# Managing Tax Drag When Diversifying Your Portfolio Your Guide to Limiting the Cost of Diversification [Srikanth Narayan](https://usecache.com/author/srikanth-narayan) Founder and CEO [Christopher Lange](https://usecache.com/author/christopher-lange) Head of Investments ## What is tax drag? Tax drag describes the ongoing negative impact paying taxes can have on an investor’s overall returns. It can occur when switching from one investment to another and triggering a taxable event (like the Facebook engineer we mentioned). When you pay taxes, the amount of principal you have to invest decreases. It’s a little like throwing away years of growth in your portfolio. As your investment compounds over time, the returns are lower because there’s less principal to compound. In certain circumstances, tax drag can be limited if you can either avoid paying the taxes altogether, defer the taxes and pay them later, or find ways to offset the capital gains with capital losses. We’ll explain all these scenarios below. ### An example of tax drag To see tax drag in action, let’s return to the early Facebook engineer we mentioned at the beginning of this piece. The engineer is a high earner in California, which means he could have an effective capital gains rate of 35%. His cost basis for the META [stock he earned as compensation](https://usecache.com/companion/equity-compensation-types) is negligible, which means every $100K in META that he wants to sell and diversify would incur $35K in taxes. If he re-invested the remaining $65K in a diversified fund, it would take almost five years to return to his starting point of $100K, assuming an average annual return of 10%. ## Calculating tax drag Modeling out the potential tax drag on your portfolio can take a little spreadsheet wizardry, so we created a tax drag calculator that makes it a little easier to understand your situation. If you know your cost basis and the approximate value of the stock you own, [check out our simulator](https://usecache.com/exchange/simulate). It calculates and compares the different outcomes if you decide to diversify and sell or participate in a tax-deferred exchange fund. The outcome with an exchange fund should be similar to the example we showed you above, however using numbers that approximate your situation can help drive home how much tax drag could potentially hurt your long term performance. ## How to optimize tax drag Tax drag does not have to be a fact of life! Let’s be clear: Taxes are (nearly) always incurred when you sell your assets (e.g. to raise cash to buy a house or other financial needs). However, when you are selling one investment to buy another, tax drag can be optimized and should be a serious consideration. ### Exchange funds Not to be confused with ETFs, exchange funds pool together stocks from multiple investors to create a diversified fund. Your stock contribution is not taxed, and after a seven year period you can withdraw a diversified pool of stocks from the fund without triggering taxes. The example above essentially describes the tax-deferred performance of an exchange fund. Exchange funds are newly available to investors with as little as $100,000 to invest. [Check out the Cache Exchange Fund](https://usecache.com/product/exchange-funds) to see more about how they help combat tax drag. ### Tax-loss harvesting An investment advisor can help you set up a separately managed account that gradually sells portions of your appreciated stock position. The proceeds are reinvested in a diversified basket of stocks. As those stocks move up and down, capital losses are recognized, which offsets some of the capital gains in your portfolio. ### Choose a new path When you participate in a retirement plan, you’re avoiding tax drag by contributing pre-tax income. Your IRA or 401(k) can’t help you defer taxes on a stock you already own, but if you’re thinking long-term, you may be able to use those accounts to acquire stock you hope to appreciate dramatically. When it comes time to retire, that could mean a decreased tax burden. ### Charitable giving Some charitable giving vehicles let you donate stocks to charitable causes without incurring capital gain taxes first. You will also receive a tax deduction that you can use in other parts of your portfolio. However you choose to proceed, it can definitely be worth your while to explore your options. Your head is in the right place if you’re thinking about diversifying and selling. Take the extra time to [calculate the potential tax drag](https://usecache.com/exchange/simulate) on your portfolio, and if you’re unsure of your options, talk to an advisor about the best ways to meet your investment objectives.