The Second Eroder: Tax on the Compounding Itself

Inflation is one leak; tax is the other, and it does more damage than most people expect because it attacks the compounding, not the balance. Shelter the growth first and the return second — that ordering is what the entire tax-advantaged-accounts chapter is built on (chapter “Tax Advantaged Accounts”), and here is the arithmetic underneath it.

Compare one dollar earning $r$ for $n$ years under two regimes. If the gain is taxed annually at rate $\tau$ — interest, non-qualified dividends, a fund distributing realized gains — only $r(1-\tau )$ survives each year to compound:

If instead the gain compounds untouched and is taxed once on withdrawal:

The trailing $+\tau$ is not a typo: only the gain ${(1+r)}^n-1$ is taxed, so you keep $1+\left({(1+r)}^n-1\right)(1-\tau )$, and multiplying that out gives the displayed form — the $+\tau$ is the tax you never owe on your original dollar. Both regimes pay the same rate. Deferral wins anyway, and the gap widens with every year and every point of volatility-free growth, because the annual version keeps removing the seed capital that would have compounded.

Run it at $r=8\%$, $\tau =35\%$, $n=30$. Annual taxation compounds at $8\%\times 0.65=5.2\%$, turning $1 into $1.052^{30}=\$4.58$. Deferral grows $1 to $1.08^{30}=\$10.06$ first, then taxes the gain: $10.06\times 0.65+0.35=\$6.89$ — half again as much terminal wealth, from identical gross returns and an identical tax rate. Expressed as an effective compound rate, the taxable account delivered 5.2% and the deferred account 6.6% (that is $6.89^{1∕30}-1$, the compound-rate calculation the CAGR section below makes routine). The 1.4-point difference is not a fee anyone disclosed to you. Differences this size are usually quoted in basis points — hundredths of a percentage point, so the 1.4-point drag is 140 bps. That is the unit fees are advertised in, precisely because it sounds small.

This leads to three fundamental takeaways: tax drag functions as a persistent rate reduction, not a one-time haircut, so it compounds against you exactly as inflation does — combine both and the real after-tax return is

which at 8% nominal, 35% tax, and 2.5% inflation is a sobering 2.6%. Second, the drag depends heavily on portfolio turnover, not merely the tax rate: a broad index fund you never sell defers almost all of its gain by default and behaves far more like the second formula than the first, which is a large part of why index funds beat active funds after tax by more than they beat them before tax. Third, deferral is not forgiveness — $\tau$ still arrives, and the full comparison of pre-tax versus Roth versus taxable, including the case where your future rate differs from today’s, is worked in section “Tax-Advantaged Accounts: Choosing Between Pre-Tax and Post-Tax Options”.