You check your portfolio, see positive returns, and assume everything is working in your favor. Your index fund is up, your 401(k) balance is climbing, and your brokerage account looks healthy on the surface.

But behind those numbers, taxes on dividends, capital gains, and interest income are steadily reducing your real returns in ways that compound against you over decades.

A new analysis from Morgan Stanley’s Global Investment Office puts a number on this hidden cost and outlines specific strategies to fight back. The findings suggest that failing to plan for tax efficiency could cost you hundreds of thousands of dollars over a 20-year period.

Morgan Stanley found that tax drag could cost 73% of potential gains

The firm’s research examined a hypothetical high-net-worth investor building wealth over a 20-year horizon using multiple tax-efficient strategies simultaneously. That investor could see an additional 1.6% in after-tax returns per year, resulting in nearly 73% more gains over the full period, according to Morgan Stanley.

“People are often surprised to learn just how much of their long-term investment returns go to taxes, and how much of a difference that can make in terms of whether or not they will meet their financial goals,” said Chief Investment Officer Lisa Shalett.

A 1.6% annual improvement might sound small in isolation, but compounding magnifies the effect dramatically. On a $500,000 portfolio earning 8% before taxes, that difference could mean the gap between $2.3 million and $1.3 million over two decades.

The tax code just changed, but the silent drag on your investments didn’t

The One Big Beautiful Bill Act, signed into law on July 4, 2025, made most of the provisions of the 2017 Tax Cuts and Jobs Act permanent. Individual income tax rates will remain at 10%, 12%, 22%, 24%, 32%, 35%, and 37%, and the larger standard deduction is now a fixed part of the tax code, according to the IRS.

Those permanent lower rates are good news for most households, but they do not eliminate the underlying problem Morgan Stanley identified. Tax drag, the annual erosion of investment returns caused by taxes on dividends, interest, and capital gains, continues to operate silently in your taxable accounts, regardless of which bracket you fall into.

The median tax-cost ratio for large-blend mutual funds was 1.28% per year over the most recent three-year period. This means investors in the highest bracket surrendered about 7% of their total returns to taxes over a decade simply from holding the fund, Morningstar noted.

Your retirement accounts are the first line of defense against tax drag

Morgan Stanley’s Daniel Hunt, Senior Investment Strategist for the firm’s Wealth Management division, outlined four key steps to reduce tax drag. The first is to maximize contributions to tax-advantaged retirement accounts such as your 401(k), IRA, and HSA, according to Morgan Stanley.

For 2026, the 401(k) contribution limit is $24,500, with an additional $8,000 in catch-up contributions for those aged 50 and older. Workers between ages 60 and 63 can contribute up to $11,250 under the SECURE 2.0 Act’s “super catch-up” provision, according to the IRS.

Traditional 401(k) contributions reduce your taxable income today, and the investments grow tax-deferred until withdrawal in retirement. Roth accounts flip the benefit: You pay taxes now but enjoy tax-free growth and tax-free qualified withdrawals later in life.

For many people, a hybrid approach that splits contributions between traditional and Roth accounts offers the best long-term flexibility. Your choice depends on your current income versus where you expect your bracket to land in retirement, Hunt’s research suggests.

Morgan Stanley’s Daniel Hunt highlights retirement contributions, Roth strategies, and long-term flexibility as essential tax-saving moves for investors today.

Jessie Casson/Getty Images

Direct indexing and tax-loss harvesting offer additional control

For investors who have already maxed out their retirement accounts, taxable brokerage accounts are where tax drag hits hardest. Every dividend payment, every realized capital gain, and every interest distribution creates a tax liability that reduces what compounds for your future. Morgan Stanley’s analysis identifies direct indexing as one of the most effective tools to combat this erosion.

Direct indexing works by purchasing individual stocks that replicate an index such as the S&P 500, rather than buying a single fund that tracks it. This structure gives you ownership of each position separately, which means you can sell declining stocks to harvest tax losses while maintaining your overall market exposure with similar holdings.

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Those harvested losses offset gains elsewhere in your portfolio and can reduce your tax bill by thousands of dollars each year. Traditional index funds and ETFs cannot offer this benefit because they are pooled vehicles where you do not own the individual positions directly, according to Morgan Stanley.

Tax-loss harvesting opportunities exist in every market environment, not just in downturns or corrections. Even in a strong year like 2024, when the S&P 500 returned 25%, roughly 35% of index constituents posted negative returns, creating meaningful harvesting opportunities for direct indexing accounts, according to Natixis Investment Managers.

Municipal bonds, asset location can shield fixed-income returns from taxes

Bonds are essential for portfolio diversification, particularly as you approach retirement. However, bond interest is taxed at your ordinary income rate, which can reach 37% under the permanent TCJA rates, making bonds one of the least tax-efficient holdings in a taxable account, according to the Tax Policy Center.

Municipal bonds solve this problem because their interest is exempt from federal income tax and often from state and local taxes. For investors in the 32% or 37% bracket, a municipal bond yielding 4% provides the equivalent of a taxable bond yielding roughly 5.9% to 6.3%.

Morgan Stanley’s Hunt also emphasizes asset location as a critical but overlooked strategy. This involves placing your least tax-efficient investments, such as taxable bonds and actively managed funds, inside tax-advantaged accounts like your 401(k) or IRA, according to Morgan Stanley.

Combining these strategies is where the real compounding benefit kicks in

No single tax-efficient strategy will transform your financial outcome on its own. The 1.6% annual return improvement and 73% increase in total gains came from layering multiple strategies, not from relying on a single approach.

Key steps to reduce tax drag on your portfolio

• Maximize contributions to your 401(k), IRA, and HSA before investing in taxable accounts.
• Use direct indexing in taxable accounts to harvest losses and offset capital gains throughout the year.
• Hold municipal bonds in taxable accounts and taxable bonds inside your 401(k) or IRA.
• Practice asset location by placing high-growth, tax-inefficient investments in tax-advantaged accounts.
• Review your portfolio with a financial advisor and tax professional at least once a year to identify new opportunities.

“Overall, how these different approaches are combined can make a significant difference when it comes to building wealth over the long term. Each of them can be helpful in and of themselves, but in concert they can provide much more significant compounded benefits,” Daniel Hunt, Senior Investment Strategist at Morgan Stanley Wealth Management, said.

The new tax law created fresh planning opportunities 

The One Big Beautiful Bill Act introduced several temporary tax provisions that expire in 2028 and may affect your planning.

New deductions for tip income, overtime pay, and auto loan interest are available through Dec. 31, 2028, and a new $6,000 senior deduction benefits single filers aged 65 or older with income below $75,000 and married couples filing jointly with income below $150,000, according to the IRS.

The SALT deduction cap has been raised from $10,000 to $40,000 for taxpayers with modified adjusted gross income under $500,000, but only through 2029. The estate and gift tax exemption has been permanently increased to $15 million per individual, creating new opportunities for wealth transfer, according to the IRS.

Tax-aware financial planning is “the single most important factor in investing that you can control,” Bill Harris, CEO of Evergreen Wealth and former CEO of PayPal and Intuit, told CNBC in January 2026.

You cannot control markets, but you can control how much of your returns you give away each year.

Related: Morgan Stanley reveals the biggest wealth killer, and it isn’t the market