The Capital Gains Dilemma

It is important to consider the big picture before making any major changes to your portfolio; while tax exposure is an important component, the outlook and purpose of the asset should also be evaluated.

Considerations:

• Are certain assets critical to fund near-term lifetime spending needs? Or would different assets serve the same purpose without having to liquidate?
• When evaluating an individual stock with a low-cost basis, does the position represent a concentration or overweight position in the portfolio? If the answer is “yes,” today may be an opportune time to reduce the position along with the risk associated with the concentration. Northern Trust defines a concentration as an individual security that makes up 15% or more of a client’s entire portfolio.

You want to make sure the higher rates would actually impact you. The proposed higher capital gain tax rates would not kick in until your income reaches $1 million. If your income fluctuates greatly, for example, it may be possible there are years where your income falls below this threshold. In addition, tax diversification strategies —mixes of taxable, tax deferred and nontaxable accounts with varying rules for taxation and withdrawals — can help mitigate the impact of higher future tax rates. Assessing the impact of future capital gains requires detailed consideration of current and future income projections and the resulting tax brackets.

Considerations:

• Does your income fluctuate? Is it possible that your income could fall below the $1 million threshold in the future, thereby allowing you to take advantage of lower capital gains tax rates?
• Have you considered tax diversification strategies to help minimize your tax liability and provide optionality?

If you believe you will remain in the highest tax bracket (your taxable income will remain over $1 million) and are thinking about selling an asset to realize a capital gain and reinvest the proceeds, the power of compounding interest on the portion used to pay taxes is lost. Pushing a tax liability far into the future (even if it occurs at a higher rate) may be advantageous if you do not need the proceeds to fund near-term goals.

Considerations:

• Under Northern Trust’s Capital Market Assumptions, our research shows that it may be prudent for investors to consider “up-costing” (selling today at lower rates) if funding near- and intermediate-term (1-10 year) goals. For longer-term goals, the up-cost benefit dissipates, and investors may choose to retain optionality in the event that future tax policy changes lowers the capital gains tax rate.
• If the rate of return of an individual security is higher than Northern Trust’s Capital Market Projections, the breakeven point could be far shorter.
• If the intent is to hold the asset for a very long period-of-time (beyond 10 years), the power of compound earnings on the entire investment will likely far exceed a higher tax rate in the future.
• Consider the possibility that tax changes may not endure as economic and political environments shift.

In addition to federal capital gains taxes, most states also apply a capital gain tax when assets are sold. (Currently Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not have a state capital gain tax.) Increased options for remote work and looming tax increases have caused some families to think more seriously about moving out of high-tax states.

Considerations:

• How does your state’s capital gain rules impact your portfolio?
• If you are considering a domicile change in the future, would it be advantageous to hold off on a sale if the new state has a more favorable tax structure related to capital gains?

Strategically fulfilling philanthropic goals can reduce your tax liability, as future increases to the capital gains rate is irrelevant if the asset is donated or used to fund a charitable vehicle.

Considerations:

• Low-basis assets are a tax-efficient tool to make direct charitable contributions or fund a charitable vehicle, including a donor-advised fund, foundation, charitable remainder unitrust or charitable remainder annuity trust. You can contribute long-term appreciated securities directly to a charity without paying any capital gains on the fair market value.
• Consider the timing of establishing and contributing assets to maximize the tax deduction in the year contributed.

Current federal tax law allows for in-estate assets to be stepped-up at death, which re-sets the tax basis of the asset to a current value. The Biden tax proposal would eliminate this provision, and cost basis would be carried over to the beneficiary of the account.

Considerations:

• If the step-up rule remains in place, it is a very powerful reason to consider maintaining in-estate assets that are at a low basis, especially for those well into retirement.
• Comparing the viability of using the step-up rules and the risk associated with continuing to hold the low-basis asset is critical.