For much of 2021, Washington, DC, has wrangled over potential changes in the tax code to pay for spending ambitions. Multiple proposals have circulated, with different components and priorities—from higher top ordinary income tax rates, to new treatment of capital gains, to a reduced estate tax exemption to higher corporate rates. The extent of the changes (assuming they happen at all) may depend on the ultimate size of the spending program, with moderates advocating for the more subdued numbers. However, given the $4.5 trillion already devoted to COVID rescue and stimulus, and the $1.2 trillion targeted for Senate’s bipartisan infrastructure plan, even if President Biden’s $3.5 trillion social spending package is reduced (it now stands at under $2 trillion), we believe that some level of higher taxes is possible—whether due to today’s frenzied legislative environment or down the road.
As a result, we think that investors may need to devote more attention to taxes than they may have in recent years. This is not simply a question of accounting or specific strategies, but rather continually viewing assets through the prism of potential after-tax results. Such a systematic approach may take place from multiple perspectives, and involve tax-efficiency, investment choice, asset location/use of tax-advantaged accounts, and effective estate planning.
Across multiple tax proposals, those with the largest potential impact on equity portfolios involve higher marginal income tax rates, as well as increased levies on capital gains (25% under a House of Representatives proposal and equal to ordinary income tax rates under the President’s plan).1 The impact could be meaningful, which is why we think the prospect of higher personal taxes strengthens the case for tax-efficiency in investment portfolios.
During the lifetime of a portfolio, we believe the two most important aspects of tax management are tax loss harvesting (realizing a loss by selling a security, which can then offset a taxable gain from another security) and tax deferral (delaying taxation so that money remains invested and continues to generate return opportunities). These tax management strategies can generate a difference between after-tax and pre-tax return that we call “tax alpha.”
In a study released last year, Neuberger Berman’s TaxM portfolio management team ran hypothetical Monte Carlo simulations to offer a sense of the tax alpha that tax loss harvesting strategy could generate, through different 10-year stock-market return and volatility scenarios, given the current federal tax regime.
The team started with an equally weighted portfolio of 500 stocks. They assumed three different market return levels (0%, 6% and 10% annualized) and two stock volatility levels (25% and 35% annualized), and correlation between stocks of 0.3, which is similar to the level observed historically between constituents of the S&P 500 Index. The threshold for tax loss harvesting was a loss of greater than two standard deviations of the volatility of the stock, in which case the stock was sold and, avoiding “wash sales,” a stock with very similar risk-factor characteristics was immediately purchased to replace it.
The team’s hypothetical portfolio analysis demonstrated that tax alpha was highest when market return was lower and stock volatility was higher. For example, the average annualized tax alpha from 1,000 simulations, when the market return was 6% and stock volatility was 25%, was 1.0%; when the return was set at 0% and stock volatility was 35%, average tax alpha was 2.4%.
What changes did we see with the hypothetical tax alpha findings when the President’s initial tax proposals were plugged in instead of the current regime? The results are shown below.
The Biden Tax Proposals and Potential ‘Tax Alpha’: Hypothetical Backtested Portfolio Illustration
Average tax alpha from 1,000 Monte Carlo simulations for each market-return and stock-volatility scenario, for the current and Biden’s initially proposed federal tax regimes
Source: Neuberger Berman. Hypothetical results shown are for illustrative purposes only. They are not intended to represent, and should not be construed to represent, a prediction of future rates of return. Tax Alpha figures assume an investment that is taxed at 50% short-term and 50% long-term rates (40.8% and 23.8%, respectively for current-taxes scenarios 40.8% for both under Biden proposals). The correlation to the S&P 500 is assumed to be 0.3 with 500 stocks in the portfolio and a dividend yield of 2%. Fees are assumed to be 0.35% over a typical passive portfolio, with no transaction costs and monthly rebalancing. A loss of 5% is the assumed threshold for harvesting. The illustration does not reflect the fees and expenses associated with managing a portfolio. If such fees and expenses were reflected, results shown would be lower. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. PLEASE SEE IMPORTANT “HYPOTHETICAL BACKTESTED PERFORMANCE DISCLOSURES” AT THE END OF THIS PUBLICATION.
