POTUS 46: 8 ways to prepare for higher taxes
After spending eight years as vice-president, Joe Biden took center stage to deliver his own speech to a joint session of Congress on Wednesday. The atmosphere was more subdued than usual, with social distancing rules limiting the size of the audience on the floor of the House of Representatives. While there may have been less pageantry than in the past, Biden's speech before Congress still managed to break new ground. The indelible image of two women seated behind the rostrum—as Speaker of the House and President of the Senate—was acknowledged immediately by President Biden as a groundbreaking event in US history.
After taking a victory lap regarding the improved vaccination rates, the president sketched out the second part of his broadly-defined infrastructure spending plan. As expected, he proposed an array of spending initiatives to strengthen the social safety net and focused many of his remarks on expanding access to education and health care. The speech before Congress was chock full of spending proposals at the heart of the Democratic Party's campaign platform, which is sure to please some members of Congress and alienate others. A summary list of the president's expenditure proposals is illustrated on in Fig. 1: at the end of this article.
The challenge, as always, is how to pay for the new initiatives. Biden may be obliged to rely on deficit financing to some degree but also expressed explicit support for an array of higher taxes on wealthier Americans. Some of the tax proposals, such as an increase in the highest marginal tax rate for ordinary income, had been telegraphed for weeks and was unsurprising. The return to a higher maximum marginal rate was scheduled to occur in 2026 anyway; we expect Congress to accelerate the return to a higher rate in 2022. Other proposals, including a doubling of the tax rate on capital gains and dividends for Americans making more than USD 1 million, will encounter greater resistance and will be subject to further negotiation. As a reminder, our base case assumes an increase in the tax rate on capital gains and dividends to 31.8% (28% + 3.8% tax on net investment income). Please refer to our prior report, POTUS 46: Rethinking Infrastructure.
Biden also reiterated his support for higher taxes on inherited wealth. He advocated the abolition of step-up rules, which presumably would trigger an estate tax liability on accumulated capital gains upon death. While family businesses and farms would be excluded from taxation in some instances, this proposal also is likely to encounter opposition. Other targets for higher taxation include carried interest on private equity investments and 1031 real estate exchanges above a relatively low threshold.
Months of negotiations ahead
President Biden's speech before a joint session of Congress signals the beginning of negotiations. The final compromise legislation will be worked out over a period of months and may bear only a passing resemblance to the broad outline set forth last night on Capitol Hill. Taxation is a notoriously complex topic and efforts to alter the Internal Revenue Code generally take months to accomplish.
We have been asked whether references to "all income" in the White House Fact Sheet foreshadow a change in rules governing tax exempt bonds. We don’t think so. Admittedly, the text is open to some interpretation but there is scant evidence that either the president or the Congress has much interest in substantially revising the rules governing tax exempt bonds. The president did not introduce a plan to promote taxable municipal bonds with an explicit federal subsidy, but a proposal along those lines may yet emerge.
Biden also opted to avoid a direct discussion of the cap on state and local tax (SALT) deductions for federal income tax returns. This is an important issue for some Democratic House members and is certain to be a principal focus of lawmakers' attention as legislation is drafted later this year. The Democratic leadership is sympathetic to calls for the elimination of the cap, and some level of relief is likely, but doing so results in a significant "cost" to the federal government in forgone tax revenue.
We have said it before, but it bears repeating: legislative proposals in Congress should be monitored closely, but investors are well-advised to avoid taking precipitous actions in response to proposals—even when they originate at the White House. A focus on asset allocation as we await further developments is the appropriate remedy to the anxiety that discussions over tax liabilities often engender.
Investment strategies to consider
Giving your hard-earned cash to the government can be even more painful than incurring other costs or losses. As a result of this pain, investors often suffer from what behavioral economists call "tax aversion bias"—a tendency to avoid taxes, even when paying taxes will result in a better after-tax outcome.
Because of this aversion, and the fact that taxes can be an emotional subject, we recommend considering potential tax risks and opportunities through the lens of the UBS Wealth Way framework, and applying these insights to your investment strategy using the Liquidity. Longevity. Legacy. framework.
The Liquidity. Longevity. Legacy. framework works by earmarking and investing your hard-earned savings into three strategies, each designed to work over a specific time horizon and for a specific purpose: The Liquidity strategy, to meet cash flow needs for the next 3–5 years; the Longevity strategy, to meet goals for the rest of your lifetime; and the Legacy strategy, to grow wealth and transfer it to others for needs that go beyond your lifetime.
