Protecting Your Portfolio from the Tax Man

Audio Description

Bernstein's Director of Wealth Strategies, Bob Dietz, joins The Pulse to discuss the potential for taxes to rise, the latest happenings in Washington, and how investors can protect their portfolios from unnecessarily high tax bills.


00:03 - 00:29

Matt Palazzolo

Hi, everybody, and welcome to The Pulse, where we cover trends in the economy, markets and asset allocation for long-term investors. I'm Matt Palazzolo, Senior Investment Strategist at Bernstein. And today we're going to be discussing a topic that likely impacts every single listener, and that topic is taxes. So joining me today to discuss the fluid tax legislation landscape is Bob Dietz, director in our Wealth Strategies Group at Bernstein. So, Bob, this is your first time on the show. Welcome to The Pulse.

00:29 - 00:30

Bill Dietz

Yeah, thanks, Matt.

00:30 - 00:54

Matt Palazzolo

Bob, we're glad to have you, particularly given what's been going on, how many conversations everybody's having about taxes. There seems to be a lot of press on this topic lately. And the proposals of interest to many of our listeners are those that would increase taxes on both corporations and on capital. Could you provide some insight? Let's level set everybody into what are the proposals that are currently on the table.

00:54 - 02:12

Bill Dietz

Yeah, Matt, so broadly, the proposals really can be divided into three categories of tax increases. So we have corporate, individual, and wealth transfer tax increases. Now, from a corporate tax perspective, the Biden administration's opening proposal was to increase the tax rate from 21 percent to 28 percent. In addition to increasing the rate, the administration is proposing reforms aimed at addressing profit shifting and offshoring incentives, as well as the 15 percent minimum book tax on accounting income of businesses. Now, this would affect businesses with net income over two billion dollars. So by most reports, that would affect 45 companies based on what we're looking at. I do want to point out, though, that as negotiations have begun, the administration does seem to be willing to leave that corporate tax rate at 21 percent, provided the Republicans agree to this 15 percent minimum book tax. And then also recently, I'd say a bipartisan group of lawmakers has come forward with opposition to really any tax increase. So I think what you're going to see is if we do see tax increases, they're probably going to be far tamer than what the Biden administration has originally proposed.

02:12 - 02:38

Matt Palazzolo

So, Bob, you mentioned early on in your answer, corporate tax increases, individual income tax increases, and wealth transfer tax increases. You just covered the corporate tax proposal. Twenty-one to 28 percent and this 15 percent minimum book tax. By the way, I didn't know that that would only affect 45 companies. That's great insight. We appreciate that. But let's move to the individual income tax increases. What is the landscape? Look there, what's being proposed and let's flesh that out.

02:38 - 03:41

Bill Dietz

So for your listeners, I think the president's proposal to reform the taxation of capital gain income would be probably the most significant impact that they'll see. And it's really a two part proposal. The first part of the president's proposal would nearly double the tax rate on long-term capital gains and qualified dividends to 40.8 percent. Now, this would affect only taxpayers with more than a million dollars of adjusted gross income. And under the president's plan, this increase would actually be retroactive back to April 28th of this year. So what that effectively means for a single filer or a married couple with AGI over a million dollars is they're looking at a 23.8 percent top rate from January 1st to April 28. And then a 40.8 percent rate would apply for the rest of the year. Now, a separate proposal would then bump that tax rate up even further to 43.4 percent in 2022. That's the first part of the proposal.

03:41 - 04:25

Bill Dietz

The second part of the proposal imposes a deemed recognition of gain on assets when they're transferred either at death or by [...]. So as many of your listeners know, under current law, assets that are held at a gain upon death receive a step-up in cost basis, which effectively eliminates that unrealized gain. Now, essentially what's happening there, right, is the cost basis is getting adjusted to the assets' market value on the date of death, and, of course, in certain circumstances, six months after the date of death. The president is proposing, however, to limit that step-up in cost basis to the first one million dollars of unrealized gains, with any excess taxed at 43.4 percent.

04:25 - 04:38

Matt Palazzolo

So there's obviously a lot in there and I'm still stuck on the retroactive. Let me go back to that. Is there any precedent as we look back in history to make tax legislation retroactive to an earlier date and time?

04:38 - 05:13

Bill Dietz

Yeah, you know, this has been looked at by constitutional scholars across the board. And there are arguments both ways. And I will tell you that when we've looked at it, we have seen historical cases where there has been retroactively effective tax legislation. I think going back to the date of when the proposal was first announced, which is what the president is proposing, that is actually much more common, I think, than most people realize. And so that's definitely something that should be taken serious and something that we shouldn't just overlook or brush under the table as a fairy-tale type proposal.

