Figure 1. Active Tax Benefit under Different Capital Flow and Tax Rate Assumptions
Tax Aware
Direct Indexing and the Proposed Biden Tax Plan
June 9, 2021
Topics - Tax Aware
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
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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,
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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.
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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.
Disclosures
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. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper 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. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. 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.
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