Seeing Beyond the Surface: How Tax Efficiency Shapes Real Investment Returns

We often think about investment costs in terms of expense ratios, which are visible and easy to compare across different ETFs and mutual funds. But like the tip of an iceberg, what you see above the surface can be only a fraction of the true cost of investing. Beneath the waterline sits something less visible but often more damaging to long-term returns: taxes.

The Hidden Cost Beneath the Surface

When you invest in a mutual fund or ETF held in a taxable account, you pay tax not only on income and dividends, but also on capital gains that the fund distributes. These tax drags, when compounded over decades, can have a larger impact on your financial success than most people realize.

A useful way to measure this is through a fund's tax cost ratio. This figure shows how much a fund's return is reduced by taxes on dividends and capital gains. Even with strong market performance, many investors discover that their after tax returns tell a different story than their pre-tax statements.

That is because different managers trade with different levels of tax sensitivity. More frequent turnover, short term gains, and nonqualified income can all increase what you owe Uncle Sam without improving long term performance.  Many of these funds with large tax drags exist in the marketplace and should only be held in tax qualified accounts like IRAs or 401(k)s.  

Not All Dividends Are Created Equal

Even within the world of income, there are good and bad kinds of investment cholesterol. Qualified dividends, similar to HDL cholesterol, tend to support your financial health. These dividends are generally taxed at the lower long term capital gains rate, which reaches up to 23.8 percent at the highest bracket in 2025.

Nonqualified dividends, on the other hand, are taxed as ordinary income, potentially as high as 40.8 percent when you include the 3.8 percent net investment income tax. Nonqualified Dividend Income (NQDI) can come from sources such as REITs, certain foreign securities, or simply from funds with higher trading activity that disrupt holding periods.

In short, two portfolios with identical pre-tax returns can produce very different after tax outcomes based on how much of their income is qualified versus nonqualified.

How Smart Fund Design Helps

This is where evidence based fund companies like Dimensional Fund Advisors shine. They design portfolios with tax efficiency in mind, reduce unnecessary turnover, manage holding periods around dividend dates, and work to maximize qualified income. The result is better tax outcomes today and a healthier compounding of wealth over time.

What You Can Do

Investors cannot control tax law, but they can control how their portfolios interact with it. A few practical steps include:

1. Locate assets strategically. Hold tax inefficient investments such as REITs or bond funds in retirement accounts, and place more tax efficient funds and ETFs such as index funds or Dimensional style equity funds in taxable accounts.
2. Consider total return, not yield. Chasing dividends can backfire if it leads to higher nonqualified income or unnecessary trading.
3. Review fund tax cost ratios or their stated tax drag. A slightly higher expense ratio may be worth it if the manager delivers lower tax costs and higher after tax returns.
4. Harvest losses thoughtfully. Realizing losses to offset gains can improve after tax results without changing your overall risk exposure.

Just as good health requires paying attention to what is beneath the surface, good tax health requires looking beyond expense ratios. A well designed, tax aware portfolio adds quiet compounding power year after year and helps you keep more of your wealth working for you.  That’s what Perkins Wealth Advantage does for you.