President Biden’s American Families Plan created buzz among investors due to the proposed tax hikes that accompany it. The White House proposed raising the capital gains tax rate for those earning more than $1 million from 20% to 39.6%.* President Biden also proposed increasing the top marginal tax rate from 37% to 39.6%.
Many are concerned about the downstream effects these changes would have on the stock market and broader economy. One of our governing principles at Archetype is “evidence not opinion”, and we summarized below data-driven responses to some of your key questions regarding the proposal.
If Congress approves the proposed tax hikes, we expect to see some volatility leading up to the date the proposed changes would go into effect (see chart below1). Historically, there has been a short-lived market decline as some investors chose to harvest capital gains prior to the raise in rates. However, these losses are typically offset by opportunistic buyers looking to enter the markets.
Additionally, only about 25% of the US stock market is owned by taxable domestic investors. The remaining 75% is owned by those not impacted by capital gains rates such as retirement accounts and foreign investors. Investors not impacted by the rate changes may view these tax hikes as an opportunity to invest at lower prices.2
Historically, there has been minimal correlation between changes in capital gains tax rates and US stock market returns. The chart below summarizes the impact of tax rate increases on annual returns of the S&P 500 since 19503. While past performance is not indicative of future results, increases in tax rates have not historically served as a reliable method for predicting the future performance of the stock market.
As of the time of this writing, President Biden’s proposal is still just that: a proposal. It must pass through the House and Senate before any changes go into effect, and there is likely to be some deliberation before a final bill is passed. We will continue to monitor the proposal and the impact of any changes in the bill as it progresses.
Donate appreciated securities and illiquid assets
Donating highly appreciated assets before you sell allows you to turn your tax dollars into giving dollars. When you sell an appreciated security, you generate taxable capital gains. For highly appreciated securities, the taxes owed can quickly become material. If you donate the appreciated asset prior to selling, you avoid paying any capital gains tax. The entire market value of the donated security is transferred into a giving vehicle, such as a donor advised fund. Money you would have sent to the IRS for capital gains taxes can instead be given away to the charities of your choice.
Invest in portfolios with low turnover
Actively traded funds generate capital gains as managers buy and sell positions in the fund. These frequent trades can generate more realized capital gains than desired. Incorporating low-cost index funds in your investment strategy lowers the overall cost of your portfolio by reducing trading costs and the amount of capital gains realized each year.
Employ tax-loss harvesting strategies
If your portfolio is in a net gain position towards the end of the year, tax-loss harvesting may help reduce your tax exposure. Identifying and selling investments in a loss position and replacing them with similar investments allows you to generate taxable losses. These realized losses can be used to offset your gains, which will reduce the tax burden of your portfolio.
When planning for the future of your business and personal finances, taxes are an important consideration. The impact of increases in the marginal tax brackets or capital gains tax rates may impact the timing of key financial decisions beyond your investment portfolio, such as the selling or purchasing of a home, real estate, or business. If you plan to sell or transition your business or a material asset in the near future, we would like to sit down with you to discuss your unique situation.
We will continue to closely monitor the proposed changes and any impact they may have on economic and market data as reported through our Three Dials. If you have questions on how changes in the tax rates might impact you or your family, you can schedule a time to speak with one of our advisors here. We look forward to the opportunity to speak with you.
*With the 3.8% net investment income tax, the capital gains rate for those earning more than $1 million would increase to 43.4%.
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Sources:
2 https://www.ubs.com/global/en/wealth-management/marketnews/home/article.1529753.html?caasID=RSS
3 https://www.fidelity.com/learning-center/trading-investing/tax-hikes-history