We have certainly heard a lot about the strong possibility of taxes going higher this year or next. Many investors have obviously been concerned with both whether or not to incur gains before that potentially happens and how to position their portfolio in anticipation of those possible changes.
First, what is President Biden proposing as a change to the tax structure? The proposed plan would raise the top marginal tax rate to 39.6%, up from the current rate of 37%. Corporate tax rates would rise from 21% to 28%. Lastly, and typically most concerning for investors is that long term capital gains tax rates would be taxed as ordinary income for those in a 39.6% bracket earning more than $1,000,000 per year.
While most investors are focused on the long-term capital gains rates, I would argue that the corporate tax rates pose a bigger threat to investors portfolios. This could translate to a dramatic hit to earnings for many public companies which in turn could make those companies less appealing to invest in. If corporate tax rates move 7% higher and we assume that the S&P 500 Index trades at approximately 22x earnings, then we would expect to see the S&P at about 4300 which is well below the recent July high. This means the markets would be above the expected “top”. Do I think the administration will get a 28% corporate tax rate? I would like to think that they would not and would probably need to settle on a rate closer to 23%-25%. Any time you raise corporate taxes, you run the risk of slowing down corporate hiring, and capital investment.
Long term capital gains tax increases while still impactful, would hurt us more than they would the overall economy. Normally they would almost certainly lead to less investment in stocks since the tax incentive would be diminished, but with interest rates as low was they are and few other alternatives to stocks in order to achieve returns above inflation, I think the stock markets themselves can handle the potential rise in long term capitals gains tax far better than the investors themselves can. This may be a good time to analyze the potential gains/losses in your portfolio.
Where then do we position portfolios if we think taxes are going higher? First, make sure your portfolio is as tax efficient as possible to reduce your potential ongoing tax liability regardless of where rates are. A return only matters after taxes, fees, and risk are factored in. Assets that generate a lot of taxable income such as fixed income, high dividend paying stocks, etc. are better positioned in a retirement account like an IRA or a Roth IRA. In an environment where bonds are looking less attractive all the time, I think one of the bright spots in the near term could be tax free municipals which could obviously have a positive effect on the tax efficiency of a portfolio. I like these tax-free municipals for investors at or near the top of the marginal tax bracket rate, but I think even those investors who like bonds could benefit as well though with less tax effect.
Lastly, while it might not seem to be a direct correlation to your portfolio, estate taxes can play a major factor in the tax your heirs may someday pay. It’s a good idea to review with your estate planning attorney how a potential rise in these rates combined with lower thresholds could affect your personal situation.
The reality is that higher taxes rarely have the intended effect. If tax rates on investments rise, investors could simply hold onto those assets longer or plan for reduce their effects now. I don’t believe that the government will see much if any of the intended tax windfall from raising taxes. I think a smarter strategy is keeping tax rates low but enforcing the rules better. I would lastly caution investors to not rely too heavily on what happened during any specific past periods of increasing taxes alone since the tax effect is part of a combination of many economic factors happening simultaneously and those factors are rarely the same at any given time. As always, you should consult with your tax advisor and financial advisor before making any changes to your portfolio.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or email@example.com.
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