Advantage of Deferral In Three Scenarios
Tax Aware
The Enduring Appeal of Gain Deferral, Part 2
February 6, 2024
Topics - Tax Aware
Our previous post showed the power of deferral for building wealth. But one key assumption in that analysis was that tax rates remain constant.
What if instead tax rates in the future are higher than they are today—could an investor be better off recognizing gains at today’s lower tax rates? 1 1 Close For instance, some have argued the size of national debt may lead Congress to curb spending, raise taxes, or both. How much higher would future tax rates have to be for deferral to be a bad idea, and over what horizon?
Let’s return to our previous example of the hypothetical $1M portfolio with a 7% expected return, net of fees, and 80% unrealized gains. For brevity, we’ll focus on the advantage of deferral, that is, the difference between post-liquidation values of the “Defer” and “Crystallize” approaches, rather than looking at each standalone. Consider three scenarios:
- The maximum capital gains tax rate stays at 23.8% 2 2 Close I.e., 20% long-term capital gains plus 3.8% net investment income tax. (i.e., what we looked at last time)
- This tax rate increases to 28.8%, and
- This tax rate increases to 43.4%.
The table below shows our results, with Scenario 1 as our baseline (i.e., deferring is always valuable). Let’s look at Scenario 2, where the assumed tax rate is 5% higher than it is today. We find that even at this higher rate, it’s still almost always better to defer gains (unless the investment horizon is 3 years or less, but even over those short horizons the differences are pretty small).
What if future tax rates shoot all the way up to 43.4%? In other words, what if future maximum long-term capital gains tax rate is set to match maximum ordinary income tax rate before the Tax Cuts and Jobs Act of 2017? Even here, there’s a pretty strong case to make for deferral. If our hypothetical investor plans to hold their portfolio for 10-15 years, 3 3 Close OK, technically 13. they’re better off compounding today and deferring till later, despite the higher future tax rate.
Source: AQR. We compute future post-liquidation wealth starting with an 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 - Tfuture) + B*Tfuture, whereas the future post-liquidation wealth per dollar invested for crystalizing the gain today is Wcurrent*(1+r)n*(1 - Tfuture) + Wcurrent*Tfuture, where Wcurrent = (1 – Tcurrent) + B*Tcurrent 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 market value, Tcurrent as the 2023 long-term capital gains tax rate, Tfuture as the long-term capital gains tax rate at the end of the investment horizon, and n as the investment horizon in years. We assume that r = 7%, Tcurrent = 23.8%, and B = 20%. We vary Tfuture. We find that varying expected returns or the cost basis does not meaningfully change the conclusion.
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