Post-liquidation Wealth for a Hypothetical $1M Starting Portfolio
Tax Matters
The Enduring Appeal of Gain Deferral, Part 1
February 1, 2024
Topics - Tax Aware
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.
Source: AQR.
We compute future post-liquidation wealth starting with an hypothetical investment with $1M value and $0.2M cost basis and assuming a full liquidation at the end of the investment horizon. The future post-liquidation wealth per dollar invested for deferring the gain till the end of the investment horizon scenario is (1+r)n*(1 - T) + B*T, whereas the future post-liquidation wealth per dollar invested for crystalizing the gain today is W*(1+r)n*(1 - T) + W*T, where W = (1 – T) + B*T is the after-tax investable capital after crystalizing the gain today. We define r as the expected annual net-of-fee pre-tax return (with all the return treated as price appreciation, taxable upon liquidation), B as the cost basis as a percentage of the portfolio market value, T as the 2023 long-term capital gains tax rate, and n as the investment horizon in years. We assume that r = 7%, T = 23.8%, and B = 20%. We find that varying expected returns or the cost basis does not meaningfully change the conclusion.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.