Understanding Tax Drag and the Long-Term Effects on Your Portfolio
October 3rd, 2025
Estimated Reading Time: 5 Minutes
Selling too soon may cost you more than you think — here’s how tax drag eats into long-term returns and why it’s important to manage it wisely.
You Don’t Just Pay Taxes, You Pay in Compounding Too
Most investors see taxes as a one-time cost: you sell an appreciated investment, pay tax on the capital gains, and reinvest the remainder. This perspective, however, misses the longer-term effect taxes have on your overall portfolio growth. When you pay taxes, you reduce the amount of your working capital. This loss creates a lasting gap in your compounding potential. This is the effect of tax drag: the compounding disadvantage that occurs when investment dollars are removed from the market prematurely.
For high-net-worth investors, the implications can be significant when gains are realized frequently or unnecessarily. The dollars you pay in taxes now represent potential future gains you’ll never realize, because they’re no longer invested. A dollar lost to taxes today is not just a dollar gone—it’s a dollar that could have doubled or tripled had it remained invested. This is why it is important to have a planned, proactive tax strategy built into your investment strategies.
A Side-by-Side Comparison: Two Investors, One Key Difference
The Investors
Investor A: Holds a $100,000 stock with a low cost basis of $20,000 (i.e., $80,000 in unrealized gains).
Investor B: Has the same stock and same gains but chooses not to sell, deferring taxes and allowing the investment to compound.
What Happens When Investor A Sells
Realized Gain: $80,000
Federal Capital Gains Tax (20% long-term rate for high earners): $16,000
Net Proceeds to Reinvest: $84,000
(Note: We’re excluding the 3.8% net investment income tax and state taxes for simplicity, but those would increase the tax drag even more.)
Growth Over Time (Assuming 10% Annual Return)
| Year | Investor B (No Sale) | Investor A (Sold, Reinvested $84,000) |
|---|---|---|
| 1 | $110,000 | $92,400 |
| 3 | $133,100 | $111,800 |
| 5 | $161,060 | $135,280 |
| 10 | $259,380 | $217,880 |
After 10 years, Investor A is more than $41,000 behind, even though both investors earned the same pre-tax return.
The Performance Hurdle: What It Takes to Catch Up
To match Investor B’s untaxed 10% annual return, Investor A would need to earn about 11.9% per year — nearly 2% more annually — just to break even after 10 years.
In shorter timeframes, the required excess return is even higher:
- Over 5 years: ~4.1% more per year
- Over 3 years: ~6.6% more per year
Selling early and paying taxes creates a "performance hurdle" that your next investment must clear. This is the hidden cost of tax drag. Even when you reinvest wisely, starting from a lower base after paying taxes sets your compounding back. The more gains you realize early, the harder your future returns must work just to get you back to where you would’ve been if you deferred.
The Power of Deferral
The more you can optimize your tax strategy, the more compounding your wealth can experience. That’s why many tax-aware strategies focus on:
- Minimizing turnover (buy-and-hold strategies)
- Harvesting losses to offset gains
- Avoiding unnecessary taxable events
- Carefully timing sales and rebalancing
Tax deferral doesn’t mean never selling. It means being intentional about when you realize gains and understanding the trade-off between tax cost and portfolio benefit.
The Cost of Switching for a Better Return
You might be tempted to sell an appreciated investment in hopes of moving into something “better.” But unless your new investment offers significantly higher expected returns you could end up worse off.
Many investors underestimate how much extra return is needed just to break even after taxes. Sometimes the smartest move is simply staying the course.
Having an intentional tax strategy built into your plan can help you optimize your future gains. While market returns fluctuate, taxes are more predictable and more controllable with good planning.
Sources:
- Crandall, Pierce & Company
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