Investors Should Consider These Changes Before Capital Gains Change

Many investors fear that a controversial choice or a change in tax policy will have a negative impact on the return on their assets. Historical results and early market reactions indicate there is no reason to panic, so more politically biased people should be careful to remove emotion from investment decision making.

However, some people may experience significant changes in their taxes. The results of the presidential elections are not expected to result in a drastic reallocation, but investors may find it useful to investigate effective investment vehicles or to think about the timing of future transactions to avoid proposed increases in overhead tax. values.

Joe Biden has proposed raising capital gains rates, but not for everyone

President-elect Joe Biden’s official tax plan calls for higher rates of long-term capital gains, which would rise to ordinary income levels for employees over $ 1 million. A Republican-controlled Senate could prevent the passage of this legislation, but the outcome of the final seats remains unknown, leaving investors with some uncertainty.

Long-term capital gains tax rates are currently 15% for individuals who earn more than $ 78,750 but less than $ 434,550 per year. Above this threshold, it drops to 20% for individuals. Joint filers have a higher threshold, at $ 488,850. Biden’s proposal only changes rates for employees above $ 1 million, but the tax rate on those earnings could nearly double for that group, to 37% under current law. About 99% of Americans have incomes below $ 300,000, so there are very few people to whom the $ 1 million threshold will apply.

In addition, these changes would not affect liabilities related to assets in IRS-recognized retirement plans such as 401 (k) s, 403 (b) s, traditional IRAs or Roth IRAs. . All of these accounts benefit from specialized tax treatment that has not been addressed in current policy proposals. Even if this were at stake, distributions from tax-deferred accounts are taxed as ordinary income, and it is not proposed that the increase in capital gains rates exceed ordinary income.

It should always be on some people’s radar

Even though many people will not be affected, there are still investors who would feel the negative effects of this policy. The sale of private businesses or real estate could easily exceed the $ 1 million threshold once for people who may not have high earned income. High net worth investors who liquidate or turn a portfolio are also potentially at risk.

Mutual funds are subject to capital gains taxation at the fund level when holdings are liquidated, which could contribute significantly to the yield erosion experienced by mutual fund shareholders. This would be especially true for funds with heavy buyout activity, which requires them to sell assets before paying exiting shareholders. Over 45% of U.S. households own mutual funds, so that’s relevant to many investors, albeit on a smaller scale than large realized gains.

Again, it would not be prudent to make drastic changes to the allocation in this situation, but investors would be advised to consider some options that would reduce outflows to the government. The tax efficiency gap between ETFs and mutual funds would widen under the proposal, so investors should consider replacing holdings of mutual funds with ETFs when suitable substitutes with a similar methodology are available. This is a simple strategy that could improve net returns without changing the allocation of the portfolio.

It can also be a critical time for investors who are approaching planned asset rotations due to aging, retirement, or other circumstances, such as the sale of a business or private property. Pre-retirees often reduce their exposure to equities and switch to bonds as they approach the expected stop in earned income. It might make sense to speed up such a rotation by several months for investors who hold assets with significant embedded capital gains liabilities. End-of-career employees could reduce potential capital gains tax outflows by 50% while taking less volatile assets that pay dividends and interest.

Investors considering this tactic should note that dividends and interest are treated as ordinary income, which would potentially be taxed at the rate they were trying to avoid in the first place. That said, the appreciated capital of a portfolio is almost certainly a much higher number than the passive interest produced. Rotation increases the cost base and allows investors to bypass higher taxes while moving into lower risk positions.

Ultimately, Biden’s capital gains tax rate proposal shouldn’t elicit drastic backlash from investors and shouldn’t lead to fundamental changes in your asset allocation. However, there are smart decisions about timing and investment vehicles that can optimize net returns.