Tax Drag of High-Turnover Funds
Example: Starting investment: 100000 $ · Gross annual return (same for both): 8 % · High-turnover fund portfolio turnover: 80 % · Short-term capital gains tax rate: 32 % · Long-term capital gains tax rate: 20 % · Investment horizon: 25 years
| Lifetime tax drag cost | $174,430 |
| Low-turnover fund (defer tax) | $567,878 |
| High-turnover fund (annual tax) | $393,448 |
| Effective after-tax return (high-turnover) | 5.63% |
Worked example
Invest $100,000 at 8% gross for 25 years. A low-turnover fund (tax deferred to the end, 20% LTCG) ends at roughly $571,000 after tax. A high-turnover fund at 80% turnover — with 80% of gains taxed at 32% short-term each year — ends at about $470,000. Tax drag destroys $101,000, reducing the effective annual return from 8% to 6.4%.
Frequently asked questions
What is portfolio turnover?
Portfolio turnover is the percentage of a fund's holdings that are replaced in a given year. A fund with 100% turnover replaces its entire portfolio once a year. Index funds typically have 2–5% turnover; some actively managed funds exceed 100%. High turnover in a taxable account generates short-term capital gains, which are taxed at ordinary income rates.
Does turnover matter in a retirement account?
No — inside a 401k, IRA, or Roth IRA, gains are not taxed annually regardless of turnover. This tax drag calculation applies only to investments held in taxable brokerage accounts. For tax-advantaged accounts, the only relevant cost is the expense ratio, not turnover.
How do I find a fund's turnover rate?
Every mutual fund and ETF reports its portfolio turnover rate annually in its prospectus and annual report. The SEC EDGAR database contains all fund prospectuses. Most brokerage platforms show turnover rate on the fund's detail page. As a rule of thumb, index funds have turnover below 10%; actively managed funds commonly range from 50% to 150%.