The Biden administration has proposed some of the most significant federal tax increases since 1993, mostly focusing on capital gains (as three of the four main items below are related to capital gains) for higher income taxpayers. Here are the main takeaways of the plan for individual taxpayers as outlined in the recent U.S. Treasury Department’s “Green Book”:
- The top marginal individual income tax rate would rise from 37% to 39.6%.
- Taxpayers with income over $1 million would pay ordinary income rates for capital gains and qualified dividends. This may be applied retroactively to transactions made after April 28, 2021.
- Treat transfers of appreciated property by gift or on death as realization events.
- Repeals the option of 1031 exchange (like-kind exchange) in real estate transactions.
Under the Biden tax plan, the benefits of tax-loss harvesting would be equally or even more important for taxable investors. Let’s take a deeper look using the tax-benefit decomposition framework we introduced in Part II (click here) of this topic with an interactive web app1.
Using our interactive framework to decompose tax benefits from tax-loss harvesting, we evaluate how the potential tax change under the Biden plan would affect a tax-loss harvesting strategy. First, we use the current tax rate for short-term of 40.8% and long-term of 23.8%. We will use the same assumptions for other variables (1,000 beginning wealth, 5% pre-tax investment return, 20 year holding period and 500 for initial tax losses applied). Feel free to plug your own assumptions in our web app to do your own sensitivity analysis. Under the current tax regime, the total tax benefit created by a tax loss harvesting strategy would be $489 higher than the base scenario wealth of $2,112, which is a 23% (= 489 / 2,112) improvement over the base case.
Tax-loss harvesting benefit under the current tax rate2:
Now, let’s look at a scenario where the full version of the Biden plan passes Congress. This would mean both short-term and long-term capital gains rates go up to 43.4%. If we plug those numbers into the web app, we have the following result2.
The last category of tax benefit, LT vs ST rate differential, would go to zero as both short-term and long-term rates are the same. However, the first two categories, pre-tax compounding and time value of deferral, would become more valuable as the long-term rate rises significantly – i.e., the benefit of saving taxes now and paying later becomes more important. The post-tax ending wealth in the base case goes down from $2,112 to $1,747 if the Biden plan passes. This is intuitive, as many investments that were considered as tax-efficient in the past where gains were taxed at lower long-term rates, would no longer be as tax-efficient.
The total tax benefit of tax-loss harvesting under the full Biden plan is $391, which is 23% (= 391 / 1747) improvement from the base case scenario. This is still significant improvement even though the third benefit goes away.
There is also a third scenario where long-term capital gains tax rates may not rise all the way to short term, but still goes higher than the current level of 23.8%. The current difference in rates between short term and long-term is 17%. Let’s assume that the LT goes up until the gap between the short term and long-term is 10%, or 7% increase in the long-term rate. The long-term rate becomes 33.4% while the short-term rate is at 43.4%.
Tax-loss harvesting benefit under this watered-down version of the Biden plan (the long term is still lower than the short term by 10%, instead of 17% currently) is as follows2:
The post-tax ending wealth under this scenario goes down from $2,112 to $1,925. The third component of the tax-loss harvesting benefit becomes smaller, but the first two components become larger than under the current rates. The total improvement is 24% (= 465 / 1925), slightly more than the scenario where LT and ST rates are equal.
Using our interactive tax-loss harvesting benefit web app in the previous post, our readers can plug their own assumptions to see the impact on the various scenarios you may have in mind.
Tax-loss harvesting plays an important role in managing the after-tax wealth of U.S. taxable investors. Through this analysis, we’ve shown the benefit of tax-loss harvesting can stay robust regardless of the direction of the future tax policy. How much an investor keeps, not how much she earns, is what counts.
1 The information provided herein is presented as a summary of potential benefits of tax-loss harvesting and does not purport to be a full description of the strategy and the investment considerations related thereto. The information contained herein is based on Quantinno’s market research and views and actual results may vary materially. There is no guarantee that any investor will achieve the results described herein. Prospective investors are urged to consult with their advisors prior to making an investment in any tax-loss harvesting instrument, including a Quantinno-sponsored vehicle.
2 These examples are purely hypothetical and are included only to illustrate the potential benefits of tax-loss harvesting. They should not be construed as an indication of performance or the effectiveness of tax-loss harvesting in actual market conditions. The information in this example is based on many assumptions that are not expected to reflect actual events that will occur.