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If Tax Rates Rise Under Biden, Should Investors Realize Gains Now?

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Andrew Subkoviak, CFA

Senior Investment Strategist

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A change may be coming to the White House—and that may require a change of plans when it comes to tax management.

As the clock winds down to November 3, the news cycle continues to be dominated by the events that have made 2020 exceptional: COVID-19, social inequality and policing, the Supreme Court, and questions of outside interference in the presidential election. Between a contentious presidential debate, an unremarkable vice presidential debate, and President Donald Trump’s diagnosis, the election is unfolding in a manner consistent with Mark Twain’s adage that the truth is stranger than fiction.  

With much of the conversation focusing not on ideas and ideologies but instead on the very structure of American democracy, we return to the practical details of tax policy. As we described in a recent blog post, it’s difficult to glean concrete predictions about future tax rates and policy when the two major parties’ views are increasingly disparate and so much uncertainty surrounds who will occupy the White House and control Congress. Despite the wide range of possible outcomes, many investors are interested in how a Biden administration would impact their taxes—particularly whether it’s more beneficial to realize gains today (pay now) or continue to defer gains into the future (pay later). Let’s take a look at the implications of each choice.

When is the best time to realize gains?

Our previous blog post indicated that the Biden tax plan includes four components pertinent to investors, and that the impact of those changes would generally increase the value of tax management. We also described how it might alter the behavior of the tax-sensitive investor through more aggressive mandates for deferring gains, the increased importance of charitable gifting, and the concept of strategic gains realization. Related to the last component, investors might ask if they should accelerate the timing of gains realization with higher tax rates expected in the future. The answer to that question depends on the investor’s assumptions about the future.

We examined two portfolios to determine whether the investor should take advantage of lower capital gains rates in the current environment or continue to defer gains until the end of their time horizon, at which point we assume they pay all taxes. The first portfolio realizes gains today and reinvests proceeds, and the portfolio consistently generates the expected return. The second portfolio defers all gains and also consistently generates the same expected return. Both portfolios realize all gains at a new, higher tax rate at the end of the investor’s time horizon, at which point we compare the relative after-tax performance of each portfolio.

How time horizon and expected return affect the benefits of paying now

Source: Parametric, 10/1/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.

The Biden tax plan proposes the elimination of advantageous capital gains rates for investors with income over $1 million, implying a tax increase of 19.6 percentage points from 23.8% to 43.4%. Given this change, we can solve for the breakeven investment horizon for varying expected return environments. An investment horizon lower than the breakeven implies that it may be advantageous for the investor to pay now, while an investment horizon greater than the breakeven implies it may be advantageous to continue deferring gains. An investor with a 10% equity return expectation and an eight-year horizon should consider paying now. The same investor with a 12-year time horizon may benefit from deferring until the end of the 12 years.

The benefits of systematic tax-loss harvesting

How does this decision affect taxes saved?

The decision of whether to pay now or later doesn’t depend on portfolio size or appreciation. Although each investor has different sensitivities to how investments are taxed, our analysis provides some guidance that depends on only a handful of parameters: the tax rate in the current regime, the tax rate in the future regime, the expected return on equities, and the investor’s time horizon. As long the investor defers gains, we can analyze the problem solely on the basis of the variables at hand.

However, the size of the embedded gain changes the amount by which a portfolio can benefit by paying now compared with paying later. Consider two different $1 million portfolios in a prospective Biden tax regime, one with a cost basis of zero and one with a cost basis of $500,000, assuming an 8% expected return over a 15-year period. Based on the above chart, both investors may find it advantageous to pay now if the time horizon is less than 12 years—but the total tax savings from each portfolio may differ considerably.

Benefits of realizing gains for two appreciated portfolios assuming 8% expected return

Source: Parametric, 10/1/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.

The above depictions make it clear that a large change in the tax rate makes paying now look particularly attractive, especially assuming low future expected returns.  When future return assumptions are more aggressive, it might make sense to pay later, except in the case of short time horizons. For return expectations in the 6% to 10% range, which is consistent with conventional wisdom, the time horizon required to justify paying now decreases by one to two years for each 1% increase in expected return.

The bottom line

While specific tax policy changes are far from certain, history shows that capital gains and income tax rates have changed often and will change again in the future. Despite the uncertainty, investors can use our analysis as a guide for how to think about their investments and after-tax equity expectations for the future. Depending on the investor’s situation, it may be desirable to realize gains in the near term at lower tax rates rather than waiting until the end of the investor’s time horizon.

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.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.