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Investment Strategy

November 08, 2021

Capital Gains Tax Sensitivity in a Goals-Based Framework

The following is a summary of a Glenmede Investment Strategy white paper that examines the potential impact on the probability of success of goals-based wealth plans for certain types of high-net-worth investors. These investors are likely to be affected by proposals to increase the tax rate on long-term capital gains. Click here to download the full whitepaper.

The Biden administration’s Build Back Better Act proposes a significant investment in America’s “social infrastructure.” To help offset the costs of these programs, some politicians have proposed raising the tax rate on long-term capital gains for households earning more than $1 million annually by creating a new bracket on top of the existing system.

Current and Proposed Capital Gains Tax Brackets

What would be the impact of higher capital gains taxes on the wealth plans of those high-net-worth individuals and families most affected by this tax change? We use a goals-based investing framework to tangibly measure probability of success sensitivity, a metric that can effectively gauge the impact of specific tax scenarios, as paired with various investment strategies.

Given the uncertainty surrounding the timing of the proposed capital gains taxation rules, we measure the general sensitivity of wealth plans to various levels of effective capital gains tax rates (ECGRs). This approach allows for the flexibility of estimating the general effects of a spectrum of potential tax outcomes.

It is important to note that not all investors have the same asset allocation targets for their investment portfolios: some target higher-risk/higher-return portfolios, while others prefer stability with lower returns. Since asset allocation can be a material factor in calculating sensitivity to changes in ECGRs, each sensitivity analysis is conducted for six hypothetical Enhanced Core+ Taxable* portfolios in a risk spectrum ranging from Capital Preservation (lower risk, lower return) to Growth (higher risk, higher return). The table above shows the asset allocation details for each portfolio in this risk spectrum, assuming annual rebalancing back to target weights.

Several hypothetical investor archetypes are analyzed through this process, each meant to be a basic representation of a typical high-net-worth investor type:

  • Imminent Retiree
  • Large Inheritor
  • Retirement Prepper
  • Young Business Owner
  • Senior Executive Nearing Retirement
  • Divesting Business Owner
  • High Earner

A few assumptions are made in the process.

  • No active tax management strategies are used, including tax loss harvesting to offset capital gains.
  • The taxation of qualified dividends is unchanged, though under current U.S. law qualified dividends receive the same tax treatment as long-term capital gains.
  • All state-level taxes are assumed to be unchanged and all archetypes are couples living in Pennsylvania and filing taxes jointly.
  • The thresholds for statutory capital gains brackets grow at a 2.2% inflation assumption per year.

As a general reference point, in terms of the probability of success for a goals-based wealth plan, Glenmede highlights the 85% probability of success threshold as a level at or above which investors should generally feel comfortable with the plan’s results. Results below the 85% mark may be a cause to consider revising assumptions, which may include but are not limited to lower spending and/or postponed retirement. The analysis conducted for each archetype is hypothetical, whereas actual sensitivity analyses utilizing the same methodology conducted for actual investors with similar financial circumstances may differ materially and produce results different from those summarized below.

Imminent Retiree

The Imminent Retiree couple (each spouse age 65) is ready to retire immediately with one goal — to maintain their standard of living. For this couple, that includes $325,000 in pretax expense on an inflation-adjusted basis through age 95. The couple has $8.5 million in investable assets to meet this goal, which includes a combination of cash savings, taxable investment accounts and retirement accounts.

Generally, if measured by the change in probability of success, the Imminent Retiree’s sensitivity to ECGR appears low. A 5–10% increase in ECGR translates to a 1–2% decline in probability of success, regardless of the investment portfolio’s risk posture. However, it is unlikely that a new $1 million capital gains tax bracket would, on average, be a factor that affects the Imminent Retiree. In most of the portfolio risk spectrum, this archetype does not even qualify for the top bracket under current law.

Large Inheritor

The Large Inheritor couple is relatively young (each spouse age 45) and would like to maintain their standard of living ($200,000 in pretax expenses) in retirement, beginning at age 65. Until retirement, they earn wage income of $200,000 per year. The couple has $4 million to meet this goal, mostly in a taxable investment account, as well as a cash savings account and 401(k)s.

