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Key takeaways
- "Gridlock is good" may be less true today: expiration of the Tax Cuts & Jobs Act could be the largest tax hike in history.
- A tax expert answers 7 key questions about what's next. His view: taxes are unlikely to fall by much and planning is vital.
- We highlight always-useful tax-aware strategies: use ETFs; equities > bonds; Prudent Yield > benchmarks; buybacks > dividends
The fragile future of the Tax Cuts and Jobs Act
Investors and firms like certainty. That's why they often don't mind electoral gridlock. But "gridlock is good" may not be true this year, if it means the expiration of tax relief from the 2017 Tax Cuts and Jobs Act (TCJA). In this report, we survey possible tax changes and what they mean for portfolios.
Gridlock is good, unless it means higher taxes
TCJA expiration may mark the largest tax increase in history, worth $4.6tn. In some estimates, the top fifth of households could pay 2-6% more of their income in taxes; they account for almost 40% of US consumption. In our interview, David Kirk, a US Private National Tax partner from Ernst &Young explains what investors can do.
Key insights on the future of tax policy
1. Tax rates are unlikely to fall by much and the value of expert guidance has never been higher. There's a shortage of accountants and attorneys. 2. Higher capital gains rates are unlikely but watch out for an increase in the net investment income tax; 3. State & local tax (SALT) deduction caps will likely remain, but caps could be raised; 4. For planned future expenses, consider accelerating asset sales to lock in known tax rates.
Four trades for a tax-efficient portfolio
Tax-aware investment themes are always worth considering: 1. ETFs have saved $250bn in taxes since 1993; 2. In the long run, equities are more efficient than fixed income; 3. In bonds, our Prudent Yield theme offers 5.7% tax-adjusted yield vs. 3.5% for the US benchmark; 4. In stocks, efficient buybacks outperformed dividends by 2-3ppt/year.
This report is an overview; consult with a financial advisor or tax professional for advice.
The RIC Outlook
The 2024 election could cause substantial changes in tax policy. In this report, we survey each party's tax proposals and what that could mean for households and investors.
In the event of divided government, the future of tax policy depends on party compromise. BofA economists think that some TCJA provisions could be extended, at least temporarily, but expect little else would be done (see The Great Debates).
Investment implications for changing tax regimes
In this report, we aim to highlight investor implications for changing tax regimes based on published platforms from each political party. Our goal is to raise awareness about potential tax issues and how to invest accordingly. There are many variables that impact asset prices, and this report only looks at issues from a personal tax perspective.
This report should not be viewed as a tax guide or a view on which tax policies will eventually be adopted.
Navigating the next tax regime
To help us navigate the potential path of taxes after the 2024 US election, we solicited help from David Kirk, a US Private National Tax Partner at EY. Below are some key insights from our conversation, with excerpts edited for clarity.
- Who were the major beneficiaries of TCJA tax changes?
Main takeaway: there is a misconception is that all high-income households benefited from TCJA. But region, occupation, and source of income meant tax changes were felt differently.
Top earners saw the individual income tax rate fall from 39.6% to 37%, but caps on state and local tax (SALT) deductions and non-deductible investment expenses may have offset lower federal rates for some people.
- Major beneficiaries: small business owners who use the 20% Qualified Business Income (QBI) 199(a) deduction to lower their tax rate further from 37% to 29.6% likely benefitted the most.
The lifetime exemption for estate and gift taxes was also meaningful. For example, a married couple could bequeath $25mn today with no tax liability. But waiting until 2026, when the TCJA estate tax provision is set to expire, could mean a $5mn tax liability.
- Minor beneficiaries: employees with high W-2 income paid lower federal taxes but, depending on region, saw lower SALT caps offset the benefit from lower rates.
- Non-beneficiaries: TCJA was largely neutral for investors with no ordinary income who pay long-term capital gains, since capital gains rates didn't change.
