A year-by-year simulation of income tax, realised gains and deferral, and why turnover, not the tax rate, is the part of the drag a family office controls.
Tax drag is the pre-tax return minus the after-tax return, both measured as compound annual rates on the same portfolio. On an illustrative $100m taxable portfolio earning 7.0 per cent, 2.0 of it income taxed at 30 per cent and 5.0 of growth taxed at 20 per cent when realised, the drag over 20 years runs from 122 basis points with no turnover to 160 basis points when every gain is realised each year: $21.1m of difference in after-tax wealth from turnover alone.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
For a taxable family the number can matter as much as the fee line, and often more. Tax rates differ by jurisdiction and are set by law; what the office controls is when gains are realised, and that choice decides how much of the drag is paid now and how much is deferred, compounding for the family in the meantime.
| Input | Value |
|---|---|
| Starting portfolio | $100m |
| Income yield, taxed each year | 2.0% |
| Price growth, taxed only when realised | 5.0% |
| Pre-tax total return | 7.0% |
| Tax on income | 30% |
| Tax on realised gains | 20% |
| Horizon | 20 years |
Before tax, $100m compounding at 7.0 per cent becomes $386.97m. Turnover is the share of the portfolio sold each year: selling that share realises the same share of the unrealised gain. Income is reinvested after tax.
Income tax = value × yield × income tax rate
Realised gain = turnover × (value − tax basis)
Gains tax = realised gain × gains tax rate, paid from the portfolio
New basis = old basis + net income reinvested + realised gain − gains tax
After-tax return = (ending value after tax ÷ starting value)1/20 − 1
Tax drag = pre-tax return − after-tax return
In Excel, after the yearly rows: =(F21/F1)^(1/20)-1
A closed-form shortcut, after-tax return = yield × (1 − income tax) + growth × (1 − gains tax), gives 5.4 per cent and a drag of 160 basis points. That is correct only for the case where every gain is realised every year. For any lower turnover it overstates the drag, because it ignores the deferral.
| Turnover | Value, liquidated | After-tax return | Tax drag, bps | Value, held | Drag if held, bps |
|---|---|---|---|---|---|
| 0% | 307.4 | 5.78% | 122 | 345.81 | 60 |
| 10% | 298.35 | 5.62% | 138 | 315.62 | 108 |
| 25% | 292.44 | 5.51% | 149 | 299.79 | 136 |
| 50% | 288.72 | 5.44% | 156 | 291.34 | 151 |
| 100% | 286.29 | 5.40% | 160 | 286.29 | 160 |
Three things stand out. First, 60 basis points of drag are fixed: the income tax on a 2.0 per cent yield at 30 per cent. No turnover policy touches it; only the mix of income and growth, or the vehicle the assets sit in, does. Second, deferral is worth $21.1m even when the deferred tax is eventually paid, because the untaxed gain keeps compounding: 122 basis points instead of 160. Third, if the gain is never realised in the family's hands, the drag falls to the 60 basis points of income tax, and the gap to full turnover is $59.51m on a $100m start.
Most of the benefit goes in the first steps. Moving from no turnover to 25 per cent costs 27 basis points a year if the portfolio is eventually liquidated, and 76 if it would otherwise have been held. Moving from 25 to 100 per cent costs only 11 and 24 more. A manager who trades a quarter of the book each year has already given away most of the deferral.
At full turnover the family loses $100.67m of the $286.97m it would have gained before tax, 35.1 per cent of the pre-tax gain. With no turnover and no sale, it loses $41.16m, 14.3 per cent. Those figures, not the managers' pre-tax returns, are the ones to compare when a family office chooses between a high-turnover strategy and a buy-and-hold one, and they belong in the same report as fees. The fee side of the same comparison is worked in what one per cent of fees actually costs.
Turnover forced by a decision to diversify a single holding is a different calculation, worked in does diversifying a concentrated stock position repay the tax.
Simulate the tax year by year at the family's own rates, compute the after-tax compound return with and without a final liquidation, and report the drag beside the fees. The income part is fixed by the asset mix; the gains part is a choice, and most of it is decided by whether the portfolio turns over at all. The office whose job it is to run these numbers is costed in the free workbook for this case.
It depends on the income share, the tax rates and turnover. In the worked case, a 7.0 per cent pre-tax return with 2.0 per cent of income taxed at 30 per cent and gains at 20 per cent, the drag over 20 years is 122 basis points with no turnover, 149 at 25 per cent turnover and 160 at full turnover. Income tax alone fixes 60 basis points.
Deferred tax stays invested and compounds for the investor. In the worked case $100m with no turnover ends at $307.4m after paying all deferred tax at the end, against $286.29m when every gain is realised each year. The $21.1m difference is the return on tax that was paid later rather than sooner.
In the worked case $100m would gain $286.97m before tax. At full turnover tax takes $100.67m, 35.1 per cent of the gain. With no turnover and no final sale it takes $41.16m, 14.3 per cent, though the unrealised gain still carries a deferred liability that a later sale may crystallise.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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