How does this decision affect taxes saved?
The decision of whether to pay now or later doesn’t depend on portfolio size or appreciation. Although each investor has different sensitivities to how investments are taxed, our analysis provides some guidance that depends on only a handful of parameters: the tax rate in the current regime, the tax rate in the future regime, the expected return on equities, and the investor’s time horizon. As long the investor defers gains, we can analyze the problem solely on the basis of the variables at hand.
However, the size of the embedded gain changes the amount by which a portfolio can benefit by paying now compared with paying later. Consider two different $1 million portfolios in a prospective Biden tax regime, one with a cost basis of zero and one with a cost basis of $500,000, assuming an 8% expected return over a 15-year period. Based on the above chart, both investors may find it advantageous to pay now if the time horizon is less than 12 years—but the total tax savings from each portfolio may differ considerably.
Benefits of realizing gains for two appreciated portfolios assuming 8% expected return
Source: Parametric, 10/1/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.
The above depictions make it clear that a large change in the tax rate makes paying now look particularly attractive, especially assuming low future expected returns. When future return assumptions are more aggressive, it might make sense to pay later, except in the case of short time horizons. For return expectations in the 6% to 10% range, which is consistent with conventional wisdom, the time horizon required to justify paying now decreases by one to two years for each 1% increase in expected return.
The bottom line
While specific tax policy changes are far from certain, history shows that capital gains and income tax rates have changed often and will change again in the future. Despite the uncertainty, investors can use our analysis as a guide for how to think about their investments and after-tax equity expectations for the future. Depending on the investor’s situation, it may be desirable to realize gains in the near term at lower tax rates rather than waiting until the end of the investor’s time horizon.
This material contains simulated performance data, which is hypothetical and should not be relied on for investment decisions. Hypothetical, backtested, or simulated performance results have many inherent limitations. No representation is being made that an investor will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular investment strategy or trading program.