High-income investors often do everything right on the portfolio side. Then taxes take a bite. That bite is “tax drag,” the gap between pre-tax and after-tax returns.
The good news is that you can narrow that gap. Thoughtful choices about wrappers, turnover, lot selection, and harvesting can improve after-tax outcomes without changing your strategic asset mix.
What tax drag looks like at high incomes
Long-term capital gains and qualified dividends are taxed at 0%, 15%, or 20% depending on taxable income. For 2025, the 20% bracket begins when total taxable income is above $533,400 for single filers and above $600,050 for those filing jointly.
The 3.8% Net Investment Income Tax applies once modified adjusted gross income crosses $200,000 for single filers and $250,000 for joint filers.
If you own active mutual funds in taxable accounts, you can also receive capital gain distributions you did not choose to realize yourself. Those distributions are taxable in the year paid.
Those rules define the terrain. The strategy is to control the timing of gains, prioritze qualified over non-qualified income, and minimize avoidable distributions.
Why structure matters
The same index can be held in different wrappers with different tax profiles.
Traditional mutual funds must sell securities to meet redemptions, which can force realized gains distributed to all shareholders.
Because of its different structure, exchange-traded funds typically have fewer taxable events than a mutual fund and are more tax-efficient. ETFs use an “in-kind” creation and redemption process. When large investors (authorized participants) want to buy or sell shares, they exchange a basket of securities for ETF shares or vice versa. This process allows ETFs to avoid selling securities to meet redemptions, which would otherwise trigger capital gains.
How to measure your tax bite
Morningstar’s tax cost ratio estimates how much of a fund’s annualized return is reduced by taxes on distributions, assuming the investor is in the highest bracket for that period. A higher number means a larger drag. Use it to compare similar funds.
Direct indexing
Direct indexing replaces a pooled vehicle with a customized portfolio of individual stocks designed to mirror an index. This approach offers two key tax advantages.
First, you can harvest losses by selling underperforming stocks within your portfolio, even if the overall index is performing well.
Second, you can control the realization of gains when trimming positions.
These features can help offset gains elsewhere or adjust your capital-gains calendar to fit your individual tax situation.
Research suggests the after-tax benefit rises with wealth, volatility, and harvesting frequency, although results vary by client facts and implementation choices.
However, direct indexing can have higher costs and minimums, diminishing tax benefits over time, and a greater administrative burden, so these factors must be evaluated before implementing this strategy.
Tax-loss harvesting that respects the rules
Tax-loss harvesting isn’t about “beating the market.” It is about swapping a position with an unrealized loss into a similar, but not “substantially identical,” replacement so you stay invested while booking a deductible capital loss.
The wash sale rule disallows the loss if you buy substantially identical securities within 30 days before or after the sale. Well-designed harvesting programs emphasize replacement discipline and reinvest any tax savings into the portfolio to compound the benefit.
Lot selection, dividend qualification, and turnover discipline
When selling investments, using specific-lot identification instead of the first-in-first-out (FIFO) method is often better. Specific-lot identification allows you to choose which shares you are selling. By selecting the shares that cost you the most (highest-basis shares), you can reduce the amount of realized gains for tax purposes, which can help lessen your tax burden.
Ensure that your broker confirms the cost-basis method (calculating your gains or losses) and the specific lots you’ve chosen to sell on Form 1099-B, the form used for reporting those sales to the IRS. Specify which lots you are selling when you make the trade and keep thorough records of these transactions.
Qualified dividends are taxed at lower capital gains rates only if holding-period rules are met. A high-turnover strategy can turn otherwise qualified income into non-qualified income taxed at ordinary rates.
Slowing turnover and favoring strategies that achieve exposure with fewer trades can help reduce tax drag. Index-tracking ETFs with broad, rules-based methodologies typically shine here, because they trade less and distribute less.
Coordinate with the rest of your balance sheet
Consider deferring voluntary gains into a lower-income year if you expect a windfall.
If your income is below the net investment income tax (NIIT) threshold for a certain year, it can be beneficial to realize gains to increase your basis without incurring the surtax.
Plan your stock harvesting alongside charitable contributions to maximize your tax benefits. When you donate shares with significant gains, the charity can sell those shares without paying taxes, allowing you to avoid realizing gains on shares you intend to give away. Focus on donating stocks that have appreciated the most in value.
Impact of OBBBA
The One Big Beautiful Bill Act (OBBBA) was signed on July 4, 2025.
OBBBA permanently raises the estate and gift tax basic exclusion amount to $15 million per person beginning January 1, 2026, with inflation adjustments thereafter.
This increase applies to the lifetime estate and gift tax basic exclusion. It does not change the annual gift exclusion amount, which remains a separate limit for tax-free gifts made each year (currently $19K/year in 2025).
A larger lifetime exclusion expands room for inter-vivos gifts to irrevocable trusts, family-controlled entities, or grantor trusts, paired with valuation discounts where appropriate. Remember that lifetime gifts carry over your basis to the recipient. The gift removes future appreciation from your estate but does not wipe out capital gains for the donee.
A related, narrower change impacts Qualified Small Business Stock. OBBBA updates parts of Section 1202, increasing the per-issuer cap and adopting tiered holding-period exclusions before year five in some cases. That is relevant if your equity exposure includes startup stock rather than public markets.
Transitions without self-inflicted taxes
Switching from active mutual funds to more tax-aware vehicles can trigger gains. The right path depends on embedded gains, your bracket this year versus next, and charitable planning. If you have a position with a significant unrealized gain and a strong desire to improve tax efficiency, consider donating appreciated shares to a donor-advised fund (DAF) while buying a more tax-efficient replacement with cash. This captures a deduction (subject to AGI limits) and avoids the gain. Consider wash sale rules if you harvested a loss in a similar position recently.
If you hold loss positions, tax-loss harvest first, then redeploy into a more tax-aware wrapper.
A staged exit across calendar years can spread recognition if you own a high-distribution fund with modest gains.
There is no single template. The common thread is to take advantage of the tax code’s timing flexibility.
Final thoughts
Tax-aware equity investing isn’t a niche tactic. It is a system.
Choose wrappers that avoid avoidable distributions. Trade less, and trade smarter. Use specific lots. Harvest losses within the rules. Coordinate with your broader tax picture, including NIIT exposure and charitable goals.
OBBBA did not change the core rules for capital gains and qualified dividends, so your playbook remains valid. However, it did raise the estate and gift tax exemption beginning in 2026, which expands how appreciated assets can be transferred across generations.
Combine both tracks. You will keep more of what your portfolio already earns.
