You’ve probably heard there was a recent election in the US. Regardless of how you feel about the outcome, “bigly” changes to the tax code are likely and they will affect all investors. If you are investor, you should be thinking about this now.
Smart investors always know the cost basis of their holdings so they can manage the tax-efficiency of their portfolios. There are often opportunities to harvest losses, time the sale of a lot so the gain is long-term (or loss is short-term) and avoid wash sales. Occasionally there are event-driven opportunities as well. One is a dramatic change to income, either an increase (a raise or large bonus) or a decrease (retirement or temporary leave from the work force). Another is a change to the tax rates themselves. With Republicans controlling both the White House and Congress next year, we should expect major tax changes that will impact investments. Anticipating those changes may influence investment decisions for the remainder of this year as well.
There are currently seven ordinary income rates, ranging from 10% to 39.6% (plus a 3.8% surtax on net investment income for high-income taxpayers). Long-term capital gains (assets held longer than one year) and qualified dividends are taxed at 15% for most taxpayers and 20% for those in the 39.6% bracket. Taxpayers in the 10% and 15% tax brackets don’t currently pay capital gains taxes.
President-elect Trump has proposed reducing the number of brackets to three, with rates of 12%, 25% and 33%. Capital gains rates for those brackets would be 0%, 15% and 20%, respectively. Trump is also proposing the elimination of the net investment income.
The implication of potential changes to the tax code is that investors may want to wait until next year to sell gains. Conversely, if rates do decrease next year, investors may want to take more losses this year as the value as an off-set to income would be higher. To take advantage of tax-efficient opportunity such as this, an investor needs to know the cost basis of all their open tax lots. Specifically, they must know the adjusted cost basis and holding period.
Let’s take a simple example to demonstrate what this might mean to an investor. A married couple with income of $200,000 who realize a short-term gain of $10,000 on an investment, would pay $2,800 in taxes at the current rates and $2,500 under the Trump plan. That’s $300, or 3% of the gain, that could be reinvested rather than paid to Uncle Sam.
The real winners will be the wealthy, in part due to a larger cut in their tax rate and part because they’re simply playing with bigger investments. Take a single tax payer earning over $415,051 (or married, filing jointly, over $466,950). At today’s rates, they would pay $39,600 on a short-term gain of $100,000. Under the Trump plan, that same filer(s) would pay $33,000. The savings translates to $6,600 (6.6% of the gain). If the net investment income surtax is eliminated, the total savings on the gain would be $10,400 (10.4%!). It’s going to be huge. It’s going to be amazing.
While most investors would see a tax break under the Trump plan, there are some quirks due to the different break points in the current and Trump tax brackets. For instance, a married couple, filing jointly, earning between $225,000 and $231,450, would actually see their ordinary income rate increase from 28% to 33%.
In addition to potential changes to tax rates, an unusually high number of mutual funds expect to make significant capital gains distributions before year-end – many to the tune of more than 20% of net asset value. There are two implications to this “tax surprise”:
- If you are currently in a fund that is anticipating a large distribution, there may still be time to exit the fund before record date and avoid the tax hit.
- If you are considering buying a mutual fund, check that the fund is not expecting a large distribution. If it does, you will take an immediate tax hit without the benefit of any increase in asset value.
To determine whether any of this applies to your funds, check capgainsvalet.com, a free resource that tracks mutual fund capital gains distributions.
All of this messy tax stuff highlights the importance of having timely, accurate cost basis information and knowing how to use it to your advantage as an investor.
Finally, a reminder: investment decisions should never be made solely on the basis (no pun) of tax considerations. And, of course, you should probably consult a tax advisor if any of this is the least bit foreign to you.
As Chief Commercial Officer, Tax & Analytics, Cameron Routh is responsible for the overall vision, leadership and management of Scivantage Maxit®, Sqope Tax and analytics products. Under his direction, Scivantage has developed the next generation of investment management applications, including pre-trade decision tools.