President Joe Biden’s capital gains tax plan could compel high-income investors to move money into tax-efficient investments. These include exchange-traded funds (ETFs) and other structured investments that trigger fewer capital gains, as well as setting up Roth conversions (commonly known as backdoor Roth IRAs). Financial experts say that investors are looking for greater flexibility to sell assets and more control over how much taxes will be paid in a specific year. Keeping this in mind, SmartAsset interviewed financial advisors to break down key investment tips that aim to protect your capital.
Minimize Biden Taxes With Tax-Efficient Investments
Generally speaking, when capital gains rates increase, investors move their money into structured investments that give them greater control over how much they will have to pay in taxes.
Some of the most common strategies include holding high-yielding investments inside retirement accounts, which allows them to compound tax-free.
“I am encouraging clients, where feasible, to max out IRA contributions, increase 401(k) contributions, and explore Roth conversions,” said Michael Collins, a chartered financial analyst (CFA) working as a financial advisor with CAPTRUST in Boston.
This is an example of a tax-efficient strategy that focuses on growing capital as a long-term investment. And advisors like Collins tell clients that long-term compounding is a good way to avoid losing money on taxes while continuing to generate growth on investments.
“Albert Einstein reportedly once said, ‘Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it,’” Collins told SmartAsset, referring to maximizing investments in IRAs and 401(k)s. “These strategies can help lower taxable income and allow for long-term compounding to take place.”
When putting together a tax-efficient strategy, financial advisors help clients pick the best types of accounts for their investment needs. These include taxable accounts like brokerages, which allow investors to sell stocks, bonds, mutual funds and other assets while owing taxes on capital gains. Financial advisors also recommend tax-advantaged accounts like IRAs and 401(k)s, which allow capital to continue growing as tax-deferred or tax-free investments.
Investors often combine both taxable and tax-advantaged accounts to diversify their portfolios. But whether they are seeking to save long-term for retirement or earn income for short-term goals, investors are keen on seizing opportunities to minimize taxes so that they could continue growing capital.
Now, as Biden’s capital gains tax plan is poised to raise taxes for high-income earners, financial advisors are looking at alternative investments, which include shifting money from mutual funds to ETFs.
Moving Capital From Mutual Funds to ETFs
Financial advisors say that Biden’s capital gains plan is driving investor attention towards ETFs, which are set up to generate fewer capital gains taxes than mutual funds.
“It is already becoming tricky trying to find any tidbit of an advantage to holding a mutual fund over an ETF, and this is just going to push the process further and faster,” said Simon Brady, a certified financial planner (CFP) who is the founder of Anglia Advisors in New York City.
Brady explains that ETFs generate fewer capital gains taxes because they track the market passively, a strategy that aims to maximize returns by minimizing how frequently assets get bought or sold.
Mutual funds, on the other hand, are actively managed. This means that financial professionals are likelier to buy and sell assets more often. And the tax liability for those capital gains and dividend distributions gets passed on to shareholders.
Financial advisors point out that investors generally know that taxes on capital gains could be owed when they sell an investment. But many are less aware that they will also owe taxes when earnings are distributed as capital or dividends, even when an investment is held.
“Many investors are unaware that they are responsible for gains that a mutual fund generates,” Collins said. “This becomes a non-issue if they are held within tax-exempt or tax-deferred accounts.”
Consequently, the Biden tax plan is also making tax-exempt accounts like Roth IRAs more attractive for high-income investors.
Minimizing Taxes With a Roth IRA Conversion
Investors generally put money into Roth IRAs when they believe their income-tax rate will be higher at the time of retirement. Account holders have to pay taxes up-front, but they can make tax-free withdrawals once they are over the age of 59.5 and have held the account for more than five years.
While taxes on retirement savings are unavoidable, some high-income investors are looking to pay those taxes now as part of a long-term strategy that could protect their capital from potential tax increases.
“This year more investors are interested in exploring a Roth conversion or a backdoor Roth, a strategy where you convert a traditional IRA into a Roth,” said Collins.
Investors should note that Roth IRAs have income limits. Individual taxpayers earning over $140,000 in tax year 2021 and joint filers earning more than $208,000 are not eligible to make contributions. But high-income earners can get around those income limits through a Roth IRA conversion or a backdoor Roth IRA, which is approved by the IRS.
For reference, the table below breaks down Roth IRA income limits for single and joint filers, as well as contribution limits for taxpayers under and over age 50. Limits are based on 2021 IRS requirements:
Single Filer MAGI Joint Filer MAGI Contribution Under 50 Contribution Over 50 Less than $125,000 Less than $198,000 $6,000 $7,000 $128,000 $200,000 $4,800 $5,600 $131,000 $202,000 $3,600 $4,200 $134,000 $204,000 $2,400 $2,800 $137,000 $206,000 $1,200 $1,400 More than $140,000 More than $208,000 $0 $0
Backdoor Roth IRAs convert traditional IRAs or 401(k)s into Roth IRAs. Investors will have to pay taxes up-front for the money they convert into the Roth IRA, as well as the money they earned between the time of opening the original retirement account and when the conversion was made.
Collins says this conversion could pay off as a long-term investment, especially if the tax rate up-front is much lower now than at the time of withdrawal.
“The cost of doing this is paying the taxes today,” he said. “This is appealing if you think your marginal tax rate may be increasing.”
Biden proposes doubling the top rate on long-term capital gains over $1 million from 20% to 39.6%. High-income investors might also have to pay an additional 3.8% net investment income tax (NIIT), which would raise the top rate to 43.4%.
While Biden’s tax plan is making ETF investments and Roth IRA conversions more attractive for high-income investors, financial advisors still caution that investment strategies should not be based on the possibility of future tax changes alone.
“It is letting the tax tail wag the dog,” Brady told SmartAsset, “especially when the likelihood of the changes actually coming into force in the format being currently discussed is relatively remote.”
When it comes to creating a financial plan, advisors say they pick the best types of investments and strategies based on the goals and needs of their clients.
Biden’s capital gains tax proposal still has to be presented and approved by both chambers of Congress before it can be signed into law.
General Tax Planning Tips for All Investors
Biden’s capital gains tax plan could have a significant impact on your finances and taxes, with specific changes on investment income. A financial advisor can help you create a financial plan and optimize your tax strategy for your needs and goals. SmartAsset’s free advisor matching tool connects you with financial advisors in your area. If you’re ready to be matched with local advisors, get started now.
SmartAsset’s free capital gains tax calculator can help you figure out how much you will owe in the 2021 tax year.
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