President Joe Biden unveiled his “American Families Plan” in a speech to Congress in April. One component that may have caught investors’ attention is Biden’s favored approach to capital gains taxes.
The president’s plan would increase the tax rate for long-term capital gains from 20% to 39.6% for taxpayers earning $1 million or more. This would bring the capital gains rate in line with Biden’s proposed top tax rate on ordinary income, which the president wants to restore to its level before the 2017 tax reform package. (Short-term capital gains are already taxed like ordinary income for all taxpayers.) Affected taxpayers could face a federal rate as high as 43.4% when including the existing 3.8% net investment income surtax. Since the plan is so far only a proposal, some details remain unresolved. For example, it is not clear if the $1 million income threshold will apply to taxable income or adjusted gross income.
Still, the prospect of the government nearly doubling the tax rate on capital gains has understandably worried potentially affected taxpayers. But there is no reason to rush to act.
First, bear in mind that just because the president wants something does not mean it will happen. Democrats plan to use the budget reconciliation process for this policy change, which only requires 50 votes in the Senate, with the vice president serving as the tie-breaker. Yet it is far from certain that every Democrat will vote with their party on the president’s plan in its current form. Several moderates, including Joe Manchin, D-W.Va., have pushed for smaller tax increases. Sen. Bob Menendez, D-N.J., said of the president’s proposal, “Right now it seems like a rather high rate to me.”
Lawmakers may negotiate down the president’s opening figures to ensure strong, uniform support, at least among Democrats. The proposed 39.6% could become, say, 28% instead. Or the income threshold could rise from $1 million to $10 million. Analysts at Goldman Sachs and UBS have both suggested that they think the tax increase will pass, but only in a scaled-back form. Taxpayers should also remember that the tax increase may phase in gradually. While Congress could choose to make it effective as of the legislation’s passage, or even retroactive to the beginning of 2021, it seems more likely that a compromise will include some sort of ramp up period.
That said, without bipartisan support – currently unlikely – the measure will probably end up being temporary. As tax professionals are well aware, administrations have a history of undoing recent policy changes that they dislike. If lawmakers are not able to reach a compromise, it is a matter of time until the other party gets enough legislative or administrative clout to wind the policy back. Many investors may want to try to wait out the higher rate if they can.
There is too much uncertainty about the plan’s timing or details to take any action right now. But if you regularly have annual income over $1 million, you can start thinking about actions you might want to take if the president’s plan seems likely to pass, whether in its current version or in a modified form.
First, you should note that there are some aspects of your portfolio that might deserve closer attention in a world with a much higher capital gains rate. You will need to be particularly sensitive to your ability to sell “selected lots” – particular securities you bought on a specific date. Many brokerages default to a “first in, first out,” or FIFO, method of choosing which shares to sell in the absence of other direction from an investor. But FIFO can trigger higher capital gains, and thus higher tax obligations. Some newer brokerage platforms, such as Robinhood and SoFi, make selecting particular lots to sell much more difficult than traditional brokerages do. Regardless, investors should take care to make sure they understand the process so they do not pay more than they must.
Concentrated stock positions, such as employer stock, may also be a bigger problem. Diversification insulates you against unnecessary risk, but selling shares to diversify could mean a large tax bill under the Biden plan. One option to diversify without triggering gains is to use an exchange fund, also known as a swap fund. In these funds, investors with concentrated, appreciated stock positions pool them in a partnership. In exchange for contributing your stock, you will receive a share of the partnership’s diversified holdings. When structured properly, an exchange fund allows investors to swap concentrated stock for a diversified basket of investments without triggering capital gains tax obligations.
A hike in the long-term capital gains tax rate could also make high earners warier of actively managed mutual funds. As I have written before, stock mutual funds often give investors an unpleasant holiday gift in the form of unanticipated capital gain distributions. Funds distribute capital gains on a schedule outside investors’ control, typically in December. With higher tax consequences, these distributions may transform from an annoyance to a deal breaker. Conversely, as high-income investors move away from actively managed mutual funds, the relatively new option of actively managed exchange-traded funds may hold a new appeal. ETFs are generally more tax efficient than traditional mutual funds. Raising the tax on long-term capital gains could speed up a shift in how certain investors approach active management.
