Tax drag is a fee you can often remove entirely
The claim
Holding the same investment inside a tax-advantaged account rather than a taxable one raises net returns with no additional risk taken.
Why we rate it strong
Arithmetic, given the tax rules. What varies is the size of the effect across jurisdictions and account types.
Tax on dividends and Capital gainThe profit on selling an asset for more than you paid. It is taxed only when realised, which makes not selling a genuine tax strategy rather than merely inertia.Read the evidence on this → works exactly like a fee: an annual deduction from returns, scaling with the balance, CompoundingReturns earning returns. It is why a percentage point of annual cost is worth far more than a percentage point of a single year's return, and why time in the market matters more than the amount invested at the start. against you. The difference is that in most jurisdictions a portion of it is optional, because tax-advantaged accounts exist and are usually under-used relative to their limits.
The size of the effect depends on your jurisdiction, Marginal tax rateThe rate applied to your next dollar of income, as opposed to the average across all of it. It is the rate that decides whether a deduction is worth taking and whether traditional beats Roth.Read the evidence on this →, and the YieldIncome as a percentage of price. For shares it is dividends over price, for a rental property it is rent over value, and for a bond it is the return implied by today's price if held to maturity. of the holding, but the direction never does. Sheltering the same asset raises the net return without changing the risk taken. No security selection decision can make that claim.
Asset locationWhich account each holding sits in, as distinct from what you hold. Placing tax-inefficient assets inside sheltered accounts and tax-efficient ones outside can add return without changing risk at all.Read the evidence on this → follows from the same logic. If some of your holdings must sit in a taxable account, put the tax-inefficient ones — high-yield bonds, high-turnover funds, anything throwing off regular taxable income — inside the shelter, and leave the tax-efficient ones outside.
This site works in US accounts, because that is where its data and its readers are: a 401(k) or 403(b) first, up to the Employer matchMoney your employer adds to your plan in proportion to what you contribute, typically up to a few percent of salary. Declining it is declining part of your stated compensation.Read the evidence on this → and then to the contribution limit, an IRA alongside it, an HSA where one is available, and a taxable brokerage account for whatever is left over. The order follows from the arithmetic above rather than from anything specific to those account types, so the logic transfers even where the names do not.
Where this breaks down
- Tax-advantaged accounts usually restrict access to the money, and that lock-up has a real cost if you need liquidity.
- Rules change. A shelter that is generous today may be less so in thirty years, which is a genuine argument for holding some assets outside it.
- Nothing here is individual tax advice, and the treatment of a specific account depends on facts this site does not know about you.
- Contribution limits bind. Beyond them the comparison shifts to tax-efficient investing inside a taxable account.
Terms used on this page
The same definitions the underlined words open, written out so nothing on this page depends on a click.
- Compounding
- Returns earning returns. It is why a percentage point of annual cost is worth far more than a percentage point of a single year's return, and why time in the market matters more than the amount invested at the start.
- Employer match
- Money your employer adds to your plan in proportion to what you contribute, typically up to a few percent of salary. Declining it is declining part of your stated compensation. Evidence →
- Asset location
- Which account each holding sits in, as distinct from what you hold. Placing tax-inefficient assets inside sheltered accounts and tax-efficient ones outside can add return without changing risk at all. Evidence →
- Marginal tax rate
- The rate applied to your next dollar of income, as opposed to the average across all of it. It is the rate that decides whether a deduction is worth taking and whether traditional beats Roth. Evidence →
- Capital gain
- The profit on selling an asset for more than you paid. It is taxed only when realised, which makes not selling a genuine tax strategy rather than merely inertia. Evidence →
- Yield
- Income as a percentage of price. For shares it is dividends over price, for a rental property it is rent over value, and for a bond it is the return implied by today's price if held to maturity.
Sources
Follow these rather than taking our word for the summary.
William F. Sharpe (1991). The Arithmetic of Active Management
Financial Analysts Journal, 47(1), 7-9
Finding: Costs, including tax drag, are deducted from a fixed pool of market return; reducing them is the reliable way to raise net returns.
Daniel Bergstresser and James Poterba (2004). Asset allocation and asset location: household evidence from the Survey of Consumer Finances
Journal of Public Economics, 88(9-10), 1893-1915
Finding: Households under-use tax-advantaged accounts relative to their limits and frequently hold the more tax-inefficient assets outside them.