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.