How Overtrading Can Undercut After-Tax Returns

It can be tempting to switch out investments in your taxable portfolio in response to prevailing market conditions. However, our research has shown that most investors fail to properly account for the tax consequences of excessive turnover in their taxable accounts.

Here's a look at just how pernicious so-called tax drag can be—and what you can do to combat it.

Every time you sell an investment in a taxable brokerage account, you run the risk of incurring a tax bill. And the more often you trade, the greater the tax toll can be—especially to those in higher tax brackets, who are subject to higher taxes on both short- and long-term gains.

For example, an individual in the highest tax bracket who sells and replaces just 5% of their investments each year could see their after-tax returns reduced by nearly three-quarters of a percentage point.

That's not to say portfolio turnover is inherently bad. There are plenty of reasons to switch up your investment mix, such as to reduce fees or to replace an underperforming security. But if you regularly change out investments in an attempt to beat the market, the tax drag might not be worth it.

While investors in the highest tax brackets are most vulnerable to tax drag, the following strategies can help all investors shield more of their returns from taxes.

• Harvest losses: If switching out an investment will result in a capital gain, look for opportunities to offset the associated tax bill by selling an investment with an equivalent or greater loss (a.k.a. tax-loss harvesting).
• Keep high-turnover funds in tax-deferred accounts: Many funds have turnover rates of more than 100%, and it's not uncommon to find funds with an annual turnover rate of more than 400%. These funds are more likely to incur capital gains, which are passed on to investors as taxable distributions. If a fund's turnover rate is substantially higher than that of market-cap index funds—which average 17% for exchange-traded funds (ETFs) and 19% for mutual funds—consider holding them in a tax-deferred account, where tax drag is not a concern.
• Consider broad-market passive funds: Broad-market index ETFs and mutual funds tend to have lower portfolio turnover because they change their holdings only when their underlying indexes do, which happens infrequently. For example, some ETFs can have an annual portfolio turnover rate of just 2% to 4%.
• Consider tax-managed funds: Certain fund managers make reducing tax drag a priority and use various techniques to reduce the impact of taxes, such as focusing on long-term asset appreciation and avoiding high-dividend-paying stocks. In addition, techniques such as tax-loss harvesting can be used to offset a portion of the gains the fund realizes.
• Think long term: The desire to fiddle with your holdings is often the result of short-term thinking. By creating and then following a sound investment plan, you can free yourself from overreacting to market turbulence—and from the temptation to overtrade.

Work with your Schwab consultant to craft an investment plan that's appropriate for your goals and risk tolerance.