As a team of CERTIFIED FINANCIAL PLANNER™ professionals, we spend a lot of time thinking about how to generate Tax Alpha even when clients need to pull from portfolios in a pinch. While appreciated assets held a year or more are touted for their preferential tax treatment, if you decide to liquidate a sizeable chunk of your portfolio to remodel your kitchen or invest in a vacation home, you could walk right into a tripwire that undoes any favorable taxation. A miscalculated move can mean your Social Security benefits, which were previously all tax-free income to you, are suddenly 85% taxable or the premiums you pay on Medicare that were originally $144 a month, have jumped all the way up to $461 or even a whopping $490 per month. If you say to yourself, “well, I’m not in retirement so I’m not worried,” you are not in the clear just yet. If your modified adjusted gross income is over $200,000 as a single person or $250,000 as a married person filing jointly, you will be subject to an additional 3.8% Net Investment Income Tax (NIIT) on any appreciated stocks or bonds you sell in a non-retirement account. This means that if you are typically in the 15% capital gains bracket, you are really paying nearly 19% in federal taxes on at least a portion of realized gains. And as an aside, if you are a resident of California, you will likely pay an additional 9% in state taxes on those sales.
Considering the significant impact this can have on wealth accumulation, we focus on maintaining tax efficiency as portfolios change with client needs, as well as in times of potential tax reform. For us, it is nearly as important to understand where we are in tax law today as where we may be tomorrow. With the presidential election a few short months away, there is a ton on every voter’s mind. As of late, I am interested in how candidates are campaigning on the treatment of long-term capital gains and what this (among many other proposals for tax reform) could mean for our clients when they want to withdraw funds for that special home improvement project.
To understand where we may be headed in legislation (and scope out any new tax tripwires), I like to first understand where we have been. Over the decades, Congress has passed a myriad of bills putting the taxation of capital gains on a wild ride. Appreciated stocks and bonds were initially taxed at a maximum ordinary income rate of 7% in the 1910s. This was bumped to 12.5% in the 1920s. Fast forward to the early 1940s and taxpayers had the option to exclude up to 50% of capital gains assets held at least 6 months or to elect an alternative tax rate of 25% if their ordinary rate exceeded 50%. But the pendulum swung yet again; by the late 1970s, maximum capital gains rates increased to nearly 40%.
When you look at the history of tax legislation, the rate shifts seem chameleon-like in character, and 2021 is sure to be no different. Unsurprisingly, Donald Trump and Joe Biden have taken diametric positions when it comes to their tax proposals. Where Biden would like to tax long-term capital gains at the prior ordinary income rate of 39.6% for those with taxable income over 1 million dollars (that’s a 43% rate when you take into account the 3.8% tax we discussed earlier), Trump is campaigning to index capital gains for inflation, allowing investors to shrink their tax burden on appreciated positions. Most recently, the White House has even presented the idea of a “capital gains tax holiday,” which gained no traction in Congress.
While is difficult to predict what reforms will come to fruition in future years, it is our job to be forward thinking in tax planning with thoughtful efficiency through all twists and turns; this means strategizing for both today and the possibilities of tomorrow!
“I believe in fostering a relationship with your personal finances. Once you begin to understand what deeply matters to you, the way you put your dollars to use becomes an expression of those values. When you can orient yourself to view your spending as a reflection of who you are, you’re able to exercise control over how your money moves; there is great power in that.”