Simulated tax alpha interquartile range for three tax regimes in varying volatility and market-return scenarios
Source: Parametric. This Monte Carlo simulation uses the following assumptions: a dividend return of 2%, index turnover of 5%, and a 10-year time horizon. The simulation is run 10,000 times, and the results shown reflect the interquartile range (25%–75%). Tax alpha is shown net of 35 bps in fees and 10 bps in two-way turnover (10 bps total cost/100% portfolio turnover) transaction costs. After-tax returns reflect all realized taxes in the period and are presented based on the highest marginal federal tax rates and include the 3.8% NIIT. This results in tax rates that vary by tax regime as indicated. We assume that all dividends are qualified and realized gains are taxed as either long term or short term, depending on the holding period, except for the Biden regime, which taxes all dividends at regular income rates. Security volatility varies as indicated, ranging from 25% to 45%. Simulated performance is provided for illustrative purposes. It does not reflect the actual experience of any investors and does not project or estimate the performance of any investment strategy offered by Parametric.
How would Biden’s proposed tax policy changes alter investors’ decisions?
Many investors in benchmark-tracking SMAs may find that standard approaches to tax-loss harvesting continue to provide an effective balance between tracking error and tax benefit. As a result, most are unlikely to feel a need to alter this approach under a prospective Biden tax regime.
However, others will want to take a more nuanced approach to tax management and slightly alter their strategy. For example, the combination of the higher rates and the loss of preferential treatment for long-term holdings may encourage some to shift to a more aggressive approach to tax-loss harvesting, with a preference for tax management over benchmark tracking as gain deferral becomes increasingly important and the ability to trim overweight positions becomes more costly. An aggressive approach to tax management allows for larger security bounds and ultimately higher predicted tracking error, so investors taking this approach should expect larger pretax benchmark deviations from month to month.
Furthermore, investors may opt to intentionally take gains as a onetime or ongoing strategy. Those at or near the $1 million AGI hurdle, where the loss of preferential treatment kicks in, may opt to opportunistically realize long-term gains in years when they’re below the threshold and take a more aggressive tax-management posture when they’re over the threshold, constantly monitoring income and revising the approach depending on their income for the year.
Still other investors will be watching the election outcome closely to consider a strategic gain realization in the event of a forthcoming change in administration and subsequent change in tax regime. Since the tax changes won’t be implemented overnight, investors can take advantage of the current lower long-term capital gains rates by realizing long-term gains now and reinvesting the proceeds. The refreshing of basis provides more opportunities for losses in the future, which will be more valuable with higher rates and increase the basis of the account. Refreshing basis has the added benefit of lowering the gains and taxes due at death if the step-up is eliminated.
Similarly, we expect this change to increase the amount of charitable gifting for the tax-aware investor. The donation of appreciated assets and the replenishment of the portfolio with cash refreshes cost basis, which both increases future tax alpha expectations and lowers the tax burden at the time of death if step-up is eliminated. The benefits of gifting with cash replenishment are amplified when done in a systematic fashion to regularly remove tax lots at the largest gains and replace with cash.
What about bonds?
Investors in fixed income SMAs should also pay attention to a change of residents in the White House. The municipal market is particularly sensitive to tax rate changes, especially tax increases. For example, starting in 2017, as a result of the TCJA, despite the top bracket being reduced to 37%, high-net-worth investors sought muni bond exposure as a result of the state and local tax (SALT) cap.
Under a Biden presidency, and particularly under Democratic control of Congress, a proposed reversion to the 39.6% income tax bracket for the highest earners could increase demand for municipal bonds, resulting in lower yields and higher prices—thus increasing their value for existing investors. The SALT cap could also be repealed, and this could be a negative for muni investors. However, with the individual tax rate returning to its pre-Trump level, the actual effect on bond prices or yields would likely be negligible.
Another significant change involves Biden’s proposal for the corporate tax rate to increase to 28%. This may lead corporations to add some muni exposure. Although the corporate rate isn’t as high as it was in the pre-TCJA era, we believe the increase in demand from corporations may result in price appreciation of existing bonds.
Lastly, similar to equity SMAs, fixed income SMAs’ ability to tax-loss harvest on a year-round basis will prove to be beneficial for high-tax-bracket investors seeking to offset gains. Biden’s proposal for all capital gains to be taxed as ordinary income for those earning more than $1 million may lead these investors to further seek out tax-loss harvesting options.
Under a second Trump term, muni demand will remain high due to the current SALT cap and the low chances of further tax reductions for individuals. However, tax-exempt investors have more to gain under a Biden presidency, since the high likelihood of either an individual or corporate tax rate increase could improve the relative value of their fixed income holdings and increase the demand for tax-exempt investments.
The bottom line
It’s important to reiterate that none of what we’ve discussed above has been enacted into law and that these potential changes are conditional on the election outcome and are subject to the legislative process. Regarding the legislative process, the question arises as to how soon a tax law would be enacted and whether that law would be applied retroactively, as some have in the past. If Democrats end up controlling both houses of Congress, we could see an effective tax regime change in 2021. However, the consensus is that in light of the economic impact of the 2020 health crisis, a significant tax bill would likely take a backseat to COVID-19 recovery and other stimulus. Tax policy changes would take most of next year to complete and would likely have an effective date at the beginning of 2022.
Still, higher overall tax rates and the loss of preferential long-term treatment of capital gains for top earners under a prospective Biden administration would increase the value of tax management for investors in passive SMAs of both the equity and fixed income varieties. Many investors may not need to pivot their approach to tax-managed investing, but, with a near doubling of the long-term capital gains rate, others will be much less willing to realize long-term gains than in previous tax regimes. For these investors, aggressive loss-harvesting mandates, strategic gain realizations, and a regular program of systematic gifting with cash replenishment may be effective ways to manage higher overall tax rates.
With additional contributions from Jeremy Milleson, senior investment strategist.
This material contains simulated performance data, which is hypothetical and should not be relied on for investment decisions. Hypothetical, backtested, or simulated performance results have many inherent limitations. No representation is being made that an investor will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular investment strategy or trading program.