Post-liquidation Wealth for a Hypothetical $1M Starting Portfolio
Deferring the realization of gains is generally a good thing. The basic idea is that when compounding wealth, you’re better off compounding pre-tax dollars than after-tax dollars. 1 1 Close There are exceptions of course. For example, in the case of appreciated concentrated stock, the upfront liquidation tax might be worth paying to reduce the high risk of catastrophic pre-tax losses that characterize poorly diversified portfolios. In such situations, an investor might use tax-aware strategies whose losses could help offset the gains realized upon liquidation of the appreciated asset. But how big is this benefit, and is deferral always a good idea?
In this two-part post, we look at:
- The value of gain deferral, and
- Whether gain deferral is still a good idea if you think tax rates might be higher in the future.
In both parts, we’ll illustrate the conclusions using a hypothetical $1M portfolio with an 80% unrealized gain and a 7% expected return, net of fees.
Let’s start with #1—how valuable is deferral? In the table below, we compare two choices for our hypothetical portfolio: In the first (“Defer Gains”), we defer unrealized gains until the end of our investment horizon; and in the second (“Crystallize Gains”), we realize gains today in hopes of paying a smaller tax bill later. The last two columns show the difference, both in dollars and as a percentage of starting portfolio value. To make our analysis apples-to-apples, at the end of the holding period we liquidate both portfolios and pay taxes on liquidation gains (i.e., these are post-liquidation values).
The results are clear. If tax rates don’t change, deferring gains is expected to lead to higher wealth, regardless of investment horizon – and like any edge in investing, this result becomes more and more powerful the longer you go.
Of course, real investor situations are more complex than this example. Real-world portfolios have a range of ongoing taxable transactions, from trades in underlying investments to regular portfolio rebalancing, and complete deferral may not always be possible. Regardless, strategies that help defer gains can be highly beneficial, irrespective of the investment horizon – and especially over the long term.