Here Comes the Pain! – A Look at the Potential Increase to the Long-term Capital Gains Tax

It has been said that the only things that are certain in this life are death and taxes. While taxes can be viewed as a symbol of an achievement such as earned income or a capital gain, paying taxes can often bring pain. To combat the devastating economic impact of the COVID-19 pandemic, in March 2020, the $2.2 trillion Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was signed into law. In 2021, large feats of fiscal spending to aid in the COVID-19 recovery efforts continued. Those efforts include the $1.9 trillion American Rescue Plan Act (ARP Act) and the proposed $2.25 trillion infrastructure agenda, known as the American Jobs Plan (AJP). These enormous fiscal policies have prompted many investors to ponder how the government is planning to pay for this extraordinary spending.

Here comes the pain!

To help pay for the recent and proposed fiscal spending, President Joe Biden unveiled his tax reform agenda. The proposed agenda included several changes including changes to corporate tax, personal income tax, and changes to the long-term capital gains (LTCG) tax. However, this piece will focus on the latter and how the proposed changes could impact investors and what investors should consider in 2021 and beyond.

The agenda proposes taxing LTCG as ordinary income for taxpayers that have income over $1 million, increasing the ordinary income top tax rate from 37% to 39.6%, and keeping the 3.8% tax on net investment income (NIIT) in place. Therefore, under the proposed tax changes, the LTCG tax rate for taxpayers earning over $1 million is 43.4% (39.6% + 3.8%)! Compared to the current effective LTCG rate for $1 million-plus earners of 23.8% (20% + 3.8%) that is about an 82% increase ({43.4% – 23.8%}/23.8%). This increase may not only apply to financial assets but could possibly be applicable to other capital assets like a personal residence, investment property, or even a family business. This is imperative because even if an individual does not typically have taxable income of $1 million or more, selling one or a combination of these capital assets in a single tax-year can undoubtedly push that individual into the higher tax bracket. 

For investors that are facing the likely increase to the LTCG rate, there are a few things to consider in 2021 and beyond:

• Should an investor have significant unrealized long-term capital gains or a heavily concentrated position with low cost-basis, consider realizing some of those embedded gains or reducing the concentrated position in 2021, under the current LTCG tax rate, rather than later when the rate will likely be higher.
  
• Where possible explore the benefits of moving capital from mutual funds to ETFs. A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, while ETFs have more flexibility to manage secondary market transactions without incurring additional capital gains.
  
• Find out if a Roth IRA conversion is appropriate. Investors that think income-tax rates will be higher in retirement will generally utilize a Roth IRA for a retirement savings. Taxes must be paid upfront but withdrawals are tax-free once over 59.5 years old and have held the account for 5 years or more. High income earners that do not qualify to contribute to a Roth IRA can convert a traditional IRA or 401(K) to a Roth IRA. In this case, the taxes on the converted amount and the earnings must be paid upfront. This can be beneficial when the tax rate upfront is significantly lower than the future tax rate at the time of withdrawal.
  
• For clients that may be charitably inclined, consider funding a charitable remainder trust (CRT) with their highly appreciated assets in 2021. A CRT is a tax-exempt irrevocable trust designed to reduce the taxable income of individuals by first distributing income to the beneficiaries of the trust for a stated period of time and then bequeathing the remainder of the trust assets to the designated charity. This is a shared-interest giving method that allows a trustor to make contributions, become qualified for a partial tax deduction, and bequeath remaining assets.
• A tax plan should be integrated into the investment strategy. The tax plan should be discussed with a financial advisor and tax professional and infused into the investment strategy, not just in December, but all year long. The tax plan should include but not be limited to a targeted annual realized capital gains budget, tax loss harvesting, and consideration of assets that are sold outside of marketable securities e.g., a property or a business. 

As previously mentioned, the proposed tax reform for 2022 covers many areas and all the intricate details could not be explored in this short piece. However, it may be worth mentioning one other detail of the proposal. That is, gifts of appreciated property would initiate an instant recognition of taxable gain. Essentially, the unrealized appreciation in assets passed at death or gifted during lifetime, would be taxed as a realized capital gain under the proposed tax reform. Furthermore, that tax would be at the higher capital gains rate. Note, that there are some modest exclusions and exemptions in the proposal for certain instances. However, instead of relying on the uncertain exclusions and exemptions, one should speak with an estate planning professional to ensure preparedness and to explore possible solutions prior to 2022. For example, in the case of highly appreciated assets, gifting those assets under the current tax rules. 

While it is unclear what the final version of the tax bill will ultimately look like, it is important to understand what the new tax landscape may look like. A holistic tax strategy should be paired with a holistic investment strategy in any year not just when there is a likely tax increase. If there is a situation such as significant unrealized LTCG or a concentrated position that will need to be reduced, this may very well be the time for that discussion. Please note, this is not a call for panic selling or irrational decision making. However, it is a call for meaningful investment and tax planning for 2021 and beyond. Conversations with financial advisors and tax professionals can help ease the pain of current and future tax implications. First State Trust Company has many partners whose investment management and financial planning expertise can assist with this topic and many more. For additional information or help finding the partner that is right for you, feel free to contact me at mburns@fs-trust.com.

Michael A. Burns, MBA
Assistant Vice President / Investment Officer

Investing is not risk free and there are no guarantees. You should carefully consider your risk tolerance, time horizon, and financial objectives before making investment decisions. By investing, you run the risk of losing money or losing buying power (where your money does not grow as fast as the cost of living). Risk can be classified into many different categories, and by knowing those categories you can better manage expectations and avoid or reduce certain kinds of risk.

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only. FSTC does not offer tax, legal, or investment advice, professional counsel should be sought for tax or legal advice.