In the updated hypothetical analysis, average tax alpha increased under Biden’s tax proposal across all six of our return and volatility scenarios, by between 20% to 30%. Keep in mind that some tax proposals are less severe than the President’s (although some are more so). However, in our view the lesson is unmistakable: The higher taxes are, the more scope there is to save money by offsetting taxes with portfolio losses.
Choice of Assets
Many choices go into the development of an asset allocation and its implementation, but we believe one key consideration should be the tax implications of a given asset class or strategy. For example, longer holding periods employed by some fundamental equity investors could have the effect of lowering immediate taxes and making more assets available to compound. Within fixed income, investment in municipal bonds has historically been an effective way to shelter income from federal, state and, in some instances, local taxes.
In our view, the appeal of municipal bonds should increase as tax rates move higher to close budget gaps. Moreover, an increase in the corporate tax rate (although not currently anticipated) could further increase demand for municipal bonds from banks and some insurance companies, benefiting many investors in the space.
That said, for much of 2021, many investors have taken note of monetary/fiscal support for states and localities, the strong economy, and the generally improving fundamentals of many issuers, while also anticipating this potential change in tax regime. As a result, municipal prices have rallied and yields have declined to where we believe many bonds are fully valued.
Rush Into Municipals
Net Flows Into Municipal Funds ($ Billions)
Source: Lipper. Data through August 2021. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
For those with a suitable risk profile, it can make sense to move down in quality somewhat given the generally supportive backdrop, in order to pick up additional income potential. High yield municipals have rallied with the rest of the market, but a muni portfolio averaging a BBB rating and seven-year maturity still may provide a 2% yield (or about 4% after-tax equivalent), which our municipal team considers attractive in the current climate. However, in our view, any move down the quality spectrum should be carefully considered and grounded in fundamental analysis. Should Treasury yields move up further (reducing bond prices), the ability to harvest losses within a separate account could also prove beneficial to the municipal investor.
Importantly, we believe saving taxes should not be the sole driver of any investment decision. Within a municipal portfolio, it could be that a non-tax-exempt municipal may provide a better after-tax yield than some tax-advantaged securities. More broadly, we believe that investors should take a flexible approach to their fixed income exposure to capture the range of opportunity that may be present in public and private fixed income markets, albeit considering the tax ramifications of various options (see “Public/Private Investing: Fixed Income at a Crossroads”).
Asset Location/Tax-Advantaged Vehicles
An important aspect of an after-tax framework is to take advantage of retirement accounts where possible, to grow assets on a tax-deferred basis in the case of traditional IRAs and 401(k)s, and a tax-free basis in the case of Roth accounts. This may involve not only maximizing contributions to the accounts, but also choosing appropriate assets for them; for example, higher-turnover or dividend-oriented investments that typically generate significant ordinary income may be better suited to a retirement account, while low-turnover assets may work best in the taxable context.
Where possible we believe investors should capitalize on all of the tax-advantaged accounts that may be available to them—for example, health spending accounts, which may be used by those with high-deductible health plans for medical expenses, have three levels of tax benefits: deductible contributions, tax-free compounding and tax-free withdrawals if used for qualified expenses. Meanwhile, 529 accounts permit after-tax contributions to grow tax-free if used for qualified education expenses, including for secondary school. It’s common to contribute up to the $15,000 per-year exclusion (per donor per recipient) from gift tax.2 Under current law, owners can choose to bundle up to five years of exclusion amounts into one annual contribution, for a total per couple per beneficiary of $150,000, without cutting into the lifetime exemption.
