Many financial advisers follow Warren Buffett’s lead, adopting a buy-and-hold mentality and urging jittery clients to shrug off scary headlines to achieve long-term gains. But what if those headlines signal a threat to a long-term investment plan?
Case in point: On April 22, U.S. stock markets reacted poorly to reports that President Joe Biden might propose a capital gains tax increase to 39.6% for Americans earning more than $1 million. That would nearly double the current base rate of 20%.
Once Biden announces the proposal, Senate lawmakers will haggle over it. The outcome remains fuzzy, but it’s entirely possible that a capital-gains tax hike for ultra-wealthy investors will kick in at some point.
Yet the news raises questions for all investors. Should they rush to sell their big winners to avoid a larger tax bite if they wait? How can they capitalize on the uncertainty? Regardless of how this shakes out, what short-term impact will the negotiations have on the markets?
Chris Diodato, a certified financial planner in Palm Beach Gardens, Fla., says a short-term market correction may occur “probably toward the end of this year” if the capital gains rate increases and isn’t made retroactive to 2021. If the rate increase becomes law and goes into effect retroactively, he suspects a correction might happen sooner.
“But if investors sell in a surge, where are they going to put that money?” he said. “They might put it back into stocks pretty soon after” the dust settles and investors adjust to the new tax rates.
Coupled with a capital-gains rate hike, Diodato’s long-range concern is a stock market coping with an increase in the corporate tax to 28% from 21%, as currently proposed.
“The combined tax rate, with the corporate tax and capital gains tax, can put a bit of a damper on long-term stock prices in general,” he said.
Because Biden ran for president in part by seeking to raise taxes on the wealthy, Diodato found the report unsurprising. Over the past year he has started to diversify some clients’ portfolios away from heavy concentrations of tech-sector high-flyers in favor of international stocks and sectors such as energy, materials and heavy industry.
Uncertainty stokes anxiety when trying to predict how a proposed tax change can impact a portfolio. When conferring with clients, it’s an adviser’s job to balance the benefits of taking proactive steps in anticipation of possible tax hikes with the costs of overreacting to speculative proposals that may or may not come to pass.
“The first question for investors and advisers is what’s the likelihood of this becoming law,” said Roy Janse, a certified financial planner in Greenville, S.C. “And if it does become law, in four- or eight years it can all change again if we have a different administration.”
To stay a step ahead of the tax repercussions of rising capital gains rates, Janse is focusing on clients with non-qualified accounts who need to extract a certain amount of income. Facing potentially higher capital gains tax if they sell their best-performing stocks, they may explore tax-smart strategies to access their cash.
“There are more creative ways to get income rather than panicking, selling appreciated stock and realizing a very high capital gains rate,” Janse said. He cites selling income-focused investments, such as municipal bonds, that may have less price appreciation. Another example: securities-based lines of credit in which investors can borrow cash against their account without liquidating their stocks.
Regardless of what ultimately happens when lawmakers finish debating changes to the capital gains rate, wealthy investors with a keen interest in the latest tax-saving strategies may want their adviser to offer direct indexing. This involves constructing portfolios to replicate a market index — and it can harness artificial intelligence to harvest gains and losses from stock transactions to minimize the overall tax bill.
“As more investors ask their adviser for ways to mitigate their taxes, maybe we will see a shift toward direct indexing,” said Justin Green, a certified financial planner in Marlborough, Mass.