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Recently, financial advisors have been fielding calls and emails from clients concerned about President Joe Biden's proposal to raise the capital gains tax. The measure would double the tax on investments held for more than one year and apply to investors with annual income over $1 million.
Biden is proposing that Congress raise the top tax rate on capital gains from 20% to 39.6%. The new top rate, combined with an existing 3.8% surtax on investment income over certain thresholds, would result in a federal tax rate as high as 43.4% in some cases. The plan would impact about 0.3% of U.S. households, according to National Economic Council Director Brian Deese.
The proposal is designed to raise investment taxes to similar levels as those on wages and salaries. Proceeds of the tax increase would go toward the president's $1.8 trillion American Families Plan. This proposal includes free community college, help with child care expenses, paid family and medical leave and other programs.
How Advisors Are Counseling Clients
Although the plan still has to get through Congress, and provisions will likely be changed through negotiations, investors are concerned.
"Our advice to clients is to wait until there are more details," says Tim Bain, president of Spark Asset Management Group in Statesville, North Carolina.
"I learned a long time ago that you shouldn't let the tax tail wag the investing dog," says Bain, who points out that the Federal Reserve's dovish policies, coupled with a potential infrastructure bill before Congress, may offset any temporary negative shock of a higher capital gains tax.
However, many analysts are predicting that investors in higher tax brackets may sell stocks ahead of the bill's passage or its effective date. That would allow them to lock in gains under the current capital gains rates.
Bain says there is a workaround for those who want exposure to the same assets, by holding them in qualified rather than taxable accounts.
"But they may turn around and buy back the same stock to establish a new basis, or they may buy the stock back in a tax-deferred (individual retirement account) or tax-free Roth," he says.
Potential Changes to Cost Basis
When Biden floated the plan in his address to Congress on April 28, he didn't mention a step-up in cost basis for inherited assets. When an account owner dies, inherited securities are valued at the date of death.
For example, say an investor who passed away in 2021 bought shares of Apple (ticker: AAPL) in 2000 and held them for 21 years. Upon her death, her daughter inherits the Apple shares, but rather than being valued at the price in 2000, the inherited shares are valued at today's price, using what's called the "stepped-up basis."
Currently, that aspect of the tax code benefits many middle-class investors who inherit even a small portfolio from a deceased individual. When the beneficiary sells the shares, he or she pays a lower capital gains tax, as previous appreciation is no longer counted.
Alvina Lo, chief wealth strategist at Wilmington Trust in New York, says eliminating the step-up in basis is probably not off the table. Nor is a decrease in the estate tax or gift tax exemption.
"Couple this with the states increasing their taxes on the wealthy -- New York being an example just last week -- and planning is ever more important," she says.
Lo says some actions must be taken immediately. For example, with the tax filing deadline on May 17, investors with earned income should consider contributing to an individual retirement account to reduce their tax burden. Other tax strategies may involve harvesting investment gains and losses or converting a traditional IRA to a Roth IRA.
"For those charitably inclined, donations to charities will become more attractive as the charitable deduction becomes more valuable when income tax rates are high," Lo adds.
New Rules May Affect Business Owners
For advisors serving mostly a middle-class clientele, there are usually very few, if any, clients with income over $1 million per year.
Howard Essner, a family wealth advisor at Ancora Advisors in Cleveland, says an increase in the capital gains rate would affect only that group of clients.
"We think that potentially one of the largest impacts on clients who fit that profile will be on those who own businesses, concentrated low-basis equity positions or investment real estate that they were considering selling or diversifying away from anyway," he says.
He adds that a meaningful increase in the capital gains rate may accelerate planning decisions about liquidity, or selling assets, and business succession.
"We have been talking to clients about potential tax changes since before the election," Essner says.
He advises caution when making decisions ahead of any tax changes that Congress may, or may not, pass.
"Too many times in the past, we have seen people make quick decisions in the face of potential tax changes, only to regret those actions when the feared tax changes did not become law or became more watered down through the political process," Essner says. "We also encourage clients to speak with their tax professional for a holistic view."