Take tax drag as a slow leak in your investment bucket. It will drip one to two percent of points a year, but it will be steady. This is why tax-efficient investing strategies matter more than most families expect. If your portfolio earns 7% before taxes and ends up keeping 6% after taxes. This single percent difference results in a much smaller nest egg decades later.
For wealthy families, this gap is not trivial. It changes as fast as the wealth grows, and the amount you spend on gifts and pass on. It even has an effect on how decisions around asset location vs asset allocation play out. In this article, we will show the simple math and point out where the leak usually starts. We will also offer practical and calm solutions to hold onto more of what you make.
What Is Tax Drag?
Before we get to the details, let’s find out what tax drag actually refers to. It is a professional term for the gap between pre-tax portfolio returns and after-tax returns. We can probably say it is the tax shaved off each year. This is something that families notice when they use a tax drag calculator during long-term planning. You will measure it the same way as you calculate the fees. But it is less visible as it comes from the tax code and distribution. For a high-net-worth family, a 1% annual drag is not trivial. It is a strategic material that deserves attention.
What Is The Fundamental Importance Of 1-2%?
According to Morgan Stanley Total Tax 365, this is a small percent compound. Those firms that model after-tax outcomes show a $1 million portfolio growing differently after 20 years. This is dependent on tax drag. Using a common hypothetical, a 0% tax drag might increase to about $4.2 million. Or a 1% drag to roughly $3.5 million, and 2% drag to about $2.9 million. This is not a rounding error. It is the difference between meaningful legacy capital and a smaller pool for gifting or investing.
Starting capital |
Gross return (ann.) |
After-tax drag |
Value after 20 years |
|
$1,000,000 |
7.5% |
0% |
~$4,200,000 |
|
$1,000,000 |
7.5% |
1% |
~$3,500,000 |
|
$1,000,000 |
7.5% |
2% |
~$2,900,000 |
All these values are collected from Morgan Stanley Total Tax 365.
Where Does All This Tax Drag Come From
Tax drag is not mysterious. Some of the familiar sources include:
- Dividend and interest distributions are taxed in the year they are paid.
- Capital gains realized by funds. These include mutual funds that can pass capital gains to shareholders even if you didn’t sell.
- Realized gains from rebalancing or liquidations in your taxable accounts.
- State and surtaxes, especially for some families, and state taxes with the NIIT add material for extra drag.
Morningstar’s Tax-Cost Measures and Tax-Cost Ratio Research show how funds are distributed, and the resulting turnover is the source of the annual drag. These insights also explain why tax loss harvesting rules 2025 remain important. Since selling positions without regard to wash-sale rules can erase expected tax benefits.
Industry’s Estimation Of The Complexity Of The Problem
Multiple industry sources quantify the typical tax drag for taxable accounts at roughly 1-2% per year. This range appears across advisor whitepapers and firm studies. It has become a base assumption when modeling after-tax outcomes for wealthy households.
One industry survey and whitepapers from wealth managers and asset managers likewise treat 1% as a conservative baseline and 2% as a plausible figure for tax-inefficient strategies.
Strategy |
Typical incremental after-tax benefit (annual) |
|
Exchange funds (to diversify without triggering gain) |
up to ~1.98% (illustrative) |
|
Direct indexing/custom tax harvesting |
~0.8%–1.7% |
|
Tax-efficient asset location & rebalancing |
up to ~0.3%–0.5% |
Each figure above is an industry illustration from Morgan Stanley materials, with assumptions and caveats.
Common Questions Wealthy Families Can Ask
The biggest concern is whether trying to save every tiny percentage point creates more complexity than value. In most cases, it does not. Simple habits like choosing which tax lot to sell, using ETFs where they make sense, or rebalancing with a light touch. This leads to working quietly in the background and compounding over time.
Another common question is whether this means giving up active managers altogether. This is rarely the answer. The better approach is to understand the way tax-efficient each manager really is and to look at results after taxes, not just before. Fund prospectuses and Morningstar report provides the facts needed to make that call with confidence.
What To Do Next?
Tax drag may seem tiny at first, but over time it changes what a family can actually afford. For households with complex finances, losing one to two percent each year can reduce funds. This affects giving and spending, and as a result, the person is left behind. The good news is that it is controllable. Start by measuring your household’s tax exposure and locating which accounts are taxable. Then work with your advisor to move the right assets into tax-friendly accounts. Apply tax-efficient investing strategies, and time gifts or withdrawals. Small, steady steps keep more of what you have built. Or you can simply contact us and get started instantly.
