Future Returns: Planning for Proposed Tax Adjustments

Changes in tax law under consideration by President Joe Biden’s administration could have a huge impact on wealthy individuals and families in the United States

While the suggestions at this point are just that – suggestions – private asset managers are talking to their clients about possible changes and strategic changes that they may want to incorporate into their investment portfolios.

At Northern Trust Wealth Management, clients are guided to align their goals with investment strategies that are funded with after-tax, after-fee and post-inflation returns, said Katie Nixon, chief investment officer.

“When taxes go up, returns go down,” says Nixon. “So you have to be very, very careful and deliberate about the types of strategies you use in your company [investment] Portfolio. ”

But it’s also important to remember that tax laws can change every time a new US president takes office. For example, the 2017 tax reform law advocated by former President Donald Trump lowered the highest income tax rate from 39.6% to 37%. Biden’s plan would bring it up again in a moment.

Because of this, Nixon advises clients not to make portfolio changes just because taxes may or may not go up. Still, it’s a good time for high net worth individuals to review their investment portfolios for possible tax changes – especially after a decade of record-breaking stock market returns in the US, Nixon recently spoke to Penta about how investors should approach this discussion.

What could change?

First of all, it is important to know what potential changes are on the table. One possibility raised by Treasury Secretary Janet Yellen is that taxes could be levied on the rich and corporations to finance spending on infrastructure, renewable energy and vocational training, among other things.

In addition to increasing the highest individual income tax rate for those earning $ 400,000 or more from 37% to 39.6%, Biden has proposed removing long-term capital gains tax and dividend tax rate tax for high net worth taxpayers (those with incomes of $ 1 million or more ) from 20% to 39.6% – almost twice as high.

Wealthy taxpayers would each have to pay an additional 3.8% net investment tax (which they also currently pay), effectively raising taxes on long-term capital gains and dividends to 43.4%.

Among other proposed changes would be a decrease in inheritance tax exemption from $ 11.7 million to $ 3.5 million. The 2017 Tax Reform Act had doubled that exemption – or the amount of a non-taxable estate – from $ 5.4 million at that time to $ 11.2 million.

And under the Biden Plan, after a person dies, assets in their estate would be transferred to heirs on their original basis or cost and would be subject to long-term capital gains taxes at 39.6%. Currently, if a person dies, the value of a property passed on to their heirs is equal to its fair value at the time of their death and is therefore not taxable.

In other words, a taxpayer who bought a share at $ 10 per share and was worth $ 50 per share when he died would give that stock to heirs worth $ 50 today. Under the proposed change, that taxpayer’s heirs would owe $ 40 in capital gains taxes if they sold the stake, Nixon says.

Prepare not predict

While tax rates may not increase historically this year or next, they are currently very low, especially when it comes to long-term capital gains, dividends and estate taxes. That means, no matter what, “It’s a good opportunity to see where in your portfolio you moved changes because you didn’t want to pay taxes,” says Nixon. It’s a strategy known as “wagging the tax tail” and is not ideal.

One option for wealthy families is to hold concentrated positions, often in stocks that were bought long ago at low prices. These clients do not want to sell positions that lead to large capital gains.

However, it is possible that these concentrated positions could jeopardize an overall portfolio as individual stocks are riskier than the overall market. “Are you being compensated for this risk? Investigations would suggest no, ”says Nixon.

In that case, it would be better to sell these positions when tax rates are low. “Now is the time to bring this up,” she says.

Many investors also hesitate to diversify their holdings into international stocks because they don’t want to sell highly valued US stocks. Because of the staggering surge in stocks over the past decade, many portfolios are out of balance between the ideal ratio of stocks, bonds, and cash to meet their needs.

“We say now is the time to possibly address this issue of equalization,” says Nixon. “It is almost always worth paying taxes for the most optimal portfolio.”

Focus on flexibility and diversification of the asset location

Customers who are flexible in the way they generate income should consider planning their income stream so that the grand total stays below $ 1 million and does not trigger some of the proposed tax increases.

“If you have the flexibility or a volatile source of income, you can use this to your advantage,” says Nixon.

Another strategy to consider is shifting high dividend, high yield, high activity strategies from taxable accounts to deferred tax accounts.

“Active high-volume and high-volume strategies will generate large taxable profits,” she says. “The ability to defer paying those profits by investing through individual retirement accounts (IRAs) is really significant.”

Again, investors may not think about those potential gains as taxes on long-term capital gains and dividends have long been relatively low.

But now that taxes may rise, it might even be worth selling investments in a taxable account and buying the same investments in a deferred tax account, “depending on your timeframe,” says Nixon. “It just really focuses on the types of assets you own and where best to own them.”