The Biden administration’s recently announced proposals to raise the top income-tax rate (to 39.6% from 37%) and the top capital-gains rate (to 43.4% from 23.8%) for households earning more than $1 million has many high-income households on edge. The administration has also proposed sharply curtailing the estate tax exemption and eliminating the step-up in basis, which boosts the market value of an inherited asset to what it was worth at the time of the benefactor’s death.
Do these proposals have teeth and what should investors be doing? Rethinking65 posed these questions to Steven Kaye, a managing director of Minnesota-headquartered Wealth Enhancement Group (WEG) and head of The Kaye Financial Advisory Team in Warren, N.J. Kaye joined WEG through its partnership with AEPG Wealth Strategies, where he served as CEO and founder for nearly 40 years.
Jerilyn Klein: Do you think it’s likely we will see the Biden administration’s proposed hikes for the top income-tax rate and top capital-gains rate become reality?
Steven Kaye: With the economy booming, unemployment falling and the states flush with cash, there doesn’t seem consensus for large tax hikes. I think we could see the top rate rising, and capital gains maybe going from 20% to 25% to 28%, but not the proposed giant increase in capital gains rates. The votes don’t seem to be there for larger increases.
The top capital gains tax rate for high earners — taxpayers earning more than $1 million a year — is currently 20% + 3.8% = 23.8%, plus state and local taxes. [The 3.8% is the net investment income tax, NIIT). The Biden proposal is for the highest earners to pay an ordinary income tax rate of 39.6% + 3.8% = 43.4% on capital gains. While most of the investment community doesn’t think the 39.6% will prevail, most of us do think that the capital gains tax will be increased for high or very high earners.
“While most of the investment community doesn’t think the 39.6% will prevail, most of us do think that the capital gains tax will be increased for high or very high earners.”
While no one knows what changes will occur, an increase of even 5% to 10% in the capital-gains tax rate should make certain people think about it, if they have a high likelihood of a large capital gain in the next few years. An individual selling stocks or a business with a $1,000,000 gain would still experience an increased capital gains tax of $50,000 to $100,000.
Additionally, President Biden has proposed reducing the estate tax exemption from $11.7 million per person ($23.4 million per married couple) to $3.5 million per person ($7 million per couple). While most of us in the estate planning community doubt the reduction will be so great, we do think there is a good chance the exemption will be reduced and everyone with an estate expected to exceed $7 million — not now, but at death — should talk to their CFP and estate attorney, sooner rather than later.
Klein: What measures are you taking, if any, to reposition clients’ portfolios for possible tax hikes?
Kaye: With tax rates possibly rising, we find “asset location” and tax-loss harvesting being of increasing importance. We also still find municipal bonds offering value, while being careful about duration. We find it makes sense for certain clients to accelerate capital gains under the current 20% rate.
Klein: What kind of asset allocations are you using for clients who are 65-years-old — the traditional retirement age — and conservative? Has there been a recent shift in your investment strategy?
Kaye: For a typical conservative 65-year-old — if there is one, since every client is a new adventure — we feel we need more tools than the traditional 60%/40% balanced fund model of stocks and bonds. With both stocks and bonds trading at such high levels, we feel that if we err, it must be on the side of conservatism. Additionally, it’s so important mathematically for “young retirees” to avoid significant losses early in retirement.
Depending on someone’s risk tolerance and comfort level, we may put up to one-third of a risk-adverse client’s equity allocation into equity index-linked structured notes. At Wealth Enhancement Group, we design the notes to “give-up,” or limit our upside in return for receiving significant downside protection of typically 10% to 20%. After designing the notes, we put them out for competitive bid with the highest quality banks. The notes help to reduce both equity volatility and market risk. Often there is upside leverage of 25% to 50% to a particular cap.
In this environment, as the markets soar to new highs, many of our clients find the notes comforting. They are particularly suitable for “clients who already won the game and don’t want to un-win the game.” ¬Clients looking for a good, but modest and more consistent return. People who want or “need” to be in the market due to low bond and money market returns but want market downside protection. They are not for investors who want to beat the market or match the market when it is up significantly. They work extremely well when returns in the equity markets are in line with historical averages, or below, or falling.
