Daniel B. Eagan, Paul Robertson and Tara Thompson-Popernik
By raising capital-gains tax rates for some investors, the American Tax Relief Act alters the ground rules for tax-aware trading. If your taxable income exceeds $400,000 (single filer) or $450,000 (joint filer), there may now be less trading in your portfolio because each trade must clear a higher hurdle.
Suppose you bought stock QXY four years ago for $40 and it’s now trading at $100. You think stock ABZ in the same industry has greater long-term potential. If you sell QXY, your $60 capital gain will now be taxed at a 23.8% rate, so instead of having $100 to invest in stock ABZ, you’ll have just $85.72 ($100 – [$60 x 23.8%]). In 2012, when the top capital-gains tax rate was 15%, you would have had $91 to invest in the new stock.
A tax-aware investor would want to be sure that the expected return of the new stock justifies the tax cost of selling the old one. Since the tax cost is a certainty and the future return is merely an expectation, we think it’s smart to require an anticipated future return that’s significantly higher.
If ABZ is expected to be a strong performer, it will clear this tax hurdle. The higher capital-gains tax rate raises this hurdle for you from where it was last year. It does not necessarily raise the hurdle for your brother, if his taxable income is less than $400,000 and he still pays the 15% capital gains tax rate. Therefore, some trades that overcame the hurdle last year won’t this year, and some trades that overcome the hurdle for your brother this year will not clear it for you.
Clearly, a one-size-fits-all approach will not be helpful here. To deliver the greatest benefit to the investor, tax-aware trading should be customized to the specific tax rate that will apply. And, as we will discuss in a future blog posting, once you’ve decided that a trade clears the basic tax-cost hurdle, the next step is determining which specific tax lot(s) to sell. Customized analysis should now be extended to that decision, too.
Bernstein does not give tax or legal advice. Taxpayers should consult professionals in those areas before making any decisions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Daniel B. Eagan is Head and Tara Thompson-Popernik is Research Director of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Paul Robertson is Senior Portfolio Manager at Bernstein Global Wealth Management.