Tax Drag is the reduction of a portfolio’s annualized return due to the taxes stemming from income-producing securities. In this article, we’ll examine how Nitrogen calculates Tax Drag for securities and portfolios.
In this article:
- Defining Tax Drag
- Setting Taxable Status on Accounts
- Calculating Tax Drag at the security level
- Calculating Tax Drag at the portfolio level
Defining Tax Drag
Tax Drag is defined as the reduction of a portfolio’s annualized return due to the tax liability triggered by distributions and capital gains in a non-qualified account.
Most investment managers talk about tax efficiency, but very few provide understandable metrics to demonstrate it to clients. Similar to how high expense ratios drag down returns, inefficient tax management has a massive impact on your clients and the assets they have invested with you.
The Tax Drag calculation measures the percentage by which a taxable account’s annualized pre-tax return is reduced by taxes. For example, a $500,000 portfolio with a Tax Drag of 1.5% has incurred an annualized tax liability of $7,500 of the portfolio value. By reducing this tax liability, the money saved would stay invested and compound over time.
Setting Taxable Status on Accounts
In order to calculate Tax Drag on an account, Nitrogen needs to know the taxable status. You can set this during the account creation process or through the portfolio/account settings.
When creating a new account, click Add Account, Funds, Stocks, Other, and then choose the taxable status.
To edit the taxable status of an existing account, click on the three-dot Menu, select Setting, Tax Status, and choose Taxable or Non-taxable.
Note: Tax Drag will not be calculated on accounts set to "non-taxable."
Calculating Tax Drag at the Security Level
The Tax Drag calculation is determined by dividing the after-tax return by the pre-tax return for a specific holding and assumes investors pay the maximum federal rate on capital gains and ordinary income rate (currently 37% and 20%, respectively based on the distribution details).
The after-tax return reflects the after-tax distribution return, meaning it does not include any assumptions or consideration for the tax consequences incurred for selling or liquidating positions. Distributions are assumed to be reinvested on the pay date.
Note: Tax Drag represents the potential reduction of a holding’s annualized return due to the tax liability triggered by distributions and capital gains in a non-qualified account. The Tax Drag calculation excludes any state and local tax liability. Tax Drag is only available for Stocks, Mutual Funds, and ETFs at this time.
Tax Drag = [1 – ((1+AT) / (1+PT))] x 100
- AT = 3-Year Annualized Distribution After-Tax Return
- PT = 3-Year Annualized Return (Pre-Tax)
Calculating Tax Drag at the Portfolio Level
When calculating Tax Drag at the portfolio level, we take the weighted average of the Tax Drag for each security within the portfolio. The estimated Tax Drag for the portfolio assumes the current holdings and respective weights have been constant over a 3-year period.