The SEIA Report Q1

Are Tax Changes on the Horizon?

By Sam Miller, CFA®, CFP®, CAIA®
Senior Investment Strategist

With President Biden now in office and a Democratic majority in Congress, we believe changes to tax policy are on the horizon. But questions remain as to the specifics and the timing. What might we expect based on what was communicated on the campaign trail and what’s transpired since? And are there steps investors should be taking now, to help soften the impact of potentially higher taxes?

Possible changes

While there were many proposals mentioned on the campaign trail, the overarching theme of the Biden tax plan appears to focus on raising taxes on the very highest of earners. The most popular of those proposals include[1]:

• Increasing the top federal income tax rate from 37% to 39.6% for those earning over $400,000

• Increasing the capital gains tax rate to 39.6% for individuals earning over $1,000,000

• Eliminating the step-up in cost basis at death for the assessment of capital gains

• Implementing a 28% cap on itemized deductions

• Applying a 12.4% social security payroll tax on earners making more than $400,000

• Reducing the estate tax exemption

We expect the specifics will almost certainly change between now and implementation, but our general consensus is that the highest earners should expect some sort of tax increase.

Timing

In terms of timing, once a Covid relief package (the administration’s first priority) is in place, the focus may then shift to a larger infrastructure and climate change package. This could require some sort of tax legislation to fund the initiatives.

With the narrowest majority in the House in 20 years, and a 50/50 split in the Senate, there may be challenges to passing any legislation. But we expect to see a healthy tax debate at some point during the summer months. If tax legislation is eventually passed, changes may be immediate or retroactive. While rare, there have been instances in the past where tax increases were retroactive to the beginning of the year. It’s possible any changes could take effect at the time the legislation is signed into law.

Strategies to consider

• Tax/estate planning—There are several strategies you may want to consider depending on your particular financial situation. If you have annual income in excess of $1,000,000, you might explore harvesting some capital gains now; before those rates potentially double. Additionally, if you have a large estate, think about using some or all of your lifetime estate tax exemption before it’s potentially lost.

• Asset location—As investment advisors, much of our time is spent on asset allocation (the mix of stocks, bonds, and alternative assets in your portfolio), but tax efficiency can be improved by focusing on asset location as well. This refers to ‘where’ you place the assets you own (tax-free vs tax-deferred vs taxable accounts). Conventional wisdom[2]suggests you should own income-producing investments like bonds inside of non-taxable accounts (to shield that income from taxes). But with low interest rates and low growth expectations, this strategy may no longer prove beneficial. Ultimately, you should strive to hold tax-efficient assets with higher expected returns inside of taxable accounts, and tax-inefficient assets with higher expected returns inside of tax-favored accounts like IRAs.

• Tax loss harvesting—While some individuals with higher incomes might consider harvesting gains before their rates potentially increase, for others tax loss harvesting may play a more important role in portfolio management to mitigate the impact of higher taxes. Tax loss harvesting refers to the process of realizing a loss on an asset for tax purposes. In any given year, the market and its component parts (individual stocks) go up and down—sometimes wildly. Even a year like 2020, where market returns were strong by year-end, more than 400 stocks in the S&P 500^® experienced a drawdown of 25% or more[3].

• Municipal bonds—Higher tax rates may mean that municipal bonds (bonds that are exempt from federal and most state taxes) become relatively more important within a portfolio. When selecting a municipal bond strategy, we believe that strong active management is important to capture opportunities that exist in a complex and sometimes opaque asset class.

In the coming months, we will likely have greater clarity around Biden’s tax plan and the specific items that will be part of that package. As these details start coming into focus, make sure to consult with your SEIA advisor to develop a mitigation strategy as part of your overall financial and investment plan.

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[1] The Tax Foundation, as of October 22, 2020
[2] Financial Analysts Journal: Integrating Investments and the Tax Code
[3] Bloomberg

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc., nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.

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