Generally, if measured by the change in probability of success, the Large Inheritor’s sensitivity to ECGR appears moderate. A 5–10% change in ECGR translates to a 3–6% decline in probability of success. However, this sensitivity to ECGR pales in comparison to the Large Inheritor’s sensitivity to portfolio selection. The largest risk they face would be failing to invest in a majority risk-asset portfolio. Since they are spending right around as much as they earn before retirement, the Large Inheritor should not expect material cash flows into their savings from their wages. As a result, they will rely solely on the compounding of existing savings to meet their spending goals in retirement.

Much like the Imminent Retiree, it is unlikely the Large Inheritor would qualify for a new top capital gains bracket set at the $1 million threshold.

Retirement Prepper

The Retirement Prepper couple (each spouse age 55) are late-career professionals earning a combined $650,000 per year. They anticipate retiring at age 65 and have one goal, to maintain their standard of living up to and through retirement. This includes $600,000 in pretax expenses on an inflation-adjusted basis through age 95. The couple has $15.5 million in investable assets, including cash savings, taxable investment accounts and retirement accounts.

If measured by the change in probability of success, the Retirement Prepper’s sensitivity to changes in ECGR appears low. A 5–10% increase in ECGR translates to a 1–2% decline in probability of success, regardless of the risk posture of the investment portfolio.

For a Retirement Prepper using a Growth w/ Income, Growth w/ Moderate Income or Growth strategy, it is likely they would qualify for a new top capital gains bracket set at the $1 million threshold in their preretirement stage and/or once required minimum distributions (RMDs) kick in around age 72.

Young Business Owner

The Young Business Owner couple are early-career professionals (each spouse age 40) with a combined wage income of $1 million per year. They would like to retire in 25 years and maintain their standard of living up to and through retirement ($450,000 in pretax spending, adjusted for inflation). The couple has $8.15 million in assets, including cash savings, taxable investment accounts and retirement accounts, but is dominated by a $5 million stake in a closely held business.

If measured by the change in probability of success, the Young Business Owner’s sensitivity to changes in ECGR appears low. A 5–10% increase in ECGR translates to a 1–2% decline in probability of success, regardless of the risk posture of the investment portfolio. The Young Business Owner can expect to qualify for a new top capital gains bracket set at the $1 million threshold in their preretirement years and in the last few years of the planning horizon if using a Growth strategy.

Senior Executive Nearing Retirement

The Senior Executive Nearing Retirement couple (each age 60) earns a combined $1 million per year and anticipates retiring in five years. During retirement, they would like to maintain their standard of living, which includes $850,000 in pretax expenses grown at inflation over time. The couple has $25 million in investable assets, with a large share of those assets held in a concentrated position of low-cost-basis stock, which is assumed to behave like a typical U.S. small cap stock carved out from the rest of the portfolio.

If measured by the change in probability of success, the Senior Executive Nearing Retirement exhibits low sensitivity to ECGR changes. A 5–10% increase in ECGR translates to a 1–2% decline in probability of success, regardless of the risk posture of the investment portfolio. The Senior Executive Nearing Retirement can expect to qualify for a new top capital gains bracket set at the $1 million threshold in their preretirement years and once RMDs kick in around age 72. From there, asset allocations with less risk (i.e., capital preservation) are more likely to face the higher threshold, as the portfolio depletes faster and the low-cost-basis concentrated positions must be liquidated to meet spending needs.

Divesting Business Owner

The Divesting Business Owner couple (each spouse age 65) is ready to retire immediately and contemplating strategies for selling their business. They have two options: the upfront sale of the business or a 10-year installment sale, which spreads the proceeds over multiple years. The couple’s goal is to maintain their standard of living through retirement of $650,000 pretax annual spending adjusted for inflation. They have $19 million in assets, which includes a cash account, taxable investments and retirement accounts, though the business represents more than half of their assets, valued at $10 million.

This sensitivity analysis is structured a bit differently. In a normal year, the Divesting Business Owner couple does not come close to qualifying for a new $1 million capital gains bracket, but they would almost certainly face it around the sale of their business. The upfront sale of the business would face the new capital gains bracket for the first year only, but with a large share of the sale subject to the highest possible tax rate. In contrast, the installment sale would face the top bracket for 10 years, but spreading it out resets the portion taxed at lower brackets every year.