In addition, we should mention Roth conversions. As many are aware, Roth retirement accounts offer the potential for tax-free growth, but unlike traditional retirement vehicles, do not require distributions by the participant or his/her spouse to begin at a certain age. Although Roth accounts have tight income limits on direct contributions, investors can currently convert traditional IRAs to Roths on an unlimited basis, with the conversion amount subject to ordinary income taxes (and ideally paid from assets outside the IRA to maximize its benefits). The House proposal would curtail the use of after-tax funds in (“back-door”) conversions starting in January, and eliminate so-called “mega-Roth” techniques where participants maximize their after-tax 401(k) contributions and then immediately convert them to Roth status.3 Given this proposal and the possibility of higher tax rates, it may make sense to maximize your assets in Roth vehicles now to take advantage of current tax rates, and also to enable heirs to potentially inherit IRA balances that will be income-tax-free to them at the withdrawal stage (up to 10 years after your death).4 To the extent that Congress continues to allow Roth conversions, their use is likely to remain compelling, along with the broader employment of retirement accounts where not limited by income or asset levels.
Longer term, life insurance and annuities could enjoy a comeback in the wake of tax reform. These insurance-based tax deferral vehicles could see a rise in popularity in coming years given the favorable tax treatment provided to cash value in life insurance products and the tax deferral offered by annuities. Annuities can also be considered tax-advantaged as distributions are taken pro-rata between basis and earnings. It’s important to consider fees and policy details in assessing insurance products.
Estate planning has been especially challenging this year in the run-up to tax reform, given the wide-ranging and sometimes extreme outcomes that have been discussed, and uncertainty as to what will actually become law and when it will become effective.
The current House plan dispenses with President Biden’s proposed elimination of the “step-up” in basis at death, but would reduce the estate and gift tax exemption from the current $11.7 million to about $6 million next year (it’s currently scheduled to sunset to that level, indexed for inflation, in 2026) and introduces some limitations to certain irrevocable grantor trusts. Senate proposals have indicated more drastic limitations to the exemption and trusts, and would increase estate tax rates at higher asset levels, while, in contrast, the Biden proposal leaves the estate, gift and generation-skipping regime largely unscathed.
In the Spring Investment Quarterly, we explored “Estate Planning in Advance of Tax Changes,” emphasizing that, where feasible, readers should consider acting now to lock in potential advantages associated with the currently favorable tax code, and we highlight some of these ideas in the accompanying “Action Plan for Year-End 2021” . These include gifting to capitalize on the current exemption amount, and creating trusts that may be curtailed in the future. Although variable in scope, the general themes of limiting tax advantages for the wealthy and curtailing strategies perceived as abusive appear likely to remain part of the public policy landscape moving forward.
Into the Future
Looking beyond the current transition, it is difficult to predict with precision the overall thrust of the pending tax changes, let alone the details that gradually allow for nuanced planning and investment strategy. Tax regimes tend to begin with certain central ideas, but over time, portfolio managers and planners have generally been able to identify new opportunities for savings based on incentives created by legislators for certain priorities, purposeful advantages to offset hardships associated with new taxes, and inadvertent changes that open up whole new areas for consideration.
Although conventional (and reasonable) wisdom is that taxes should never drive investment decisions, they are a factor that we believe should be taken into account, and could become increasingly important in the coming years. Rather than think of them from one static perspective, we believe that multiple ideas can be employed to limit tax impact and enhance potential after-tax results.
Personal Tax Proposals: Highlights
Congress continues to consider an array of potential tax changes to pay for infrastructure and social spending ambitions. Below are some key recommendations from U.S. House Ways and Means Committee, as well as other sources where noted.* Historically, many proposals that have failed to become law in one year have been reintroduced later and may bear watching as debates over taxation continue in the future.
