Could a capital gains tax hike affect your investments?

September 27, 2021

SOME AFFLUENT AMERICANS could soon be paying higher capital gains taxes on the investments they sell. These taxes — levied on the increase in value of an asset — kick in whenever you sell a stock and realize a gain. A proposal under consideration by Congress would increase the top capital gains tax rate from 20% to 25% for sales of long-term appreciated assets that occur on or after September 14, 2021. 

The new top rate would apply at the breakpoint currently in place for 2021: $501,600 for married couples filing jointly and $445,800 for single taxpayers. Those thresholds would drop to $450,000 for couples and $400,000 for single taxpayers in 2022. With the already existing 3.8% Affordable Care Act surcharge on net investment income, that would come to a rate of 28.8% on investment gains for those taxpayers in 2021.

Beginning in 2022, a new surcharge is proposed. This new surcharge would add an additional 3%, but it would only apply to individual taxpayers whose income (whether wages, gains or other) exceeded $5 million. This would bring the top capital gains rate to 31.8%. Qualified dividends on or after September 14, 2021 would also be subject to the higher proposed rate. That’s because qualified dividends are taxed at capital gains rates.

Congress may not ultimately pass the full proposed capital gains tax increase, says Mitchell Drossman, head of National Wealth Strategies in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank. Yet some increase is likely, he adds. “While there may not be an opportunity to sell and capture the lower (former) rate, now’s the time for investors to consider the potential portfolio and overall capital markets effect.”

Here, Drossman and others from the Chief Investment Office answer questions top of mind for investors about the proposed tax increase and offer some strategies for them to consider. Learn more by reading “Democrats Release Details of Tax Plan to Pay for Social Spending Expansion,” a report from the CIO.

How high could the capital gains rate go, and when might the change take effect?

While the capital gains tax changes are still only proposals, it appears that they will soon find their way into a comprehensive reconciliation bill to be addressed in both the House and Senate. Though no date has been set to vote on the reconciliation bill, the proposed effective date of September 14 for capital gains will likely stick, Drossman says. Assuming a bill is signed in 2021, other increases, including the proposed new 3% surcharge on those with income above $5 million, will likely take effect on the first day of 2022.

How could markets respond?

“Based on past capital gains increases, in 2012 and in 1986, we would expect a sharp but temporary wave of selling by investors seeking to lock in gains before new rates take effect,” says Joe Quinlan, head of CIO Market Strategy, Chief Investment Office for Merrill and Bank of America Private Bank. “In both previous cases, momentum stocks—those that had been rising fastest and generating the highest gains—suffered the most.”

Yet any negative impact on markets would likely be brief, especially with the overall economy doing well, Quinlan adds. “History shows that markets respond much more closely to trends such as corporate earnings growth and momentum, the cost of capital and real economic growth.” For example, “when capital gains rates rose by 9% in 2012, the S&P 500 index returned nearly 30% the following year,” he notes.

What portfolio adjustments could equity and fixed-income investors consider?

Start by reviewing your current holdings, suggests Joe Curtin, head of Portfolio Management for the Chief Investment Office, Merrill and Bank of America Private Bank. If your investments include a fair amount of assets that have grown in value, speak with your tax and investment advisors about possible portfolio adjustments, he suggests. For the taxable part of your portfolio, you might consider index-based mutual funds and exchange-traded funds (ETFs), which sell assets infrequently and hence may potentially generate lower capital gains taxes than other funds. “ETFs offer the added advantage of enabling investors to harvest losses at any time, potentially offsetting capital gains,” Curtin says.

Retirement accounts such as 401(k)s and IRAs are generally not subject to capital gains taxes (rather, for traditional 401(k)s and IRAs, withdrawals at retirement may be taxed at your ordinary income rate). Thus, those could potentially be a more appropriate place for investments with higher turnover, he adds. The same thinking applies when you periodically rebalance your portfolio, selling some assets and buying others to stay in line with your long-term goals. If capital gains taxes rise, you may want to concentrate your rebalancing in your retirement accounts, since you won’t be subject to capital gains for selling appreciated assets.

“For bond investors, a capital gains tax increase will likely have only a limited effect,” Curtin adds. While selling bonds can generate capital gains taxes, many investors buy and hold them for income. “Thus, a change in the ordinary income tax rates would be of more concern,” Curtin says. At a time of higher taxes, municipal bonds, if appropriate, could help you manage your overall tax exposure, because they are generally free from federal and state income taxes, he adds. 

Should investors consider selling appreciated assets now, before rates rise?

While selling now locks in gains at the current tax rate, the potential drawback is missing out on potential future returns on the funds used to pay taxes on those gains. “The ‘sell now or later’ decision is unique to each investor,” Drossman says. “The two big considerations are your anticipated returns and your investment horizon.” If you’re only planning to hold an asset for a short time, selling before rates rise could make sense. But if your horizon is longer and the asset seems promising, holding on could possibly generate returns that outpace a potential tax increase.

A rate increase isn’t the only factor to consider when determining your capital gains tax strategy, Drossman adds. “If your income is unusually high in a given year, you might want to delay selling assets and generating capital gains taxes until a year when your income is lower,” he says. This and other tax-bracket management considerations could go a long way in helping you manage any jump in capital gains rates pegged to a specific income threshold. If charitable giving is a priority, you could help mitigate some capital gains taxes by gifting appreciated securities directly to a charity, rather than selling the securities, paying capital gains and gifting cash.

Consult your advisor and tax specialist before making any decisions, Drossman says. And keep in mind that tax rates, while important, shouldn’t define your investments. “Whichever way taxes go, the important thing is to maintain a balanced portfolio designed to meet your personal goals, time horizon, liquidity needs and risk tolerance.”