What Is the Tax-Cost Ratio and Why Does It Matter?

A topic that has been frequently making headlines lately has been the increase in the prices of various goods and services. Whether it is the cost of a house, new car or groceries, everyone seems to be paying more attention to prices in an attempt to not pay more than necessary.

This has also been an issue in the investing world. In recent years individuals have become more focused on controlling costs within their portfolios. When investment costs are considered, it is common to only consider trading costs, expense ratios and advisory fees. This is because these types of costs are typically easy to determine, known in advance and straightforward to measure. Yet for taxable investors there is often another hidden cost that can be just as significant (if not more) than all these other costs combined. Although it's something not often talked about or even considered, the cost of taxes on an investment can create a significant drag on its returns and represent the single largest cost in an investor's portfolio.

What is the tax-cost ratio?

The tax-cost ratio is how Morningstar measures how much a fund’s annualized return is reduced by the taxes investors pay on distributions. Morningstar calculates it on products such as mutual funds and Exchange Traded Funds (ETFs). Generally, for taxable investors the more distributions a fund makes, the larger the tax-cost ratio will be, meaning a larger amount of return is lost to taxes. We call it "tax drag."

Though the tax-cost ratio is not commonly discussed or even thought of for many investors, this tax drag can be large and represents an additional headwind to after-tax investment results. As shown below, when compared to the average expense ratio across U.S. large cap, U.S. small cap and fixed income funds, the average tax drag over the last three years has been around 1.5 to 2 times greater than the average expense ratio. The numbers below suggest that investors in either U.S. large cap or U.S. small cap equities lost roughly 1.8% of return per year to taxes (as of September), while fixed income investors have lost nearly 1.3%. Although these numbers may be somewhat hidden for most investors, they unfortunately can have a very real impact on investment results.

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Tax-cost ratio bar chart

For three years ending Sep 2022. Source: Morningstar. U.S. Large Cap: Morningstar U.S. Large Blend Universes average, U.S. Small Cap: Morningstar U.S. Small Blend Universes average, Fixed Income: Morningstar Taxable Bond Universes average. Tax Drag: Morningstar Tax Cost Ratio. Morningstar’s tax cost ratio assumes the highest possible applicable tax rates, including the 3.8% net investment income tax. Many investors are not subject to the highest rates. Note that tax drag calculations only apply to taxable accounts.