|AREA OF IMPACT||CURRENT||PROPOSED CHANGE|
|Ordinary Income Tax||Top marginal rate of 37% on income over $523,600 for individuals and $628,301 for married couples.**||Top marginal rate of 39.6% on income over $400,000 for individuals and $450,000 for married couples, plus a 3% surcharge on modified adjusted gross income (AGI) over $5 million. Biden's latest framework calls for a 5% surcharge on income over $10 million, and an additional 3% levy on income over $25 million.|
|Net Investment Tax||3.8% tax on passive income from passthrough entities.||Broader application to those earning over $400,000, likely including active owners of passthrough entities.|
|Carried Interest||Taxed at long-term capital gains rates if held more than three years.||Extends the holding period to receive long-term capital gains treatment to five years, except for real estate trades or businesses, and those earning less than $400,000.|
|Qualified Small Business Stock||Receives generous capital gains exclusion if 80% invested in a qualified trade or business and held over five years.||Eliminates the 75% and 100% capital gains exclusion for those with AGI of $400,000 or more; baseline 50% exclusion will remain in place for all taxpayers; applies to sales/exchanges after September 13, 2021, subject to “binding contract” exception.|
|Retirement Accounts||Unlimited accumulation within contribution limits. Income caps on direct funding of Roth accounts, but extensive use of conversions of pre- and after-tax assets in traditional retirement accounts to Roths.||Caps IRA contributions where aggregate retirement accounts total more than $10 million for individuals earning $400,000 or more; substantial required minimum distributions designed to reduce account balances above $10 million; prohibits conversion of after-tax retirement contributions to Roth accounts at all income levels starting on January 1, 2022; ends conversions of pre-tax dollars in 10 years for those earning over $400,000; prohibits IRAs from holding assets requiring accredited investor status after 2021, with a two-year transition for IRAs that already have them.|
|Qualified Dividend/ Capital Gains Tax||Top rate of 20%, plus the 3.8% Affordable Care Act surcharge, or 23.8%.||Top rate of 25% plus 3.8% Affordable Care Act tax, or 28.8%, applied at current bracket levels, retroactive to September 2021. 3% surtax on AGI over $5 million, beginning January 2022 (see Ordinary Income Tax, above).|
|Step-Up of Basis, Recognition of Gains||Step-up in tax basis at death; gifts not taxable below exemption amount, donee receives basis of donor.||Step-up in tax basis remains in place, with no income tax incurred at death by gifting; Biden would eliminate the step-up on capital gains above the first $1 million, or at the time of gifting.|
|Billionaire Tax||No tax on wealth or unrealized capital gains at any level.||A recent proposal would create an annual tax on billionaires’ imbedded capital gains on financial assets; details are limited and the idea may be subject to Constitutional challenge.|
|Estate/Gift/GST Tax Exemption||$11.7 million exemption.**||Reduces the exemption to about $6 million for 2022, in contrast to Biden’s proposal, which leaves the current estate tax regime in place.|
|Estate/Gift Tax Rate||40% top rate.||No change. Senator Bernie Sanders had called for an increase to 45% – 65% graduated rates.|
|Annual Gift Tax Exclusion||$15,000 per recipient, per donor each year.||No change. Sanders would limit annual exclusion gifts to qualified trusts to $30,000 per donor.|
|Like-Kind Exchange||Real estate like-kind exchanges may be entitled to capital gains tax deferral.||No change. Biden would eliminate like-kind exchanges for taxpayers with income over $400,000.|
|Trusts, Valuation Discounts||Flexibility on terms, use of exemptions, allows for effective wealth transfer.||Grantor trusts (non-grandfathered) included in estate; distributions to beneficiaries, conversions to non-grantor trusts would be taxable gifts. Curbs on discounts, GRATs.|
*Certain Biden campaign proposals did not make it into the President’s Build Back Better tax package, nor ultimately the House plan. Various senators introduce relatively severe measures, but those are not generally considered “in play” at this time.
**Set to expire after 2025 under the Tax Cuts and Jobs Act of 2017.
Source: The Tax Foundation, news reports. As of October 28, 2021.
1 One late proposal would introduce an annual tax on billionaires’ unrealized gains, although details remain limited.
2 Contribution limits are determined under state law.
3 The legislation would eliminate, 10 years from now, all back-door Roth conversions for individuals with income of $400,000 or more.
4 Roth accounts are included in the estate of the participant and may be subject to estate tax.
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