Beyond reviewing potential tripwires, investors may want to consider some possible strategies for dealing with appreciated assets. Most straightforwardly, if you are already thinking of selling an appreciated asset, it won’t hurt to do so sooner rather than later. As I mentioned, while lawmakers could make a change to long-term capital gain taxes retroactive, it seems more likely that they will take a gradual approach. Morningstar columnist Sheryl Rowling recently reassured investors: “It appears that we can feel fairly confident there won't be increases affecting 2021 taxes. So, there is time to plan for any potential changes.” Most experts believe investors will have plenty of time to act as the legislation takes shape. If you have been procrastinating diversification or other portfolio moves, it may be a good time to carry out your intentions.
Traditionally, estate planning has been another avenue for making the most of appreciated assets. Under the current rules, heirs a get a “step up” in basis when they inherit appreciated assets from someone who has died. This means that if investors leave such assets to their children or other heirs, the recipients only have to pay tax on any appreciation that happened after the original owner’s death. Biden’s proposal could change this system. The president has proposed that the deceased owe tax on all unrealized gains above a $1 million exemption before assets pass to beneficiaries. This exemption would stack with the existing home-sellers’ exemption of $250,000 of gain on a primary residence for single filers and $500,000 for couples. Like the other proposals in this article, there is no guarantee that the new approach to basis step-up will become law, in exactly this way or at all. But bear in mind when planning that death may no longer wipe out tax obligations for appreciated assets.
Timing of capital gains has always mattered, but a higher tax rate can make it even more important. If you expect your income to fluctuate from year to year, using capital losses to offset capital gains will be a valuable strategy. In the past, most taxpayers have focused on accelerating or deferring ordinary income. This strategy can reduce taxes by shifting income toward years where the taxpayer faces a lower marginal tax rate. In a world where high-income taxpayers face equally high taxes on capital gains, accelerating or deferring capital gains between years as income fluctuates may also become a routine part of tax planning. As has always been the case with ordinary income tax planning, capital gains tax planning should not become the tax tail wagging the investment dog. Your long-term investment plan can take taxes into account. Still, investment decisions should generally take precedence over tax concerns.
In a future where the president’s plan, or one like it, becomes law, investors will have a greater incentive to consider tax gain harvesting. Many investors are familiar with tax loss harvesting: selling investments that have lost value to lock in capital losses that can offset current or future capital gains. Tax gain harvesting involves timing sales of appreciated assets to take advantage of a year in which the gain would be taxed at a lower rate. Investors may also want to consider selling winners in advance of a new tax regime and repurchasing them. This will reset the investment’s basis, so previous appreciation would escape a higher future tax rate.
Finally, philanthropy is likely to become a more important part of certain investors’ gift or estate planning. Donating appreciated securities to a tax-exempt recipient means the charity can recognize the gains without tax. You can also claim a gift of appreciated shares as an income tax deduction, assuming you itemize your deductions. If you already have philanthropic aims, donating appreciated assets makes your gift more effective for both you and your intended recipient. However, bear in mind that there are threshold limits for deducting charitable gifts of appreciated stock, though unused deductions can carry forward up to five years. To the extent that charitable donations are a tax strategy for you, you should also stay alert for potential future limits to deductions, which are not out of the question in the current legislative atmosphere.
Investors with philanthropic goals may want to consider a charitable remainder trust. This trust will provide a steady stream of income back to the grantor, or another designated beneficiary, for some set amount of time. After that term, remaining assets pass to one or more selected charities. Funding a charitable remainder trust allows you to take an immediate tax deduction equal to the present value of the amount expected to pass to charity (called the “remainder interest”). Investors who do not have an immediate charitable recipient in mind may also want to consider a gift to a donor-advised fund. Gifts to donor-advised funds are irrevocable and allow donors to immediately take an income tax deduction, even if the funds are not distributed to a recipient right away. Recommendations to donor-advised funds are nonbinding, so donors do give up some control. But the administrative burden is lower than that of a trust, and donor-advised funds allow more flexibility than an outright gift.
For most investors, it is far too soon to rework their capital gains tax plan. But paying attention as the president’s plan progresses in Congress – or fails to – will give you the best chance to prepare yourself to face a new tax reality when it arrives.