With bonds being so expensive, providing such meager returns, and credit spreads tight, in the presence of duration risk, we see benefits in reducing traditional bond allocations and replacing a portion with high quality, conservative, low expense, diversified, income-oriented private REITs. The particular type of product we like has an extremely low standard deviation of less than 2.0% historically — less volatile than bonds — and seeks modest income in the 4% to 5% range, plus some capital appreciation.
Consequently, a risk adverse retiree with a 60%/40% profile might be better suited with 40% long equities, 20% equity-linked structured notes, 30% traditional fixed income and 10% private REITs.
Klein: What are some ways you’re doing tax-loss harvesting for clients?
Kaye: Old-fashioned tax-loss harvesting still works very well “most of the time.” If a holding — for example, a stock, mutual fund or ETF which you like a lot — happens to fall significantly, or uncharacteristically, you can sell the holding, book the tax loss and simultaneously buy a proxy/similar holding. This allows you to immediately obtain the tax benefit, but without losing a very similar position. You can even reverse the transaction after 30 days, without any adverse effects. It’s almost like having your tax cake and eating it too.
The only drawback, besides any transaction costs, is you wouldn’t want to unwind the transaction and buy back your original holding if the proxy/similar investment you bought has gone up much, since it would be subject to short term gains (ordinary income). There is more potential “tracking error,” or mismatch, doing this with an individual stock. For example, selling one pharmaceutical stock and buying another, versus selling one healthcare ETF and replacing it with another healthcare ETF, or healthcare mutual fund comprised of very, very similar holdings.
Klein: How are you helping some clients accelerate capital gains? Is this just with investable assets or other assets too?
Kaye: Accelerating capital gains taxes is simply selling something sooner to accelerate the taxation, instead of deferring the sale and the taxation to a future unknown tax rate. This applies to both large stock positions as well as pending business sale transactions, or any capital asset.
I’m helping a client sell a firearms business, and helping a physician sell a medical practice to lock in low capital gains rates and subsequently work for the buying practice We’re working with a client who works for a bank, who has a concentrated, low cost basis stock they intended to sell in a year to two at retirement; they’ll probably sell at least part of the position this year in order to lock in the current capital gains tax.
Klein: How could clients potentially be impacted if the Biden administration is able to eliminate the step-up in basis on inherited assets?
Kaye: There seems to be resistance for eliminating the step-up in basis. However, one useful technique is using trust arrangements which permit asset swapping — allowing you to swap out high-basis assets for low-basis assets.
Trust assets receive an estate-tax benefit, but not an income-tax benefit. Individually held assets receive an income tax benefit (the “step-up in basis”), but are estate taxable. Consequently, it has usually been better to have “high cost basis assets” inside the trust since trusts don’t receive a step-up in cost basis and the low cost basis assets held personally do obtain the ‘”income tax freebie at death.”
Since no one knows what income and estate tax provisions will exist in the future, it is important to discuss the availability of the trust having the ability to swap out assets. This is a complicated area that requires an estate attorney’s guidance and is not permissible with all trust structures. We incorporate such whenever practical.
This provides potential flexibility depending on tax rules change in the future. For example, if the step-up in basis is eliminated, it may be best for many estates to reverse previous income-tax planning for estates by moving “high cost basis trust assets” from the trust to the individual to avoid income taxes at death and moving low cost basis assets, which can be held long term, into the trust. This defers income taxes on those assets from the date of death, into the future, whenever the trust sells the asset — which could be many years away.
Klein: How can clients prepare for the possibility of a change in the step-up in basis rules?
Kaye: Most high-net-worth and ultra-high-net-worth clients will need to thoroughly review their estate and gifting/asset transfer plans and it’s certainly not too late to start now.
Jerilyn Klein is editorial director of Rethinking65.