Tax Drag Calculator
Tax drag is the annual performance penalty imposed on taxable accounts by dividend taxes, interest taxes, and capital gains distributions. Even if you do not sell a fund, mutual funds pass through realized gains to shareholders annually, triggering tax. This calculator compares the after-tax return of a taxable investment against a tax-deferred account holding the same underlying investment, showing the compound cost of annual taxes over your investment horizon.
Tax drag formula
After-tax return = Gross return - (Distribution yield * Tax rate)
Taxable FV = PV * (1 + After-tax return)^n
Deferred FV = PV * (1 + Gross return)^n
Tax drag = Deferred FV - Taxable FV
(This models annual tax on distributions; deferred account shows pre-tax FV)
The after-tax return equals the gross return minus the tax paid on distributions each year. Tax is calculated as the distribution yield multiplied by the marginal tax rate applied to that portion of return.
Asset location strategies to reduce tax drag
- Hold bonds and high-yield funds in IRAs and 401(k)s: interest income is taxed as ordinary income and benefits most from tax deferral.
- Hold broad index equity funds in taxable accounts: they have low distributions and qualify for long-term capital gains rates.
- Consider municipal bonds in taxable accounts: interest is federally tax-exempt and may be state-exempt too.
- Use ETFs over mutual funds in taxable accounts: ETF structure typically avoids capital gains distributions that mutual funds pass through.
- Tax-loss harvesting: realize losses in taxable accounts to offset gains, reducing annual tax drag.
Tax drag: frequently asked questions
What is tax drag?
Tax drag is the reduction in investment return caused by annual taxes on dividends, interest, and realized capital gains distributions. It differs from capital gains tax on sale: tax drag occurs each year you hold the investment in a taxable account.
Which investments have the most tax drag?
Actively managed funds with high turnover have the most tax drag because they realize capital gains frequently. Bond funds and high-dividend stock funds also create annual taxable income. Broad index funds with low turnover have significantly less tax drag.
How can I reduce tax drag?
Strategies include: holding tax-inefficient assets (bonds, active funds) in tax-advantaged accounts (IRA, 401k); holding tax-efficient assets (index funds) in taxable accounts; tax-loss harvesting to offset gains; and using ETFs instead of mutual funds (ETFs have structural advantages that reduce taxable distributions).
What is the difference between ordinary income tax and long-term capital gains tax?
Ordinary income (including short-term capital gains, bond interest, and non-qualified dividends) is taxed at your marginal tax rate. Long-term capital gains (assets held more than 12 months) and qualified dividends are taxed at lower preferential rates of 0%, 15%, or 20% depending on income.
What is tax-equivalent yield?
Tax-equivalent yield converts a tax-exempt yield (from municipal bonds) to its equivalent taxable yield: TEY = Tax-Exempt Yield / (1 - Marginal Tax Rate). This allows comparison between taxable and tax-exempt investments.
Official sources
- IRS: Topic No. 409 Capital Gains and Losses.
- IRS: Publication 550: Investment Income and Expenses.
- SEC: Tax Efficiency of Funds.
Reviewed by the CalculatorHub team, edited by James Graham, 14 June 2026. See our methodology.