- Based on current candidate proposals, how could tax policy change?
Main takeaway: compromise will likely be required in every election outcome. And, with tax rates already near 100-year lows, rates are unlikely to fall further (Exhibit 3).
In a gridlock or divided government scenario where an extension isn't passed, the CBO estimates a $4.6tn tax increase over ten years, or approximately $460bn/year.
- Who's hardest hit if tax rates rise? The major beneficiaries (e.g., high income small business owners) who leverage the QBI deduction. Their tax rates could rise 33%, from 29.6% back to 39.6%.
- Where does the tax revenue come from? Although high-income households do have a lower propensity to spend, Mr. Kirk noted that higher taxes would probably prompt small business owners to respond with some combination of lower wages, lower capex, and slower hiring (Exhibit 4).
Changes in tax policies are not straightforward in a sweep scenario, either. Margins in Congress are expected to be narrow, which would require intra-party compromise.
- Where do you see areas of potential policy overlap?
Main takeaway: there will likely be concessions around the deficit and policies meant to mollify certain constituencies. Exhibit 5 shows the key proposals from each party.
Preserving provisions like larger standard deductions and child tax credits would not be important for households paying the most taxes but could be extended as part of a compromise package. Democrats have also said they don't want to raise taxes on people making less than $400k per year, a possible area of compromise with GOP leaders.
Provisions like the 199A QBI small business deduction might not be extended at current levels but could have a lower cap with more stringent income limits.
- What about other provisions? Do you expect any changes to capital gains?
Main takeaway: changes to the capital gains look relatively unlikely. On the other hand, the 3.8% net investment income surtax could be expanded.
- Net investment income (NII): the current 3.8% NII tax, which was part of the Affordable Care Act, could be expanded as a 'pay-for'. This could be another area of natural compromise. Not much would change for investors with majority investment income who are already paying it. But transactions, such as the sale of a closely held business, could be newly required to pay.
- Capital gains: Vice President Harris has suggested a 28% capital gains tax, while also raising the NII to 5%, which could bring the top capital gains rate to 33%. But Mr. Kirk notes she was not specific on whether the 28% was inclusive of NII or not.
- Do you envision any changes to state & local tax (SALT) deductions?
Main takeaway: little to no change-it's too expensive to uncap the SALT deductions entirely. The cap could be raised from $10k to somewhere between $25-50k.
Higher SALT deductions could help high-income W-2 employees, but things become more complicated as earnings rise and as business interests are considered. IRS notice 2020-75 (the "workaround notice") allows passthrough entities to pay state income taxes at the business level but get state tax credits that offset state income tax liability at the owner level. This benefits small business owners but not W-2 employees and could be an area of scrutiny.
- What are some general ideas for tax mitigation strategies?
Main takeaway: consulting an expert for your unique situation is the best course of action.
- Tax-deferred accounts: if an investor has most of their money in IRAs or other tax-deferred vehicles, they'll probably just have to weather the storm and hope for the best. It's difficult to transfer money from these accounts in a tax-efficient way.
- Tax-advantaged charitable gifts: an investor could make gifts and donations now to avoid higher taxes later. But large gifts must be considered in relation to how they would affect current lifestyle choices.
- Spousal lifetime access trusts (SLATs): The TCJA doubled the estate tax exemption. If the provision expires, the exemption in 2026 will be about $14.3mn for married couples, compared to $28.6mn if the provision is extended.
One option to mitigate the liability could be to establish a SLAT where an investor can put assets (e.g., cash, marketable securities, real estate, etc.) into a trust and report it on their gift tax return. The SLAT gets assets out of the estate and uses their lifetime exemption, but spouses still have access to the funds if needed down the road. SLATs get complicated if the couple divorces. SLATs and other strategies require help from a qualified tax and/or legal professional.
- How much time do investors have to make changes in portfolios?
