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In Case of Capital Gains Tax Hike, Don't Panic

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What You Need to Know

  • A record $3.1T budget deficit makes tax increases likely, but containing the pandemic and boosting the economy are Biden's top priorities.
  • Biden's pre-election proposal of doubling the top rate is unlikely to become a reality.
  • Individuals may want to delay realizing capital gains to reduce their present tax burden.

With a new administration in place, many Americans are concerned about the prospect of higher taxes. Their anxiety is justified — with a record $3.1 trillion budget deficit and pandemic-related stimulus packages projected to lead to even higher federal debt, there is a strong probability of at least some tax increases ahead.

Plans to raise taxes are further fueled by the desire among some influential legislators to reduce income inequality through higher taxes for upper-income taxpayers.

In his election campaign, President Joe Biden put forth an extensive list of planned tax increases. It is unlikely, however, that all these measures will be enacted as proposed, especially in the first year of the new administration.

For one, the administration’s immediate focus is on containing the pandemic and bolstering the economy. Further, with a strongly divided country and slim majorities in Congress, dealing with major tax increases is likely to be a long-term project.

There has been considerable discussion, however, of ways to capture more tax revenue from capital gains.

Biden’s pre-election proposal advocated almost doubling the top tax rate on capital gains from the current 20% (or 23.8% including the Medicare surtax) to a rate equal to that for ordinary income (close to 40% for taxpayers in the top income tax bracket).

Such a large increase seems unlikely, particularly in light of historical evidence that an increase in the capital gains rate often triggers the “lock-in” effect, whereby investors forgo or postpone selling assets with significant embedded gains. Thus less tax is actually collected!

Notwithstanding, given the need for revenue and the focus on income inequality, bumping the rate up to the 25%-28% range would appear likely. Some proposals limit this to only those in top tax brackets or those earning more than $1 million annually.

Equally concerning to the more affluent taxpayers is the possibility that tax increases will be retroactive to the beginning of 2021.

This would mean actions taken now, which under the current tax regime would generate a certain level of tax or possibly no tax, may end up being taxed more heavily by the time 2021 tax returns are due. Retroactive increases are highly unpopular, though, and so quite rare. More often, tax increases become effective at a future date.

 Plan, but Don’t Panic

So, what are taxpayers to do? Now is the time for thoughtful planning. Remember the old but relevant advice not to let the proverbial “tax tail” wag the dog.

History is littered with examples of hastily crafted documents and asset transfers done in front of rumored tax changes, and later regretted.

To guard against the possibility of retroactive changes, it could be prudent to wait until later in the year to complete a transfer.

But those who have large taxable estates who intend to leave significant amounts to their heirs may want to consider planning now regarding how and when to take advantage of the current federal gift and estate exemptions.

According to the Penn Wharton Budget Model, the burden of increased taxes would be borne primarily by those with high incomes, with the top 1% shouldering 80% of the tax increase.

Despite this, taxpayers can mitigate the possible consequences of an increased capital gains tax. As already noted, individuals can delay realizing their capital gains, which reduces the present tax burden. This may be counter to the best investment decisions, however.

Additional strategies include:

1. Working with an investment advisor to regularly rebalance asset allocation by utilizing a tax-managed strategy that efficiently manages realized gains and losses.

2. Funding cash flow needs by borrowing against an investment portfolio in a low interest rate environment, thus avoiding having to realize capital gains when tax rates are high.

3. Utilizing gift and estate tax planning techniques that shift embedded capital gains to taxpayers in lower tax brackets, such as children, grandchildren or even parents.

4. Gifting or bequeathing appreciated assets to tax-exempt entities such as charities.

5. Accelerating capital gains before tax changes become law, particularly when concentrated positions in some assets support diversification.

The many studies of the far-reaching implications that capital gains rates have on capital formation, investor behavior and tax revenue indicate that changes in the capital gains rates have multiple consequences, some intended and some likely unintended. However, with active wealth management in conjunction with an experienced wealth advisor, taxpayers can plan accordingly to maximize returns in uncertain times.

Joan Crain is senior director, global wealth strategist of BNY Mellon Wealth Management.

(Photo: Shutterstock)