Most investors review their portfolios for performance. Far fewer review them for tax efficiency — and that gap can cost real money over time.
Tax drag is one of the most overlooked factors in long-term wealth building. According to Morningstar research, tax costs for the typical actively managed U.S. equity mutual fund have taken more than 1.6 percentage points out of annualized returns over a recent five-year period. Compounded over a decade or more, that adds up.
Here's how to identify the problem — and what to do about it.
Step 1: Diagnose Where the Drag Is Coming From
Start by looking at your taxable accounts — the ones outside of IRAs and 401(k)s. Ask these questions:
- Do you hold high-turnover mutual funds in a taxable account?
- Have you received unexpected capital gains distributions in recent years?
- Are you holding bonds or REITs outside of a tax-advantaged account?
If the answer to any of these is yes, you likely have tax drag working against you.
Step 2: Reposition Without Triggering a Tax Event
The instinct is to fix everything at once — but selling appreciated positions creates taxable events. A smarter approach is to redirect new contributions toward more tax-efficient holdings and let existing positions run until you have losses to offset them, or until you're in a lower tax bracket.
Step 3: Use Tax-Loss Harvesting
If you have positions sitting at a loss, selling them strategically can offset gains elsewhere in your portfolio. The proceeds can be reinvested in a similar — but not identical — holding to maintain your market exposure while locking in the tax benefit.
Step 4: Review Your Account Structure
Where you hold assets matters as much as what you hold. The general rule: put tax-inefficient assets (bonds, REITs, high-dividend stocks) inside IRAs and 401(k)s. Keep tax-efficient assets (broad equity ETFs, index funds) in your taxable accounts.
Step 5: Schedule an Annual Tax Efficiency Review
Tax efficiency isn't a one-time fix — it's an ongoing process. Markets move, tax laws change, and your income picture evolves. A brief annual review of your portfolio's tax posture can catch problems before they compound.
The Bottom Line
You can't control what the market does. You can control how much of your return you keep. A tax-aware portfolio strategy is one of the highest-leverage moves available to long-term investors.
If you'd like a second opinion on how your current portfolio stacks up from a tax efficiency standpoint, I'm happy to take a look.
This material is for educational purposes only and does not constitute tax or legal advice. Please consult a qualified tax professional regarding your individual circumstances.