The IRS Is Eating Your Returns

A few years ago, Mark — a guy I know who runs a 6-person design studio — did something he was proud of. He moved his investment account from a brokerage that was charging him about 1% a year into a handful of index funds with a fee of 0.03%. He pulled out a calculator, did some quick math, and realized he was going to save tens of thousands of dollars over the next twenty years.

He told his wife. He told his accountant. He told me.

Then January rolled around and he got a 1099 in the mail with a number on it that made him do a double-take. A small fortune in “capital gains distributions” he didn’t remember collecting, attached to funds he hadn’t sold a single share of. He owed thousands in taxes on money he never actually saw.

He called me up and asked the most reasonable question in the world: “I thought I made this cheaper. What just happened?”

What just happened is that Mark — like a lot of smart, frugal, do-your-homework small business owners — won the battle on fees and is quietly losing the war on taxes.

The Number Nobody Talks About

A Wall Street Journal piece this week put a sharp point on something that’s been true for a long time but rarely shows up in the brochures: for most investors, the biggest cost of investing isn’t the fund fee anymore. It’s taxes.

The article points out that you can now buy an index fund for 0.03% a year. That’s three dollars on every ten thousand. Wall Street’s old fee model is essentially dead, and that’s a beautiful thing.

But here’s the part most people miss. Research the Journal cites shows that taxes have historically eaten 1.6 to 1.8 percentage points out of the stock market’s roughly 10% annual return. That’s more than one-sixth of everything you earn, sliced off the top, every year, forever.

The article gives a real example that’s almost hard to believe. A popular ETF returned 41.1% on paper from early 2024 through the end of 2025. After taxes? 16.3%.

If a fund company charged you a fee that big, you would burn the building down. But because it’s tax — and because nobody mailed you an invoice — most people don’t even notice it happened.

Why This Hits Business Owners Harder

If you’re a solopreneur or small business owner, this is your problem more than most.

Here’s why.

You almost certainly have multiple income streams — your business income, maybe a spouse’s W-2, distributions, contractor work, investment income. That stacks up into a higher marginal tax bracket than the average employee with a single salary.

You’re more likely to be holding investments in a regular taxable brokerage account, not just an IRA or 401(k), because you’ve never had an employer offering you a 401(k) match in the first place. Every dividend, every capital gain, every fund distribution in that account is taxable in the year it happens, even if you didn’t touch the money.

And if you’re in California like a lot of my clients, your state takes a generous additional bite. A capital gain that costs a Texas business owner 15% in federal tax can cost a California business owner closer to 28% once state tax piles on.

You’re paying for the same investment. You’re getting a very different bill.

What’s Actually Going On Behind the Scenes

When the Journal article talks about taxes eating your returns, here’s the simple version of what’s happening:

Most mutual funds buy and sell stocks inside the fund. Every time they sell something at a profit, the fund has to pass that gain along to you at the end of the year. You owe tax on it. You didn’t make the decision. You can’t opt out. You can’t even see it coming until the statement shows up in January.

ETFs — the cousin product, sold in the same store — are built in a way that mostly avoids this. In 2024, only 7% of U.S. equity ETFs kicked out a capital gains distribution. For mutual funds in the same categories? 78%.

Same stocks. Same strategy. Wildly different tax bill. Most owners I meet have no idea their account is full of one and not the other.

What Actually Moves the Needle

You don’t need a finance degree to fix this. You need a few decisions made on purpose instead of by accident.

ETFs instead of mutual funds, where it makes sense. For most stock exposure in a taxable account, this one swap can save you a percentage point or more a year. Quietly. Forever.

Putting the right investments in the right accounts. Your tax-deferred accounts (Solo 401(k), SEP-IRA, IRA) are great places to hold the investments that throw off the most taxable income. Your taxable brokerage account should hold the calmer, more tax-friendly stuff. This is called asset location, and almost nobody does it on their own, because nobody told them it was a knob they could turn.

Maxing out the retirement accounts you actually have access to. If you’re a solopreneur making solid money, a Solo 401(k) lets you sock away vastly more than a regular IRA, with the contributions coming straight off your taxable income this year. For most owners I work with, this is the single biggest tax move on the table, and most haven’t made it.

Harvesting losses on purpose. When part of your portfolio is down, you can sell it, capture the loss for tax purposes, and buy something similar. You stay invested. The IRS gives you a discount on this year’s tax bill. The savings compound.

Tax-free municipal bonds, especially for Californians. If you’re in a high bracket in a high-tax state, California muni bond income can effectively beat what a taxable bond pays you, once you do the math. Most owners don’t do the math.

None of these are exotic. None of these require you to time the market or pick the next hot stock. They are unglamorous, repeatable decisions that add up — quietly, the same way taxes were quietly subtracting — to real money.

The Part Where I Actually Help

Here’s the honest version of the pitch. The 0.03% expense ratio fight is over. You already won it. The next conversation — the one where the actual money is sitting on the table — is about taxes.