Interestingly, in the default scenario (assuming capital gains taxation structure continues under current law), selling the business upfront yields a higher probability of success. It appears the large initial capital gains bill is outweighed by the benefit of receiving the full proceeds and reinvesting it into a diversified portfolio more quickly. In addition, the incremental benefit of the upfront sale decreases as the allocation to risk assets increases.

On the other hand, reworking the capital gains taxation rules reverses the more optimal choice via probability of success. In this scenario, the initial tax cost of selling all at once at the higher rate becomes too punitive relative to the offsetting benefit of getting invested in a diversified portfolio. The incremental benefit of the installment sale decreases as the allocation to risk assets increases.

High Earner

The High Earner couple (each spouse age 60) earns $2 million wage income per year and has pretax expenses of $1.5 million, both on an inflation-adjusted basis. They would like to retire in five years and maintain their standard of living up to and through retirement. The couple has $46 million in assets, held mostly in taxable investment accounts, with some in cash savings and retirement accounts as well. Outside of their estate, they have $25 million in intentionally defective grantor trusts (IDGTs), for which they pay the tax bill but do not currently receive income or principal distributions.

If measured by the change in probability of success, the High Earner’s sensitivity to changes in ECGR appears high. A 5–10% increase in ECGR can translate anywhere from a 4% to 36% decline in probability of success. There is a real risk to probability of success for the Higher Earner, with a planning goal of significant scale relative to the size of their assets. In reality, if they were facing real risk to their ongoing spending habits, they could consider taking distributions from the IDGTs so those assets could be used to meet their remaining spending goals. This is just one example among many estate planning techniques that could help investors of this scale overcome the punitive impacts of higher capital gains tax rates.

Conclusions

What conclusions can we draw from this sensitivity analysis?

  • Higher ECGRs are a headwind to the long-term compounding of assets. To the extent that an investor relies solely on the compounding of assets to meet goals, he or she may exhibit higher sensitivity.
  • Some investors that had an 85%+ probability of success for their wealth plans under current tax law may dip below that key threshold due to the costs associated with higher capital gains rates.
  • Even among the cohort of high-net-worth individuals and families, many are unlikely to qualify for a new capital gains tax bracket at the $1 million threshold.
  • Some may find themselves subject to a new $1 million+ bracket only in specific stages of their lives (e.g., wage-earning years, pre-RMD retirement, post-RMD retirement, sale of business).
  • Younger individuals or families are typically more sensitive than those in or near retirement, as higher ECGRs are an incremental headwind to the compounding of taxable assets over time.
  • Those who are dependent on an existing pool of investment assets with few ongoing savings flows into their portfolios (like inheritors) exhibit higher-than-average ECGR sensitivity.
  • The share of assets in retirement plans (e.g., IRAs, 401(k)s, 403(b)s) can reduce the share of cash flows subject to capital gains rates, though large RMDs can push some into higher brackets.
  • Higher ECGRs can change the calculus on the attractiveness of installment plans used for the sale of closely-held businesses.
  • The most affluent appear to have the largest sensitivity to rising ECGRs and will perhaps benefit most greatly from proactive estate planning and tax avoidance strategies.

A goals-based investing framework provides a way to tangibly measure the sensitivity of holistic wealth plans in an easily understood metric — probability of success. It is important for investors to understand the circumstances under which they would qualify for a new capital gains tax bracket. For many investors, a new bracket should have no impact at all. For some, it may play a role in only certain stages of their lives. Others may face this novel cost on a consistent basis. In any case, armed with this knowledge, a team of Glenmede investment and wealth professionals is prepared to help individuals and families navigate the path forward for their wealth.

For more information on how rising capital gains tax rates can affect your unique financial circumstances, please reach out to a member of your Relationship Team.

 

 

*Enhanced Core+ refers to a group of Glenmede’s proprietary investment models for investors seeking a diversified portfolio with public market investment vehicles, including equities, fixed income, real estate, absolute return and cash. The Taxable models are optimized for investors that are subject to income and capital gains taxes.

 

This presentation is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.