Investing

How 'talk about raising taxes' could move the market and affect your investments

"You could see a rush to the exits with investors selling out while they can while taxes are lower."

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Some policy changes are big enough that their mere proposal moves markets. That's what happened last week when news broke that President Joe Biden was planning to unveil a hike to the top capital gains tax rate, a move meant to fund the administration's forthcoming infrastructure plan.

Investors reacted negatively: Major stock indexes shed about 1% on the news.

The move won't result in higher taxes for the vast majority of investors. About 75% of U.S. stock investors hold stocks in tax-advantaged retirement accounts, which aren't subject to capital gains tax, wrote analysts at UBS in a recent note. Among the other 25%, only those making more than $1 million a year will be subject to the higher tax rate. These ultra-wealthy taxpayers represented just 0.3% of tax filers in 2018 — the most recent year for which the IRS has data.

For that small ultra-high-income group, though, the change would be significant. Under Biden's proposal, the rate they'd pay on investment profits would nearly double, from 20% to 39.6%. With the 3.8% Medicare surtax on investment income remaining in place, the top capital gains rate of 43.4% would equal what the wealthiest taxpayers would owe in income tax under the new plan. The rate would be the highest that wealthy U.S. investors have paid on capital gains since the 1920s, and the first time since World War II that the rate breached 33.8%.

But even for investors who make far less than the $1 million a year required for the tax hike, the legislation could make waves in the market, says Jeff Carbone, a certified financial planner and managing partner at Cornerstone Wealth in Huntersville, North Carolina.

"Want the market to move negative? Talk about raising taxes," Carbone says.

Here's what investors need to know.

A quick refresher on capital gains taxes

A capital gain is the profit you earn from selling a taxable investment such as stocks, bonds, or even your home. It's calculated on the difference between the price you paid to acquire the asset and what it's worth when you sell it.

If you hold an asset for a year or less and sell it at a profit, you've realized a short-term capital gain, which the IRS taxes at your regular income-tax rate. To reward long-term investors, the IRS taxes gains on investments held for more than a year at a lower rate, which currently can be 0%, 15%, or 20%, depending on your tax bracket.

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Critics of the tax code point out that under this system, uber-rich investors who live off their investment income can end up paying a lower tax rate than everyday people whose income primarily comes from wage labor. Among the critics (and major beneficiaries) of the current tax code: Warren Buffett, who has famously claimed that he pays a lower tax rate than his office staff as a result of favorable capital gains rates.

Under Biden's plan, the highest earners would see their wage and investment income taxed at the same rate, a reversal of the longstanding paradigm that saw investment returns receive a friendlier tax treatment than money earned through labor.

It remains unclear what exactly the proposed legislation — expected to be unveiled this week — will entail. Experts say the legislation may include exemptions for certain types of taxpayers, such as small-business owners.

Expect some short-term market volatility

Should Biden's plan become law, a move as momentous as doubling the top capital gains rate could roil markets, says Carbone.

"You could see a rush to the exits, with wealthy investors selling out while they can while taxes are lower," he says. "It may not affect you from a tax standpoint, but now your shares are worth less because of a mass exodus."

But that doesn't mean you should be preparing your portfolio for a tax-hike-fueled market downturn, according to Carbone. "You're already seeing markets bounce back from the news," he says. "I think investors understand that the likelihood of passing legislation that would double the rate is maybe low," given the Democrats' razor-thin majority in the Senate.

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Even if markets do react negatively to a capital gains tax hike, it likely won't be for long, UBS Global Wealth Management Chief Investment Officer Mark Haefele wrote in a recent note: "Historically, increases in capital gains taxes have not harmed performance. For example, the last time capital gains taxes went up was in 2013, when they jumped by nearly nine percentage points. Yet stocks rose 30% that year."

Other factors, such as interest-rate moves and corporate earnings growth, have a bigger effect on markets, Haefele says.

Make moves now to minimize your capital gains tax bill

The best thing to do with the news about capital gains tax hikes: "Pay zero attention to it," says Greg McBride, chief financial analyst at Bankrate. "And if the market dips on the news, use it as an opportunity to add to your portfolio."

While most everyday investors won't be affected by this latest capital gains tax hike, it's important to consistently manage your portfolio now to limit your potential for capital gains taxes later.

For most investors, the best way to mitigate the damage is to invest through a tax-advantaged account, such as a 401(k) or IRA, says McBride. "All of those entities, traditional or Roth, are exempt from capital gains taxes."

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If you're investing in a taxable account, holding ETFs, rather than mutual funds, can help you avoid capital-gains surprises. Mutual-fund managers are occasionally forced to sell investments within the fund at a gain, which they then pass on to investors. In the event that this happens, you'll owe capital gains taxes on the fund distribution.

Because of the way they're structured, ETFs rarely pass along gains that cause their shareholders to be taxed. Investment firm CFRA rated 585 stock ETFs from the five biggest ETF firms, and found that only three passed on a gain to shareholders in 2020.

No matter which investment you choose, you'll likely owe taxes on it if you hold it in a regular brokerage account, says McBride. "Whether it's a mutual fund or ETF, if you buy it at one price and sell it at a higher price, you'll owe capital gains tax on it."

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