for individuals with a modified adjusted gross income (MAGI) over $200,000 and couples with a MAGI over $250,000. Your rate can be as low as zero if your AGI is low enough (i.e. in early retirement), but will most likelyowe somewhere between 15% and 35% while working.
Some “real life” examples
I’d like to introduce three hypothetical characters, each with a healthy one million dollar taxable portfolio. We’ll examine how tax drag can be affected by different investing strategies, incomes, and states of residence.
Joel
Joel is a retired family practitioner living in Alaska. A native of New York City who moved north to eliminate his student loans, he relishes in the fresh air and mountain scenery abundant inour nation’s 49th state.
Joel invests in passive index funds and his portfolio sees very little turnover. In retirement, he and his wife Maggie keep their taxable income low enough to remain in the 15% tax bracket, avoiding all taxes on qualified dividends and long-term capital gains. Joel keeps the international portion of his asset allocation in his taxable account to take advantage of the tax credit.
Pete
Pete is a retired engineer turned successful blogger living in Colorado. Like Joel, he avoids actively managed funds in his taxable account. He did take some long-term capital gains this year when he sold a fund which held a large stake in a mining company that was found to have polluted the Colorado River. Some of those gains were offset by automatic tax loss harvesting in his Betterment account.
Pete doesn’t receive a foreign tax credit, as he has no international exposure. No, Pete.Aroad trip to Canada does not count as international exposure, at least not for this exercise.
Vince
Vince is a Hollywood actor living in [where else?]Hollywood, California. Vince sees more income in one year than Joel & Pete have earned in their lifetimes. He also spends money like it’s going out of style. To keep from going broke, Vinny asks his business manager Eric to handle a million dollar taxable portfolio for him.
Eric knows more about tossing pizzas than tax-efficient investing. He buys and sells “hot stocks” based on tips from Hollywood insiders. He got lucky this year, as novices sometimes do, and ended the year aheadwhile generating$50,000 in short-term capital gains.
Investing mainly in growth stocks in the tech industry, Eric unwittingly avoids receiving much dividend income,another good thing hedoes with the portfolio in spite ofhis naivety.
Care for a drag?
Adding up the total taxes paid on investment income, and dividing by the portfolio’s value, we can come up with a tax drag for each of the three taxpayers.
Looking at the tax drag on these million dollar accounts, we see a wide range from just under zero for Joel to 3% for Vince. Pete has a reasonable tax drag of 0.7%. Vince’s 3% may not sound like much, but it represents a >50%tax of nearly $30,000 on $57,000incapital gains and dividends. Have you seen what a 3% reduction in returnscan do over the long haul? It can cost you millions.
What can be done to minimize tax drag?
Fortunately, strategies exist to minimize tax drag in a taxable account:
- Choose funds with dividends that are mostly or all qualified (examples from my portfolio include VTSAX (total stock index)and VFIAX (S&P 500 index).
- Research funds @ Morningstar.com.
- Place international funds in a taxable account.
- Avoid actively managed funds in a taxable account.
- Minimize turnover. Buy-and-hold as opposed to buy-and-sell.
- Live in a state with low or no state income tax.
- Earn less (retire early), but don’t let the tax tail wag the dog.
The Excel file used in this sheet is available to use online or as a download with the other PoF calculators on the calculators page. Subscribe to download.
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Do you have a taxable account? Do you know your tax drag? What strategies do you take to minimize it?
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22 thoughts on “Tax Drag: What a Drag it is Getting Taxed”
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Good Post.
I feel that:
◾Place bonds in a non-taxable accountand
◾Place REITs in a non-taxable account
both deserve to be on that “What can be done to minimize tax drag?” list.
Reply
While you factored in the available tax credit for the foreign taxes, you neglected the fact that those foreign taxes were paid. In other words, you paid $350 in foreign taxes in order to get a credit against your U.S. taxes. So while the U.S. tax drag is zero in your example, there is in fact some tax drag due to the foreign taxes that were paid.
Reply
I recognize that, but those foreign taxes paid are reflected in the return from those foreign funds.
Holding international funds in taxable versus tax-advantaged gives you a benefit that doesn’t exist for US funds, and that’s the point I was attempting to make.
