5/26/21: Federal deficits are brimming at levels not seen since World War II: the most recent $1.9 trillion stimulus package has been piled onto 2020’s $2 trillion CARES Act and $900 billion in stimulus tax relief bills. Now on the docket is a proposed infrastructure bill that could easily add another $1 trillion to our government’s tab. President Biden is calling for a higher capital gains tax rate, among other tax increases, to help pay for the gaping spending and revenue mismatch. While the President is proposing a 40 per cent capital gains tax rate, we suspect the number will coalesce around 28 per cent. Wherever the capital gains rate ultimate lands, the result will have a meaningful effect on taxable investors. Assuming that the capital gains rate will be raised to 28 per cent next year, we recommend four strategies to mitigate the impact on your portfolio.
1. Realize gains in 2021, particularly if you were planning to sell any time before 2031
A lot depends on what you expect your anticipated investment growth rate and capital gains tax to be, but assuming investments return about 5 per cent annually, it would make sense to maximize your after-tax value by realizing a capital gain in 2021. Higher return expectations would shorten the breakeven time for holding. For example, a 10 per cent annual return assumption at a 28 per cent tax rate shortens the breakeven time for holding to 6 years from 10. Raising the tax rate assumption, like adding the 3+ per cent Obamacare tax premium, would lengthen the breakeven timeframe. It’s safe to say if you’re planning on selling sometime over the next 10 years anyway, it probably makes more sense to pull the trigger this year.
2. Consider exchange-traded funds
Popularized in the 1980s, mutual funds were a great way to benefit from a diversified, actively managed portfolio with one simple investment vehicle. While mutual funds represented a democratization of investing to a broader audience, they aren’t tax efficient, particularly actively managed mutual funds with high portfolio turnover. That’s because mutual funds are forced to distribute their capital gains taxes annually, whether the tax-paying fundholder is a trader or a buy-and-hold investor. Exchange-traded funds (ETFs), introduced in that late 1990s, solved that problem. ETF holders are only required to pay capital gains taxes when they sell the fund. That could be in a year, five years or never. Mutual funds carry another, hidden, tax liability: unrealized capital gains liabilities. New fund purchasers, whether they realize it or not, may be buying into a sizable capital gains tax liability if the cost basis of the underlying holdings is substantially below the current market value, particularly if those positions are sold. It’s important to learn the unrealized gain liability for every mutual fund you hold in your taxable accounts to see if you’re sitting on a ticking tax timebomb. It’s possible that a new fund holder could be liable for sizable capital gains taxes even if the fund they bought declined in value during the period they held it. Exchange-traded funds don’t carry an unrealized tax liability. As a result, ETFs generally offer investors better after-tax returns than their mutual fund counterparts.
To illustrate, let’s compare two S&P 500 Index funds: a mutual fund and an exchange-traded fund. We estimate the 20 per cent tax rate costs shareholders of State Street’s S&P 500 Index Fund – one of the country’s largest mutual funds – about 1 per cent annually in taxes. Increasing the capital gains rate to 28 per cent would bump that liability to 1.4 per cent annually. Because the ETF counterpart pays out only dividends, not capital gains, its after-tax annualized cost is only about 0.4 per cent at today’s tax rates. A capital gains tax rate hike wouldn’t move the needle for those ETF shareholders planning to hold. Actively managed mutual fund still deserve a place in investor portfolios, particularly in retirement accounts that are tax exempt or where the incremental value added from smart managers overcomes any adverse tax impact.
3. Consider Separately Managed Accounts
Separately managed accounts of individual securities may offer investors the most flexibility of all. Individual securities aren’t subject to capital gains taxes unless they’re sold at a gain. Since a portfolio of individual stocks will likely contain both winners and losers, investors have the ability to go one step further and actively harvest capital losses to offset capital gains elsewhere in their portfolio. A strategy of active tax-loss harvesting is a fruitful way to add incremental after-tax return to a traditional public market equity portfolio. Even if you don’t anticipate any capital gains in a given year, tax-loss harvesting is still beneficial because capital losses can be used to offset ordinary income. In addition, losses can also be carried into the future and used to offset future gains.
Take, for example, $1 million invested in the Dow 30 over the last month. Overall, the Dow Industrial Average is up about 1 per cent since then, representing an unrealized gain of about $11,000. Yet 12 of the 30 Dow constituents have fallen in price over the last month, constituting about $10,000 of potential losses that could be “harvested” to offset future gains. While tax laws don’t allow “wash sales” – rebuying the same security sold at a loss within 30 days – harvesting strategies can rebuy similar, not identical, securities to keep the portfolio strategy intact. Eventually, rising markets limit the ability harvest tax losses, but holding individual securities, versus holding a Dow fund in this case, enables harvesting where the fund holding would not.
4. Shift your realized gains into a Qualified Opportunity Zone fund
The Tax Cuts and Jobs Act of 2017 created Qualified Opportunity Zones (QOZs) to provide potentially significant tax benefits to investors who re-invest capital gains into long-term investments in communities designated for economic development. This solution is useful for accredited investors who have substantial capital gains, a desire to realize them in a tax-efficient manner and a commitment to making investments with a social impact. Unlike traditional investments, a QOZ investment offers investors three primary tax advantages. First, it enables investors to defer paying taxes on their realized capital gains. Second, it reduces deferred taxes owed by 10 per cent if the opportunity zone investment is held for seven years or more. Lastly, it eliminates taxes on opportunity funds held 10 years or more. These benefits accrue to investors regardless of the prevailing capital gains tax rate.
Whether you’re holding appreciated investments or contemplating selling your business, your Cresset team is equipped to address your personal situation. Talk to us so we can help you make an informed decision.