As the holding period increases, TAE decreases. Tax Drag% > Tax Rate. Can anyone explain why? I could understand the first part. As holding period increase, tax efficiency increases (i.e., TAE decrease), but as tax efficiency increases, why Tax Drag % > Tax rate?
This should be true for accrual taxes but not deferred (CG gain) taxes. Am I wrong? Will check my notes and come back on this. J.
True for accrual taxes Tax drag % > Tax rate because… Tax drag % = [Vo(1+r)^n - Vo(1+r(1-T))^n]/ [Vo((1+r)^n - Vo] when n increase, Vo(1+r)^n increase more than Vo(1+r(1-T))^n increase For deferred CG tax, tax drag % = Tax rate
Ok, let me try this… Tax drag = is a result from being taxed periodically taxed (examples - dividends and interest income) Let’s say the tax rate is 40%. If I invested $100 on Jan1, and earned $10 in dividends at the end of the year, I can now only reinvest $6. So next year, if my taxable return is 10%, I will earn 106*10%=$10.6. The following year, I earn (106+10.6*(1-40%))*10%. and so on and so forth… so the longer I wait, the bigger the tax drag will be. To calculate the tax drag: I would take the return of the guy who wasn’t taxed for some reason and see how much better he has done with 10% annual rate of return vs. me. 1. His return = 100*(1+10%)^10years=259.37 2. My return = 100*(1+10%(1-40%))^10years = 179.08 3. He made $80 more than I did due to tax advantage… 4. He made 159.37 5. My tax drag is $80/159.37 = 50% (DAMN!) Hope this was helpful…
Can some one please define “tax drag”?
tax Drag - The reduction of potential income due to taxes
Tax Drag = gain lost to taxes / total gain if no taxes
So Tax Drag = (FV pre tax - FV post tax) / (FV pre tax - Initial Principal) ?
Yup, that’s the formula =) So, let’s say you defer your periodic tax payments (retirement plans) and pay at some future date… your tax drag will simply equal to your tax rate…