Most of us start making our first investments in tax-sheltered accounts. These accounts, which include traditional and Roth IRAs, 401(k) and similar employer-based retirement accounts, allow your investments to grow tax-free.
We eventually reach a point in our lives where we have filled all available tax-sheltered space, and have money left over to invest. This is where a simple brokerage account, or taxable account comes into play.
Simply stated, tax drag is the amount that your returns in a taxable account are decreased by taxes. It is commonly given as a percentage of the portfolio.
You must calculate your taxes paid on short and long term capital gains, and on ordinary and qualified dividends. Divide that number by the sum of your taxable investments, and you’ve got your tax drag.
We’ll examine how tax drag can be affected by different investing strategies, incomes, and states of residence.
In retirement, he and his wife Maggie keep their taxable income low enough to remain in the 15% tax bracket, avoiding all taxes on qualified dividends and long-term capital gains.