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Financial Planning > Tax Planning

Mallouk: Capital Gains Tax Hike Could 'Devastate' Hedge Funds, Boost DAFs

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What You Need to Know

  • President Biden is expected to propose a 43.4% capital gains tax rate for investors earnings more than $1 million.
  • Such a tax hike — more than double the current rate — could affect portfolios, charitable giving, tax planning and more.
  • It could inspire more wealthy investors in high-tax states to relocate.

On Wednesday, President Joe Biden announced his American Families Plan, which includes not only a proposed increase in the top marginal tax rate for those earning more than $400,000 but also a capital gains tax increase for investors earning more than $1 million a year.

If the plan is enacted, the top marginal tax rate would increase from 37% to 39.6% and the top capital gains rate would be even higher, 43.4%, up from 23.8%. That top capital gains tax rate, comprising a 39.6% capital gains rate and the 3.8% Medicare surtax, would affect many ultra-high net worth clients of financial advisors.

The White House has said the increase would affect only about 0.3%-0.5% of all U.S. taxpayers.

ThinkAdvisor spoke with several experts on the potential fallout of a capital gains tax increase for wealthy clients of financial advisors, including Peter Mallouk, president of Creative Planning, which has $76 billion in assets under management; Megan Gorman, founder and managing partner at Chequers Financial Management, a boutique financial advisory firm with nearly $500 million in AUM; and John Mousseau, president, CEO and director of fixed income at Cumberland Advisors, which designs customized investment portfolios for individuals and institutions.

They discussed the impact on portfolios, tax planning, charitable giving, business planning and relocations.

Portfolio Impact

Mallouk said the capital gains tax increase for wealthy investors could “devastate” investments with high turnover such as hedge funds while simultaneously spurring more direct gifts to donor-advised funds, which could be “off the charts.”

DAFs are already popular among wealthy taxpayers in part because they accept appreciated assets as donations, which helps taxpayers avoid capital gains on those contributions and therefore allows them to contribute even more money.

The Biden administration, however, could propose changes in how quickly DAFs distribute their contributions to charities, which a broad coalition of philanthropists, leaders of major foundations, nonprofits and others is pushing for.

Gorman said the capital gains increase for wealthy investors could spur more investments into opportunity zone funds, which allow investors to defer capital gains if invested within 180 days and eliminate them as well as any new gains from the opportunity zone investment if the investment is held for 10 years.

Rules for opportunity zone investments, which have failed to live up to their promise of reviving low-income neighborhoods and creating jobs, may also change under the Biden administration.

Demand for municipal bonds could also rise if the capital gains tax hike for wealthy investors is implemented, even though the primary tax advantage of munis is the exemption of their interest payments from income taxes.

“Wealthy investors are voting with their pocketbook,” Mousseau said. “They smell higher income taxes and a higher overall rate when you add an increase in capital gains taxes.”

But favoring one asset class over another is not the only portfolio impact of higher capital gains taxes. “Asset location would also be affected,” Gorman said.

She expects a capital gains increase will move high-dividend investments into tax-advantaged accounts like traditional IRAs, Roth IRAs and 401(k) plans as wealthy investors continue to convert traditional IRAs to Roth IRAs. Gorman also counsels her wealthy clients to fund Roth 401(k) plans outright and to use backdoor Roths, converting a traditional IRA to a Roth because their incomes exceed the threshold for opening a Roth IRA directly.

A capital gains tax increase could also increase demand for direct indexing among wealthy investors as the strategy allows for more customized tax loss harvesting, Gorman said.

Estate Planning

A higher capital gains rate for wealthy investors becomes another factor for advisors to consider in estate planning. Should a wealthy client, for example, keep assets in their estate, which would receive a stepped-up basis when the client dies, which helps minimize capital gains taxes for their heirs?

“A lot will depend on the amount of the unified credit, which is also in flux because even if the Democrats do not lower the estate tax exemption, the Trump-era exemption is scheduled to revert back on Dec. 31, 2025,“ said Gorman.

She noted “the number of moving parts” that wealthy individuals and their families need to consider about income and estate tax consequences in their planning. “It is not uncommon that they will have to prioritize one over the other,” said Gorman.

Biden is expected to propose changes in the estate tax, which could include a sharp reduction from the current exemption of $11.5 million per person ($23 million per couple).

What Will Happen?

Even if the Biden administration chooses to go the reconciliation route to pass proposed tax increases, which a recent ruling from the Senate parliamentarian allows, nothing is certain yet. Some Democrats in the House of Representatives from high-tax states like New York, New Jersey, Connecticut and California have shown reluctance to back a bill that doesn’t include elimination of the $10,000 state and local tax (SALT) deduction limit of $10,000, which was enacted as part of the 2017 tax overhaul.

Support from moderate Democrats in the Senate such as Joe Manchin of West Virginia and Kyrsten Sinema of Arizona is also uncertain.

A compromise could be reached on all or some of these tax proposals in order to assure passage, but that would change their impact. If the capital gains tax hike for wealthy investors  was lowered to around 28%, for example, there “won’t be much change for portfolios,” said Mallouk. “That won’t change behavior.”

If, however, the proposed capital gains increase for those taxpayers remains at 43.4%, they  could accelerate business sales and choose real estate exchanges over sales to avoid the higher tax later on, he said.

And if they live in a high-tax state that has increased income taxes on millionaire residents like New York or New Jersey — California is considering a similar tax hike — that could “drive more people from those states to move” to lower tax states, he said.

In the meantime, Mallouk is advising clients to do nothing about potentially higher taxes until more is known. “There will be plenty of time to make adjustments,” he said.

(Pictured: Creative Planning CEO Peter Mallouk)

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