Tax friction — also known as tax cost ratio — is the difference between an investor’s pretax and after-tax returns, or the amount of annualized return lost due to taxes from net realized capital gains and other taxable income, such as dividends from stocks or interest from bonds. Though it is often represented as a small percentage, its long-term effects can be substantial.
For example, a 1.5 percent annual tax friction on a $1 million investment growing at an annual rate of 8 percent pretax for 10 years can result in more than $250,000 in wealth erosion. The more wealth a client accumulates over time, the more they stand to lose without a proactive approach to managing tax friction.
Strategic vehicle selection, such as the use of separately managed accounts and optimizing asset allocations are two ways to help mitigate the tax bite on returns. However, the most effective method is proper asset location — strategically placing different investments according to