05:13 - 05:35

Matt Palazzolo

OK, so fairly significant tax increases being proposed by the Biden administration against corporate tax increases, individual income tax increases, wealth transfer, tax increases. We don't we haven't talked about that yet, but let's try and handicap the tax increases. I don't want to put you on the spot and ask you to put a probability weight on this, but how likely is it that these proposals become law?

05:35 - 06:10

Bill Dietz

I think it's highly unlikely that we're going to see tax increases anywhere near what the Biden administration is proposing. And that's really because the margin that the Democrats have in both the House and the Senate are razor thin. So the reality is right now, the power is really with the moderate Democrats. Now, these are very bold tax proposals being put forward by the president, and they may become a reality at some point in the future. But right now, the thin margins in both chambers really point to something much more moderate than the proposals that I just outlined for you.

06:10 - 06:20

Matt Palazzolo

What's the time frame that you think this legislation could become law? Is this going to happen in 2021? Does it push down to 2022?

06:20 - 07:00

Bill Dietz

Yeah, that's a great question, Matt. I think we're looking at the fourth quarter now. If you had asked me this question just a few weeks ago, I would have told you that we were expecting to see legislation this summer. But what happened is the Senate parliamentarian ruled in effect that Republican cooperation would be required to get any further legislation adopted in fiscal year 2021. Now fiscal year 2021 ends September 30th. So kind of in a nutshell here, what's happened is we don't think that reconciliation will be possible until fiscal year 2022.. So that starts in October. So that's something to look forward to. But I think we're probably looking at Q4 at this point.

07:01 - 07:13

Matt Palazzolo

I assume that that's something some, not all, some of the Democrats take issue with, doing it so far out, not this summer, but doing it potentially later in the year. Are there any options that those Democrats have at this point in time?

07:13 - 08:11

Bill Dietz

Yes, there are several different options for the Democrats. And so let me walk through them one by one here. The first option would be just to push forward with a single comprehensive bill in the fourth quarter when budget reconciliation becomes available again. Now, the problem with this is we're talking about a massive bill that would include both the American Jobs Plan, which is really focused on the infrastructure and transportation, and then the American Families Plan, which is really focused more on social initiatives. Now, the bill would come with a hefty price tag and then also certain expenditures that the Republicans and even some Democrats are likely to oppose. And so with these razor thin margins, I think the Democrats may struggle to craft a package that would be acceptable to majorities in both the House and the Senate. And I suppose another option would be to compromise with the Republicans on a bipartisan infrastructure bill this summer and save really the other pieces for a catchall reconciliation bill in the fourth quarter.

08:12 - 08:44

Bill Dietz

Now, this would mute some of the sticker shock of a more comprehensive bill, which would make the strategy more politically acceptable, but it also carries risks. I mean, you pointed out one of those risks, which is potential backlash by some elements of the Democratic Party that want to see these bold policies move forward much quicker than what's being advertised here. I'd also say the other thing to remember is the ruling or advice from the parliamentarian can also be overruled. It's merely advisory.

08:45 - 09:28

Bill Dietz

Now, what we saw earlier in the year was President Biden and Senate moderates being unwilling to really kind of move in that direction. And that was really in the wake of the parliamentarian's opinion that the $15 per hour federal minimum wage could not be part of the American Rescue Plan Act. And so I'd say finally, the Democrats could change the filibuster rule. That's always a possibility, because, as you know, under current Senate rules, the votes of 60 senators are required to end debate on any pending measure. And so the Democrats could modify this requirement using one of several different mechanisms. But it's unclear whether they'll have the political will to do that.

09:28 - 10:02

Bill Dietz

And to be quite frank, there is political advantage to leaving the current rules in place. For example, if a bill fails because you didn't receive 60 votes, it's very easy to blame the other party. But if it fails because it's so controversial that you could not gather, say, 50 votes from your own party, well, that can have some pretty strong political repercussions. So changing the Senate filibuster rules really requires you to know in advance how the game is going to end up before it's played. And that's tough when you can't really afford to even lose a single vote. I think that answer highlights

10:02 - 10:47

Matt Palazzolo

how complicated this whole thing is. Before we let you go now, I want to ask the question: You go out and certainly over the last couple of months you've been traveling around through Zoom, I guess, talking to many of our clients, along with my colleagues on the investment side, related to what to do for those individuals who are potentially right in the crosshairs of these tax increases or have a big tax year because they sold a business or something like that. So what are my colleagues on the investment side, together with your insights on the tax side, proposing to clients in this year or in 2022? And I guess always for anybody who is a high tax individual, what are the right strategies to try and mute the impact of taxes on after tax return?

