More than a month into President Biden’s administration there have been a slew of executive orders, confirmation hearings and COVID-19-related task forces designed to tackle the vaccine rollout, among other priorities. In the background Congress has been negotiating the next round of stimulus to Americans, which is due to land on the president’s desk in a matter of days. In many ways, while these are difficult and time-consuming measures, they represent the low hanging fruit that often defines the first 100 days of a new administration, particularly one that controls both houses of Congress.
More comprehensive measures lurk behind these largely procedural tactics. One of the largest efforts a new president undertakes is the federal budget, which tends to define the shape and tone of an administration. Biden’s inaugural budget is already delayed, with the White House citing transition issues and a desire to focus its coordinated efforts on the vaccine rollout, first and foremost.
When the budget is ultimately delivered, it will set off a torrent of debate and move through the legislative process for several months. At the center of these negotiations will no doubt be Biden’s tax plan and its impact on top earners and high net worth individuals.
What is Tax Loss Harvesting?
Tax loss harvesting involves selling an investment that has declined in value and replacing it with a similar investment. The investor can use the loss on the original investment to offset capital gains moving forward. Individuals or couples filing jointly can also use the loss to offset ordinary income taxes up to $3,000 per year (for couples). This strategy cannot, however, be used to offset gains in qualified retirement plans that are tax-deferred by nature. It’s unlikely that this basic structure will be affected by any changes to the tax code.
An important caveat to this strategy is that the replacement stock or security cannot be identical to the one sold for a loss within 30 days of the sale. Investors can replace the security with one of a similar nature but not what the IRS would consider “substantially identical.” This is what the IRS calls a “wash sale” and it is strictly prohibited and is subject to a clawback if executed incorrectly. This provision extends to other accounts one might hold such as an individual retirement arrangement (IRA) or accounts held by a spouse or a corporation substantially controlled by the investor.
Understanding Proposed Tax Changes Under Biden
Most of the tax changes proposed by then-candidate Biden—the closest approximation we currently have to understanding what might occur later this year—affect high income earners and high net worth individuals. Thus, it’s important to understand the nature of these changes and create a plan with your investment advisor to account for them.
Currently the top marginal tax rate is 37% for couples earning more than $622,000. This bracket is scheduled to increase to 39.6% in 2026 under the Trump tax plan. The Biden plan would increase this immediately. It’s unclear whether this would affect households earning more than $415,000 as they are currently taxed at a rate of 35%. What Biden has signaled throughout his campaign is that households earning below $400,000 would not be affected, though it’s difficult to predict where this will land once the full budget has been adopted.
Many high income earners are able to partially offset some income recognized through pass-through entities such as S-corporations and partnerships. In theory, this deduction will remain for those making less than $400,000 but it’s likely that this benefit will disappear over time for anyone earning in excess of this amount.
The Biden plan would reduce benefits of selling long-term holdings for gains to households earning in excess of $1 million in annual income, as investment gains would now be taxed as normal income rather than capital gains. This helps make the case for a more active tax loss harvesting approach to help offset gains where possible, but there is already research that suggests this strategy is more effective in a high volatility market environment.
SMA’s in the Wealth Advisor Toolkit
One of the benefits to advisors of utilizing separately managed accounts (SMAs) as an advisor is the ability to employ a strategy such as tax loss harvesting on their clients’ behalf. In the case of mutual funds or exchange traded funds (ETFs) for example, gains and losses are shared among all investors and therefore advisors aren’t able to sell securities strategically for tax planning purposes.
SMAs also offer a higher level of customization to structure investments around a client’s needs and preferences and oftentimes they allow the advisor community to communicate through their institutions with portfolio managers such as Hilton Capital.
Investors should have an understanding of the changes ahead under a new administration, as there is a clear case to structure high net worth portfolios to minimize tax consequences. Most competent advisors already employ tax loss harvesting on behalf of their clients, but it’s still important to understand the nature of it. Much of it depends upon the holistic strategy your advisor is administering for your specific circumstances and desired outcome. Tax loss harvesting is a critical strategy to balance a portfolio, but individual circumstances could dictate a more active approach to seek these opportunities.
Remember that there is a cost to administer a more actively managed SMA for these purposes. An active effort to utilize tax loss harvesting to offset gains could signify a shift in investing rationale from performance to tax mitigation. Not that these are mutually exclusive items, as one should always be cognizant of tax thresholds and policies that could negatively impact an individual’s bottom line. The point is that tax loss harvesting is more than a box that one checks when building a wealth management plan. It’s a deliberate strategy that involves planning and execution based on a number of factors specific to the individual investor. It should be built with your particular needs in mind and in context of updated tax laws.