Definition
The reduction in a taxable investment account's growth caused by the taxes paid each year on dividends, interest, and capital gains distributions, and on gains realized by trading. It is usually expressed as a yearly percentage subtracted from the return, the same way an expense ratio is, and it does not apply inside tax-advantaged accounts.
Why it matters
Over decades a fraction of a percent of drag compounds into real money, which is why what you hold in a taxable account (tax-efficient index funds versus high-turnover funds or bonds) matters as much as what you hold overall. It is the reason asset location, not just allocation, shows up in retirement planning.
Example
Two investors each put $100,000 in a taxable account earning 7% before tax. One holds a low-turnover index fund whose dividends and rare distributions cost about 0.3% a year in tax, ending 25 years later near $506,000. The other holds an active fund whose frequent distributions cost about 1% a year, ending near $429,000. The same investments in a Roth IRA would have reached about $543,000.
Put it into practice
Related terms
This definition is educational, not financial, legal, or tax advice. U.S. rules and limits change; verify time-sensitive details with official sources. See our disclaimer.