10:48 - 11:33

Bill Dietz

Yeah, that's a great set of questions. So I would say, although the legislative landscape is still very unclear, taxpayers really should continue to evaluate various strategies and implement proactive tax-saving strategies where appropriate. So let me give you a few examples. Going forward, I think investors should be considering more of a systematic portfolio loss-harvesting strategy as part of their core allocation. And then you also would pair that with investments through low-cost, privately placed life insurance policies. And that's where you would house more of your actively managed portfolios. And this, of course, would require you to be a qualified purchaser. So assuming you're a qualified purchaser, you'd have access to those types of vehicles.

11:33 - 12:07

Bill Dietz

But the idea here is that the systematic portfolio loss-harvesting strategy, it has a very low turnover rate and the loss harvesting makes these portfolios much more tax efficient. And then, on the other hand, with your actively managed portfolios, which tend to have a much higher turnover rate, when you hold these portfolios in a low-cost life insurance policy, you're able to shelter the gains from income taxes because no taxes are due until you actually make a withdrawal earnings from the life insurance policy.

12:07 - 12:37

Bill Dietz

The other important piece that life insurance can play here is the death benefit is paid out income tax free. You can almost think of that as a synthetic step up in cost basis. So if we do lose the ability to get that step up in cost basis, investing through life insurance can be an alternative to that. Again, to do this successfully, you can't just do it with any life insurance policy. You've got to run the analysis and make sure the fees and expenses are well below the tax benefit that's being provided.

12:37 - 13:09

Bill Dietz

And so that's something that you want to make sure you're using a, well, strategist or an analyst to help you with some of the other strategies that we find very interesting right now include qualified opportunity funds from a pre transaction standpoint, charitable remainder trusts look very interesting to us. And then after a transaction, looking at a charitable lead annuity trust to help capture some upfront deductions can be very attractive. Then, of course, qualified small business stock as well. These are all great strategies depending upon the investors facts and circumstances.

13:09 - 14:00

Bill Dietz

And finally, we haven't really talked about wealth transfer taxes and the proposals there. And that's really because we don't at this point see anything that's probably going to happen in 2021 when it comes to [...] estate tax at this point. But I would still argue that these are on the table into the future and so you shouldn't just stop your planning. Many of our clients are using trust structures and transferring up to $11.7 million off of their balance sheet to lock in that $11.7 million basic exclusion. That's the amount that you can transfer without triggering a gift tax. And the risk is that that's going to decrease either from a future proposal or potentially just under current law. It's set to be reduced to about five to six million after 2025.

14:00 - 14:58

Matt Palazzolo

Again, there's a lot there, but portfolio tax loss harvesting to offset gains that inevitably occur elsewhere in somebody's account, taking income-producing, higher returning vehicles and then putting them inside of a structure that shields that income from taxes. And then you pointed out a number of trust structures that could be helpful for high tax individuals, either before a business sale or unrelated to a business sale. So a lot to think through for any of our clients alongside their Bernstein adviser, and to work in coordination with your team, Bob, the Wealth Strategies team, to think through and to actually model some of the proposals that the advisor is making to see whether or not they would make sense and whether or not you can trade off this for that. So, Bob, we're going to have to leave it there. This certainly on taxes is a fluid situation as these negotiations often are. Assuming you're right about the timing. We're going to have to check back with you as we get closer to the fourth quarter. But I just wanted to thank you on behalf of our listeners for joining us today and sharing your insights.

14:58 - 14:59

Bill Dietz

Yeah, you're welcome. And thanks for having me.

14:59 - 15:02

Matt Palazzolo

And thanks to all of you for listening. If you have enjoyed this

15:02 - 15:18

Matt Palazzolo

podcast, please subscribe and rate us on Apple Podcasts or Google Play, Spotify, or wherever you listen to podcasts and e-mail us with your thoughts or questions or any feedback you might have to and be sure to find us on Instagram and Twitter at BernsteinPWM. So thanks a lot

15:18 - 15:29

Speaker 3

And Bewell Bernstein making money meaningful for individuals, families and foundations for over 50 years. Visit us at Bernstein Dotcom.

Matthew D. Palazzolo
Senior National Director, Investment Insights—Investment Strategy Group

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