The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.
This week’s unveiling of the American Families Plan, the latest proposal from the White House, makes it clear that President Joe Biden is serious about pursuing some of the individual tax increases he called for during the 2020 campaign. One major proposal within the plan calls for taxing capital gains and dividend income at ordinary income tax rates for those with earnings over $1 million.
The details as to how this tax would be implemented are a bit slim at this point, but Congress will ultimately make the decisions about how to proceed. Finding the right combination of spending and tax increases that can be approved by the razor-thin Democratic majorities in the House and Senate will be a tricky process that is likely to take several months (check out "Will Taxes Rise for the Wealthy? What You Should Know” for more on the legislation’s chances on Capitol Hill). Therefore, investors should not overreact to the news, but keep an eye out as the process unfolds in the coming months.
Assuming the proposal becomes law, planning for transactions that could result in large capital gains would become even more important than ever for wealthier households. Fortunately, there are many strategies that investors could use to help reduce the tax impact from this proposed tax law change, both today and in the future. However, we generally recommend a wait-and-see attitude at this point, as it’s unclear exactly what the law would look like, and it’s likely investors would have time to consider the following strategies if this proposal became law.
Here are some possible ways those who are concerned about this possible law change could potentially mitigate some of the negative tax impact:
- Tax gain harvesting: Investors often focus on selling losing investments and letting the winners ride. However, from a tax-planning prospective it sometimes can be better to sell a winner to lock in a lower tax rate today— a strategy known as tax-gain harvesting. Some investors may want to consider recognizing a portion of their capital gains before any new tax laws go into effect. Doing so could result in a lower tax bill and the opportunity to rebalance a portfolio into more tax-efficient investments.
- Tax loss harvesting: The proposed higher tax rate on income over $1 million likely would be levied only on the “net” gain realized. This means investors could sell a losing asset to offset the taxable gain from profitable investment, a strategy known as tax-loss harvesting. The recognized losses could be used to bring the net gain to just below the $1 million limit, which could provide significant tax savings in certain situations—just be aware of the wash sale rules before considering this strategy.
- Bucketing stock sales: If the tax rate on capital gains increases, investors could strategically plan asset sales to ensure that gains are recognized only up to the $1 million limit. As long as the total income recognized stayed below that limit, you would be subject only to the standard capital gains tax rates of 0%, 15%, and 20%.1 After you pass that limit the higher 39.6% tax rate would kick in, but only on the gain that was over $1 million. This strategy can be done every year, and also combined with items #1 and #2 above, to help minimize taxes over multiple years.
- Hold assets longer: For long-term investors, a possible strategy to avoid higher capital gains tax rates is simply not to sell investments with large built-in gains while tax rates are high. As we have seen in the past few years, the tax code is constantly changing. It’s possible that even if the current administration changes the capital gains tax rate, some future Congress could change the tax rates back again. Unfortunately, there’s no way to know what the future of taxes will be, but change seems to the new norm.
Taxes affect almost every aspect of investing and planning; however, avoiding taxes generally should not be the primary motive in making changes to your portfolio. First and foremost, your planning and investment selections should be based on your overall goals and risk tolerance. Before implementing any tax-planning strategies, we recommend meeting with financial and tax professionals to thoroughly analyze your particular situation.
1 For 2021, capital gains tax rates are based on the following income thresholds: 0% for single filers with taxable income up to $40,400 ($80,800 for married filing jointly); 15% for single filers with taxable income of $40,401 to $445,850 ($80,801 to $501,600 for married filing jointly); and 20% for single filers with taxable income over $445,850 (over $501,600 for married filing jointly).