Five ways to boost tax efficiency
We see long-term value in simple, tax-aware investing advice. In the March RIC Report, we highlighted five examples for investors looking to make portfolios more tax efficient (for full details, see The RIC Report: Tax-efficient upgrades hiding in plain sight).
Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice or to be used by anyone to provide tax advice. For more information see the appendix.
- Own tax-efficient wrappers: ETFs > mutual funds
For the same investment, taxable events mean mutual funds cost investors 1.3% per year vs. just 0.4% for ETFs. An investor who bought $100,000 of an S&P 500 ETF in October 2013 and held through today would have accumulated $359,000, compared to just $316,000 if the investment was in an S&P 500 mutual fund (Exhibit 8). We estimate that ETFs have helped save investors $250bn in taxes since 1993. See our primer Exchange Traded Funds: Primer: the relentless hunt for diversification for more.
- Maximize the power of compounding: stocks > bonds
>90% of fixed income total returns comes from coupon payments which can be taxable at the highest rates. Most equity payouts are qualified dividend income (QDI), with a max rate of 20%. Paying taxes on distributions every year blunts the magic of compounding Each year, Treasury gains lose 2.4% to taxes vs. 0.6% from stocks (Exhibit 9). Equities have outperformed bonds and cash by 6.7-8.5% a year, net of taxes, for nearly 50 years.
- Prioritize tax-advantaged yield: Prudent Yield > US Aggregate Bond Index
Fixed income investors have tax efficient options-our Prudent Yield strategy offers 5.7% tax-adjusted yield vs 3.5% for US Aggregate Bond benchmark.
- High yield municipal bonds (HYMB, HYD, FMHI) offer 6-7% tax-adjusted yields basis, 350bps more than the US aggregate bond index. Aggregate bond coupons are taxable at ordinary income rates. Returns have trailed HY munis by >220% since Dec 1995 (Exhibit 10). (see Own HY munis for more yield, less default).
- Preferred stock ETFs (PFFD, PFF, PFXF) pay some QDI. 63% of ETF holdings in our coverage are QDI eligible (see Initiating coverage of preferred stock ETFs).
- Opt for low-friction compounding: buybacks > dividends
Buybacks are more tax efficient than dividends. Even if dividends are qualified, payouts are taxed at the end of every year where they're received. An investor who pays taxes on reinvested dividends has less money to compound every year. The S&P 500 buyback factor has led dividend factors by 200-380bps per year since 1994 and has led the broad index by 2,500% and outperformance persists net of taxes (Exhibit 11 - see Exchange Traded Funds: Banking on buybacks).
Bonus: proactively seek tax efficiency in existing holdings
Investors should audit portfolios to understand where tax costs can be lowered. Many ETFs take advantage of QDI & return of capital for tax efficient distribution.
- MLPs (MLPX, MLPA) distributions are often treated as return of capital, making them tax-exempt in the year received.
- US sector funds (IYK, XLU) dividends could be 100% QDI. The same is true of broad equity funds that most already own like SPY or VOO.
- Closed end funds: muni funds (NMZ, MUA, MFM) payouts are tax-exempt and look attractive in a Fed cutting cycle. Tax-advantaged funds (AGD, ETG, GDV, HTD) are equity funds that offer 7% yields, sheltered by nearly 60% QDI on average (see Closed End Funds: Fed cuts & credit spreads say buy).
Dynamic Prudent Yield
The BofA Dynamic Prudent Yield strategy remains fully invested. This year on average Prudent Yield sector ETFs have outperformed the US Aggregate Bond Index by +3.4% and US Treasuries by +6.1% YTD and have an average 5.7% tax adjusted yield today.
For details on the Dynamic Prudent Yield Strategy including the full Appendix see: The RIC Report: A new bond strategy for the end of 60/40. Monthly updates can be received via email immediately after publishing by subscribing to "The ETF Angle". Full ETF coverage can be found on our Full ETF coverage can be found on our ETF Research Library.
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