Bearing this framework in mind, here are some specific steps that you should consider given the Biden administration's proposal:
1. Increase tax efficiency. Consider the tax properties of investment vehicles. For example, tilting asset allocations toward exchange traded funds (ETFs) and tax-managed separately managed accounts over mutual funds could make sense depending on your situation. Mutual funds tend to generate capital gains in bull markets that are distributed periodically to shareholders; by contrast, ETFs generally have fewer capital gains to distribute to shareholders, giving you more control over when capital gains are realized. The ETF tax efficiency advantage is largely driven by the exchange trading and process to execute redemptions. These features help to insulate an ETF’s portfolio from the potential tax effects of shareholder buying/selling. See Kicking the tax-can down the road for more information.
It's important to note that not only the tax drag should be considered when deciding whether to switch investment vehicles. For example, while a passive ETF would feature fewer capital gains distributions than an active mutual fund, certain active managers may be able to overcome the additional tax drag on an after-tax performance basis, depending on the amount they can outperform a passive equivalent. Additionally, if an investment already has a large capital gain, the switching costs may offset the benefits of a more tax-efficient vehicle. Therefore, investors should also evaluate both their current capital gains on a position, alongside the outperformance potential, before turning over any portfolio positions.
Separately managed accounts can be especially tax-efficient because they can utilize a tax-management overlay that realizes capital losses and defers capital gains on your investment down to the individual security and tax lot level.
2. Give stocks to charity. Donate securities that have appreciated in value to charities or to a donor advised fund, rather than realizing capital gains tax and using cash. Nonprofit organizations are shielded from taxation, so they can benefit from capital gains on prior investments without incurring a liability at year-end.
3. Give to others, with growth. Donor advised funds, private foundations, and some trusts can offer the potential to make gifts out of your taxable estate today and grow those assets for years or decades before ultimately disbursing your gift—and any gains—to charities and other nonprofit organizations. These can help to reduce or defer your tax payments, and increase the after-tax value of your gifts. See Give to others, not the IRS, for more information.
4. Increase your tax-free income. Allocating assets to tax exempt municipal securities over corporate bonds can help to reduce your ordinary taxable income. We do not expect substantive changes in the treatment of interest on state and local government bonds. Thus far, the president has not unveiled a proposal to limit the benefits of tax exemption to lower tax brackets, which was a recurring feature of President Obama's own budget proposals.
5. Harvest tax losses and defer capital gains. "Tax loss harvesting" can help you to defer capital gains taxes further into the future, and the growth of deferred taxes will often eventually make up for higher future tax rates, allowing your portfolio to create more after-tax wealth than if you needed to pay taxes today. While many investors focus on tax loss harvesting in the fourth quarter, this can result in missed opportunities because the market tends to recover from dips quickly. We recommend harvesting capital losses throughout the year, whenever losses are available, in order to maximize your tax deferral potential. See How and why does tax loss harvesting add value? for more information.
6. Focus on tax diversification. You can manage your tax burden today, and in the future, by investing more of your wealth into tax-deferred accounts (e.g. Traditional IRAs/401ks/403bs) and tax-exempt accounts (e.g. Roth IRAs/401ks/403bs, Health Savings Accounts, and 529 college savings). See The savings waterfall: How to prioritize your investing for more information.
7. Increase after-tax growth with "asset location". By allocating to the right investments (stocks, bonds, etc.) in the right accounts (taxable, tax-deferred, tax-exempt), you have an opportunity to increase the after-tax growth potential of your investments. Generally speaking, high-income and high-turnover investments generate more tax drag than growth-oriented investments, and can contribute more to your wealth when they are held in tax-advantaged accounts. See How and why does asset location add value? for more information.
8. Build your Legacy strategy and accelerate lifetime gifting. We are in a historically attractive window of opportunity for managing estate and inheritance taxes, and although President Biden hasn't proposed a lower lifetime gift and estate tax exemption at this time, that window is scheduled to close in 2025 even if Congress doesn't act sooner. It can take weeks or even months to implement a thoughtful estate plan, and the cost of procrastination could be steep, so we don't recommend waiting until a proposal is finalized. See 2021 strategy guide: Managing taxes and giving to others for guidance, and speak with your financial advisor about taking proactive steps to protect your legacy.
Final thoughts
President Biden has gone "all-in" on his two-part infrastructure proposal. At present, we believe Congress will pass a single bill after Labor Day that combines some elements of both the American Jobs Plan and the American Families Plan. But the size and scope of the entire program is likely to be adjusted. The magnitude of the tax increases now being proposed also are likely to be pared back.
Fig. 1: Provisions in the American Families Plan
