Preparing for Potential Capital Gains Tax Hikes
After months of anticipation, the House Ways and Means Committee released their amended tax proposal on September 13, 2021. As promised, President Joe Biden is proposing to raise taxes on capital gains on the wealthiest individuals from 20% to 25%. But, it also lowers the amount of income needed to get to the top tax bracket (for both ordinary income and capital gains) to only $400,000 for individuals and $450,000 for couples filing jointly. This being the case, individuals who stand to be most impacted by these changes are those in the $400,000 to $500,000 income range who can expect to see themselves move from the 35% bracket to the new 39.6% bracket.
As of now, if passed by Congress, the new capital gains rate will go into effect on January 1, 2022, though there is also talk of making the effective date retroactive to April 2021. While the legislation will now be debated in Congress and finalized in the weeks to come, investors are being encouraged to take action before the legislation is signed and certain planning windows are closed!
Is Selling Now the Answer?
The possibility of a doubling of capital gains taxes has investors considering whether they should sell stocks before the end of the year to take advantage of the lower rate. However, there are a couple of reasons why that might be a bad idea.
The first reason is that this is politics, and, in politics, nothing is carved in stone until the final bill is voted through and signed into law. There’s bound to be a lot of negotiations before a final number is determined. As mentioned above, the House Ways and Means Committee approved legislation that would tax capital gains at a much lower top rate of 25%, but it will apply to a lower income threshold of $400,000. With that slight increase, it probably wouldn’t make sense to adjust your investment strategy very much.
Secondly, a knee-jerk stock sale could push you into a higher tax bracket and impact your Medicare premiums and Social Security taxes. It could also trigger the 3.8% Medicare surtax if your net investment income exceeds $200,000 for individuals or $250,000 for joint filers. This could significantly impact your drawdown strategy in retirement, adversely affecting the amount of income you would be able to receive. Any plan to manage your capital gains should be coordinated between your investment advisor and tax advisor, considering the short- and long-term tax implications on your financial plan.
The bottom line is investors should play it cool until they find out what, if any, additional tax is imposed and, more importantly, until they spend the time to reassess their investment strategy. Should we see a significant increase in the capital gains tax, here are some strategies to help mitigate the increase.
Ways to Potentially Mitigate a Capital Gains Increase
1) Accelerating Gain Realization
Selling securities with long-term capital gains before the effective date will be less expensive than selling them in 2022. You just have to be careful that the sale doesn’t push you into a higher income tax bracket or trigger the Medicare surtax. Your tax advisor could help you determine that threshold. If you expect to be in a higher tax bracket next year, it may make sense to realize gains this year.
2) Gift Appreciated Securities
If you practice philanthropy, you can gift appreciated securities to a charitable organization. You would not only receive a current deduction for the market value of the security, but you could also avoid the capital gains tax.
3) Don’t Sell
Another option is to hold on to your securities to postpone realizing capital gains. Of course, that could impact your retirement drawdown strategy. Plus, you need to consider whether holding a security and risking a pullback in the price is worth it.
One strategy is to evaluate each stock on a case-by-case basis to determine if they still have the upside potential that would make it worth holding. For stocks you’ve held under a year, you may want to consider selling if it looks like it has reached its price target, which means it may not make sense to hold it until it reaches long-term status.
4) Rebalance Your Portfolio
If your stock portfolio value has increased significantly over the last 18 months, a sharp increase in the capital gains tax rate could make it difficult to rebalance your portfolio or rotate out of sectors as needed in the future. If anything, the proposed tax increase could be the impetus to do some serious rebalancing before the effective date.
5) Selling Your Business? Consider Locking in a Purchase Agreement Now
If you own a business with a significant gain and are considering selling it in the near future, it makes sense to lock in a purchase agreement before the end of the year. Depending on your tax rate, it might also make sense to structure the sale in a way that produces ordinary income for you as opposed to capital gains.
Until the proposed tax increases become law, and there’s a big question as to what Congress can or will pass, it’s best to wait and see. Even if it is enacted, it’s important not to make any knee-jerk moves that could end up hurting you more in the long run. However, it’s not a bad idea to huddle with your advisor to play a game of “what if” just to be prepared.
Tax planning is always a major part of wealth planning. After all, the less you spend paying the IRS, the more revenue you have to invest and build wealth for your future. If you are a business owner who is at all concerned about how you will mitigate these potential tax hikes, or need help managing your investments in a high capital gains environment, the advisors at Trivium Point are only a phone call away.
We serve clients locally in the greater New York area and virtually across the country. Contact us today to schedule a complimentary consultation call to discuss your opportunities.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.