Best,
-PoFReply
Hi PoF,
I actually find this very confusing and would love your insight. I am planning to start investing in an international index fund. I max out my tax-advantage accounts. I keep reading that you should put international funds in taxable accounts. However, this logic isn’t clear to me. With an international fund in a taxable account you 1) pay international tax, 2) pay domestic tax 3) get a domestic tax credit, while in a tax-advantaged account you 1) pay international tax. Its not clear to me that the tax credit is greater than the domestic tax, in which case its not clear to me that putting international in a tax-advantaged account makes sense as you’re paying extra taxes to get that tax credit. Thank!!
Reply
Here’s one way to look at it.
Take away our #2 (pay domestic tax) from what happens in a taxable account, because that is true of any investment in taxable, whether foreign or domestic stock, bond, etc…
Now, you’re comparing getting the foreign tax credit versus not getting it.
A caveat that I’ll add is that if the domestic tax drag on the international fund is a lot higher than it would be on a US stock fund, and the delta between the two is in excess of the foreign tax credit, then it wouldn’t make sense to own the international fund in taxable. It is true that international funds tend to pay somewhat higher dividend yields with a lower percentage of qualified dividends.
Does that help?
Perhaps an elementary question, but how would one know if a dividend is qualified or unqualified (for purposes of including particular funds in a taxable account’s portfolio)?
Reply
The 1099 at the end of the year will tell you. Fund companies also give you this information, and I’m sure there are other sources, as well. Here are Vanguard’s percentages for 2016. Note that the S&P 500 fund is 100% qualified. Total stock Market is 93%. Total international is 72%.
Best,
-PoFReply
Great Post! I’ve been trying to explain the advantages of a Traditional vs Roth TSP to my compatriots who are moving up in tax brackets – macro-Tax Drag. This post, and especially the calculator will be a great help. Its amazing to see what tweaking small parts of the portfolio can do to net returns. I need to stop putting my International Index funds into my IRA i guess.
Reply
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Great Post! I’ve been trying to explain the advantages of a Traditional vs Roth TSP & IRA’s to my coworkers who are moving up in tax brackets – macro-Tax Drag. This post, and especially the calculator will be a great help. Its amazing to see what tweaking small parts of the portfolio can do to net returns.
Reply
Most people try to minimize taxes as much as possible when they use their 401k, HSA, etc but then when they switch to their taxable account, it seems they don’t think they can do things to keep taxes low in that account as well. This is a great example that there are things people can do so they don’t get killed by the tax drag! Nice post!
Reply
Thanks, Thias! I’ve definitely tried to optimize tax efficiency.
It didn’t make much difference when it was a 4-figure or 5-figure account. The taxes become noticeable once you’ve got 6 or 7 figures in the taxable account.
Reply
It’s funny how when you don’t have any money, minimizing taxes seem to be the last thing on your mind. So the good news is that once you start worrying about it, it’s usually because you’re in a much better position financially in your life.
I finally hired a CPA after doing my own taxes since college with tax strategy being a big reason why. So glad I made that decision – it’s already paying off in my planning.
— Jim
Reply
Living in a state with no income tax is sure a big help! I can’t recommend it enough!
Reply
It’s amazing how much difference the tax drag can make. The kind of alpha/excess return you can gather from smart tax management (and also low cost index funds) is something even professionals can only dream of. And every retail investor can achieve that with very little effort.
PS: Our emergency fund article that you featured in “The Sunday Best” section on May 15, also got picked up by Rockstar Finance yesterday. Thanks for boosting its popularity, I’m sure that helped!!!
Reply
So true. Tax treatment of returns are very important and often overlooked.
And yes, I noticed the RSF feature, congrats! I like the Sunday Best badge you put up as well, which gives me an idea… Thanks!
Reply
The tax drag has been quite annoying in recent years for me as this account has grown, and my marginal tax rate has increased. This has forced me to optimize my holdings in that account better to avoid tax just like you have outlined. Very informative post, thanks!
See AlsoMaking Your Own Stock DividendsReply
I hear you, Green Swan. I started taking a closer look once my taxable portfolio started having noticeable tax consequences. I had some old actively managed funds that were generating a whole lot of capital gains. Some of them went to the donor advised fund, and others were sold after I had done some tax loss harvesting to offset the gains I would take to get out of the active funds.
Tax-efficiency in a taxable account is very important, particularly during your high earning years.
Best,
PoFReply
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