Figure 1. Active Tax Benefit under Different Capital Flow and Tax Rate Assumptions
There are two basic ways to invest in a stock market index: you can buy an index fund, or you can directly buy a stock portfolio that tracks the index. If you are a taxable investor, a benefit of the direct approach is that you can harvest losses on individual positions. But how high are those benefits—and what happens to them under the proposed Biden Tax Plan?
Our new paper takes a look at this by digging into three important questions:
1) What kinds of investors are most likely to benefit from direct indexing?
2) How well do these benefits hold up over time?
3) What would the proposed Biden Tax Plan 1 1 Close For high-income taxpayers, the Biden administration proposed to increase the highest bracket tax rate, tax long-term capital gains at the same rate as short-term capital gains, eliminate the step-up in cost basis upon death for assets passing through estate, and even tax all the unrealized gains upon death if the asset is not donated to charity. mean for their efficacy?
First, we show that investors with regular short-term gains from their other investments are likely to derive the biggest benefit from direct indexing. (We present evidence that such investors might be predominantly high-net-worth investors with allocations to hedge funds and derivatives). How much lower is the tax benefit for investors with only long-term gains? Let’s start with the left-most chart in Figure 1, 2 2 Close Figure 1 presents the same data as Figure 1 in the paper. which is based on historical simulations of a direct indexing strategy. For investors who don’t regularly add capital to the strategy, the difference in tax benefit between having short-term gains (purple line) and having only long-term gains (green line) from other investments is 2% in the first year!
Second, as time progresses, after approximately five to six years, the presence of regular short-term gains can make a difference between a positive tax benefit and a small tax liability. 3 3 Close A direct indexing strategy builds up unrealized gains due to the deferral of gains in earlier years. While this is generally beneficial for an investor, a consequence is that after a few years, rebalancing the strategy (e.g., to stay within a certain tracking error of the index) may cause the strategy to realize more gains than losses and result in a tax liability rather than a tax benefit. While many investors familiar with direct indexing strategies expect their tax benefits to decay over time and to be generally lower in the absence of short-term gains from other investments, Figure 1 shows just how striking the impact is.
The last issue we tackle in the paper is the impact of the Biden Plan’s proposed higher tax rates on long-term capital gains and elimination of the step-up in cost basis upon death. We use a tax rate of 43.4% (the tax rate proposed under the Biden Tax Plan for the top income bracket) for all capital gains. Sticking with the left-most chart in Figure 1, the Biden Tax Plan (red line) makes all investors look more like investors who only have long-term capital gains under the current tax regime. This makes sense: under the proposed plan, high-income investors would no longer benefit from the difference between short-term and long-term capital gains tax rates—for them the two rates will be equal.
Finally, we show how investors might be able to do better in terms of their tax benefits: 1) by contributing capital over time or, 2) by combining the strategy with a charitable giving program. 4 4 Close By combining the strategy with a charitable giving program an investor donates the most appreciated positions to charity and replaces them with new capital. Regularly contributing capital to a direct indexing strategy (the middle chart) can increase the tax benefit in later years to positive territory, even for investors with only long-term capital gains from other investments. Incorporating a charitable giving program (the right-most chart) provides a meaningful bump to all investors and in all tax regimes, but especially under the Biden Tax Plan, where the build-up of unrealized gains, which results from systematic gain deferral, becomes materially less punitive because investors are able to donate appreciated positions.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially and should not be relied upon as such. This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. You should conduct your own analysis and consult with professional advisors prior to making any investment decision. Changes in tax laws or severe market events, among various other risks, as described herein, can adversely impact performance expectations and realized results.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Information contained on third party websites that AQR Capital Management, LLC, (“AQR”) may link to are not reviewed in their entirety for accuracy and AQR assumes no liability for the information contained on these websites.
This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.
Risks of Tax Aware Strategies (Not Exhaustive)
1. Underperformance of pre-tax returns: tax aware strategies are investment strategies with the associated risk of pre-tax returns meaningfully underperforming expectations.
2. Adverse variation in tax benefits: deductible losses and expenses allocated by the strategy may be less than expected.
3. Lower marginal tax rates: the value of losses and expenses depends on an individual investor’s marginal tax rate, which may be lower than expected for reasons including low Adjusted Gross Income (AGI) due to unexpected losses and the Alternative Minimum Tax (AMT).
4. Inefficient use of allocated losses and expenses: the tax benefit of the strategy may be lower than expected if an investor cannot use the full value of losses and expenses allocated by the strategy to offset gains and income of the same character from other sources. This may occur for a variety of reasons including variation in gains and income realized by other investments, at-risk rules, limitation on excess business losses and/or net interest expense, or insufficient outside cost basis in a partnership.
5. Larger tax on redemption or lesser benefit of gifting: gain deferral and net tax losses may result in large recognized gains on redemption, even in the event of pre-tax losses. Allocation of liabilities should be considered when calculating the tax benefit of gifting.
6. Adverse changes in tax law or IRS challenge: the potential tax benefit of the strategy may be lessened or eliminated prospectively by changes in tax law, or retrospectively by an IRS challenge under current law if conceded or upheld by a court. In the case of an IRS challenge, penalties may apply.