Tax Drag

In a taxable account, interest, dividends and gains on sales are taxed in the year they arrive, so part of each year's return leaves the account instead of compounding. The yearly amount is small, and the compounding it gives up is what makes it large.

At 8% a year, $10,000 grows to $100,627 over thirty years untaxed. Take one point off the rate for tax along the way and it reaches $76,123, about a quarter less from the same holding and the same gross return.

How large the drag is depends on the holding and the account. Bond interest is taxed as ordinary income every year, broad index funds distribute little beyond qualified dividends, and tax-advantaged accounts defer or remove the drag, which is the arithmetic asset location is built on.