Tax Drag is defined as the reduction of a portfolio’s annualized return due to taxes. In this article, we’ll look at how Riskalyze calculates Tax Drag for securities and portfolios.
In this article:
Defining Tax Drag
Tax Drag is defined as the reduction of a portfolio’s annualized return due to taxes. Very simply, it’s 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.
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 reduction to the 3-year annualized return resulting from income taxes. The calculation also excludes any state and local tax liability. This is only available on 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)