Wealthy investors may be in for a capital gains tax hike. Here’s how they’ll manage

Published Tue, May 4 202110:04 AM EDTUpdated Tue, May 4 202111:01 AM EDT

Key Points

President Joe Biden proposed raising the top rate on long-term capital gains to 39.6% from 20%. The tax hike would apply to households making more than $1 million.
These higher taxes would apply to taxable brokerage accounts, but not tax-deferred accounts, which include 401(k) plans.
Higher income investors may find ways to manage the taxes owed, including making deductible charitable donations and weighing tax-managed investment strategies to minimize capital gain distributions.

The future of President Joe Biden's proposal to raise capital gains taxes on the wealthiest households is uncertain, but accountants are weighing strategies to help mitigate the tax bite. To help fund his $1.8 trillion American Families Plan – a new stimulus proposal that i ncludes enhanced tax credits for families – Biden is calling for higher levies on capital gains and income for top earners. He'd like to raise the top rate on income taxes to 39.6% from 37%. Further, Biden is proposing a hike to the long-term capital gains rate to 39.6%. Currently, the top rate on those gains is 20%. The increase would apply to households making over $1 million. Accountants don't anticipate a wave of panic selling out of taxable accounts , but they say it's a good time to think about tax strategies. "People hear 'tax rate increase' and start doing things they otherwise wouldn't do," CPA and Pimco senior consultant of education Tim Steffen said. "Rarely are investment decisions based on one factor alone," he said. "Be sensitive, but not driven by taxes." Here are four tax mitigation strategies to consider in a time of higher rates. Charitable giving Charitable donations bring a host of tax benefits, particularly if you're donating highly appreciated assets. For starters, if you itemize on your income tax return and you give assets other than cash to a qualified charity, you can generally deduct the fair market value of the property. By donating highly appreciated stock , you're also eliminating the capital gains tax you'd otherwise pay for selling out of the position. Further, you dilute risky concentrations in your portfolio, Morningstar director of personal finance Christine Benz said. "A lot of people have highly appreciated individual positions, especially in employer stocks or inherited stocks," Benz said. "Earmark some of these stocks for charity." Simplify your giving by opening a donor-advised fund . These funds can readily receive donations of stocks, funds and even complex assets, like cryptocurrency or a closely held business interest. You'll still get the same tax deduction in the year you make the gift — and you can make grants from your fund at any time. Harvest tax losses Tax-loss harvesting allows you to sell off losing positions in your brokerage account and use those losses to counter taxable gains incurred elsewhere. If your losses exceed your gains, you can apply up to $3,000 a year to offset ordinary income. Be cognizant of when you incur the losses and the gains. "If you'll be subject to the higher capital gains rate, you'll want to offset the gains next year," Pimco's Steffen said. That's because if you have a loss and a gain in the same year, you'll need to net them against each other for that year. Diversify your tax treatment Savers should already be thinking about owning assets in accounts with varying tax treatment. That is, taxable, tax-deferred and tax-free accounts. Having a mix of all three helps savers manage their tax bills in retirement as they draw down income. Tax-deferred accounts, like 401(k) plans and traditional individual retirement accounts, and tax-free accounts – such as Roth IRAs – may be even more valuable under the Biden proposal, as they would be spared the capital gains hike. Roth IRAs are funded with after-tax dollars, but they accumulate free of taxes. You can also draw down from these accounts tax-free in retirement. Rarely are investment decisions based on one factor alone. Be sensitive, but not driven by taxes. Pimco Tim Steffen, CPA Meanwhile, tax-deferred accounts aren't levied as they grow, but withdrawals are subject to income tax. "Simply put, the greater the tax on any investment, the more valuable asset location becomes because the more you can save yourself," CPA and Buckingham Strategic Wealth chief planning officer Jeff Levine said. As a result, he believes a low-cost variable annuity – which is tax-deferred – with no riders might be attractive for some wealthy investors if the capital gains rate doubles. "Aside from the cost, the biggest argument against variable annuities is that you're turning qualified dividends and capital gains into ordinary income," Levine said. "But if it's already ordinary income, don't tax me now. Tax me at the same rate later in life." Reassess your brokerage account holdings At a time of higher capital gains rates, investors need to pay close attention to holdings that may kick out taxable gains. For instance, mutual funds tend to distribute capital gains to their investors near the end of the year. This results in taxes if you're holding the fund in a taxable account. Actively managed funds are more likely to produce these distributions, as they tend to have higher turnover compared to passively managed funds. Big shareholder redemptions, which force fund managers to sell holdings, can also lead to surprise distributions, according to Morningstar's Benz. "It might be a good idea to use tax-managed equity portfolios, particularly those that track a designated index," Northern Trust managing director John Voltaggio said. These funds aim to rein in capital gains by minimizing portfolio turnover. Be aware that tax-managed funds are helpful when it comes to pushing gains into the future, but at some point you may sell that holding — and that's when Uncle Sam will take his share. "They solve for deferring taxes as long as you hold the money in there," Benz said. "Assuming you sell it and have a profit, you'll still owe on the gain."

President Joe Biden addresses a joint session of Congress at the US Capitol in Washington, DC, on April 28, 2021.

Chip Somodevilla | AFP | Getty Images

The future of President Joe Biden's proposal to raise capital gains taxes on the wealthiest households is uncertain, but accountants are weighing strategies to help mitigate the tax bite.

To help fund his $1.8 trillion American Families Plan – a new stimulus proposal that includes enhanced tax credits for families – Biden is calling for higher levies on capital gains and income for top earners.

He'd like to raise the top rate on income taxes to 39.6% from 37%.

Further, Biden is proposing a hike to the long-term capital gains rate to 39.6%. Currently, the top rate on those gains is 20%. The increase would apply to households making over $1 million.

Accountants don't anticipate a wave of panic selling out of taxable accounts, but they say it's a good time to think about tax strategies.

"People hear 'tax rate increase' and start doing things they otherwise wouldn't do," CPA and Pimco senior consultant of education Tim Steffen said.

"Rarely are investment decisions based on one factor alone," he said. "Be sensitive, but not driven by taxes."

Here are four tax mitigation strategies to consider in a time of higher rates.