That’s the conversation I have all day. I’m a fiduciary financial advisor based in Hermosa Beach, California, working specifically with solopreneurs and small business owners who have fewer than 10 employees. I charge a flat fee, not a percentage of your money, which means I have no reason to recommend anything except what makes you the most after-tax dollars.

If you’ve got a brokerage account, a retirement account, or both — and you’ve never had somebody walk you through what’s actually happening to your returns when the IRS gets in the middle of them — let’s fix that.

You’ll get a clear, plain-English read on what your investments are actually costing you in tax — and what you can do about it before next April rolls around.

Mark’s bill this year, by the way, is a fraction of what it would have been. Same returns. Same risk. Different decisions.

If you would like to discuss tax strategy in more detail, click Book A Meeting.

Frequently Asked Questions About Investment Taxes

1. What is tax drag and how much does it cost investors?

Tax drag is the reduction in your investment returns caused by taxes on dividends, capital gains, and fund distributions. For most investors it quietly subtracts between 1% and 2% per year from total return — and research cited in the blog estimates the historical average at 1.6 to 1.8 percentage points on the stock market's roughly 10% annual return. In one real example, an ETF that returned 41.1% on paper from early 2024 through the end of 2025 delivered just 16.3% after taxes. Most investors never notice because there's no invoice — the tax bill just shows up on a 1099.

2. Why am I getting capital gains distributions on funds I didn't sell?

Because the fund did the selling for you. Most mutual funds buy and sell stocks inside the fund all year. Every time the manager sells something at a profit, the fund is legally required to pass that gain along to you as a capital gains distribution at year-end. You owe tax on it — even if you reinvested the distribution and never touched a dollar. You didn't make the decision, you can't opt out, and you usually can't see it coming until the January 1099 arrives.

3. What's the tax difference between ETFs and mutual funds?

Massive. ETFs are built using a creation/redemption mechanism that mostly avoids triggering taxable capital gains inside the fund. The result: in 2024, only 7% of U.S. equity ETFs distributed capital gains to shareholders. For mutual funds in the same categories, 78% did. Same stocks, same strategy, wildly different tax bill. For most stock exposure held in a taxable brokerage account, swapping mutual funds for tax-comparable ETFs can save a percentage point or more per year — every year, forever.

4. What is asset location and how does it lower your tax bill?

Asset location is the practice of putting the right investments in the right accounts. Investments that generate the most taxable income — bonds, REITs, actively-traded funds — belong in tax-deferred accounts like a Solo 401(k), SEP-IRA, or IRA, where their distributions aren't taxed each year. Tax-efficient investments — broad-market stock ETFs, individual stocks held long-term, municipal bonds — belong in your taxable brokerage account. Done well, asset location can add meaningful basis points of after-tax return per year without changing your overall risk profile. Almost no one does it on their own because nobody told them it was a knob they could turn.

5. What is tax-loss harvesting and how does it work?

Tax-loss harvesting is selling an investment that's currently down, capturing the loss for tax purposes, and immediately buying a similar (but not "substantially identical") investment to stay invested in the market. The realized loss offsets capital gains elsewhere in your portfolio, plus up to $3,000 of ordinary income per year, with any remaining losses carrying forward indefinitely. The wash-sale rule prohibits buying back the identical security within 30 days, which is why the replacement has to be similar but not identical. Done systematically, it can shave a meaningful percentage off your annual tax bill.

6. Why does tax-efficient investing matter more for business owners?

Three reasons stack up. First, business owners typically have multiple income streams — business income, a spouse's W-2, distributions, contractor work, investment income — which pushes them into a higher marginal tax bracket. Second, they're more likely to hold investments in taxable brokerage accounts (vs. an employer-sponsored 401(k)) because they had to build their own retirement system from scratch. Third, if they're in a high-tax state like California, state tax compounds the federal hit — a capital gain that costs 15% federally can cost a Californian closer to 28% once state tax is added.

7. Are California municipal bonds worth it for high earners?

For investors in a high federal bracket and a high-tax state like California, yes — often dramatically so. California municipal bond interest is generally exempt from both federal and California state income tax. For a high-bracket Californian, that exemption can make a 4% muni yield equivalent to roughly 7%+ on a taxable bond, depending on the bracket. The math has to be run individually because the right answer depends on your specific federal bracket, state bracket, and alternative tax-equivalent yields, but for high earners in California it's frequently the most efficient income source available.

8. What's the difference between pre-tax (gross) and after-tax investment returns?

Pre-tax (or gross) returns are the headline number a fund advertises — what the investment earned before any taxes were withheld. After-tax returns are what you actually keep after federal capital gains tax, ordinary income tax on dividends and bond income, and state tax are all deducted. The gap between the two is what matters for building real wealth, and it's larger than most investors realize. In the blog's example, an ETF's 41.1% pre-tax return became 16.3% after-tax — more than half the return lost. Headline numbers don't pay for retirement; after-tax numbers do.