President Obama's tax proposal: What equity investors need to know

Taxes may rise on capital gains and dividends, so how can investors be prepared?

Author: Michael A. Allison

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Feb 11, 2015, 05:30 ET

BOSTON, Feb. 11, 2015 /PRNewswire/ --

Over the past week, President Obama has outlined several significant tax increases that could impact equity investors in the future. From our perspective as tax-managed equity managers, the most important proposal is one that calls for higher maximum rates on long-term gains and dividends. Although the likelihood of these tax increases gaining approval in Congress appears to be very low, President Obama's proposal shows that future tax hikes, particularly around investment income, are possible.

What did the president announce?

Among several proposals, President Obama is calling for the top capital gains and dividend rate to increase to 28%. Currently, the maximum tax rate on long-term capital gains and qualified dividends is 24.99%, which includes the 3.8% Medicare surtax on net investment income for high income earners as well as a 1.19% for limitations on itemized deductions. Details on this proposal are still emerging, so it is unclear as of this writing if the proposed maximum rate of 28% includes the Medicare surtax.

In a statement from the White House, these tax increases are billed as a return to the rate under President Reagan. Recall that the American Taxpayer Relief Act of 2012 raised the highest tax rate on long-term capital gains and dividends from 15% to 20%. If this proposal were to be passed by Congress, the maximum tax rate on long-term gains and qualified dividends will have increased by almost 87% during President Obama's time in office. This can have a major impact on the long-term growth of an investment portfolio.

What should investors do?

Even if these recent proposals are dead on arrival, we think it's clear that taxes on investment income are squarely in the crosshairs, no matter who is in office. For that reason, investors, particularly those in the highest tax brackets, should be aware of the heightened value and importance of tax-managed equity investing. These investors may want to consider a combination of valuable tax management techniques used by tax-managed equity funds that may help mitigate increases in tax rates.

These techniques, which may help investors reduce the tax burden and protect their wealth, include:

Buy and hold
Using a long-term perspective when investing can delay capital gains recognition. The incentive to do so is higher, as long-term gains are taxed at a lower rate than short-term gains. This technique can also help keep unnecessary turnover low, potentially minimizing short-term gains.
Tax-loss harvesting
Using tax-loss turnover in a disciplined fashion to harvest losses can help offset gains taken elsewhere in the portfolio. Essentially, this means a fund will unload some shares to intentionally realize a capital loss to offset capital gains.
QDI
Tax-managed equity funds typically follow holding period rules to have any dividends qualify to be taxed at the lower qualified dividend income (QDI) rate.
Tax lot selling
Specific lot accounting is a strategy tax-managed equity funds can use to help minimize capital gains realizations. By selling shares with the highest basis first, investors may minimize capital gains.
Buy and hedge
Funds may also use tax-advantaged hedging techniques as alternatives to taxable sales in order to manage gains and losses, potentially maximizing after-tax returns.

It's time to consider tax-managed equity investing

While higher taxes may be particularly painful for high-income earners, the reality is, the tax increases have a much broader effect due to increases in capital gains distributions. Investors should be aware that they may be overlooking taxes in their pursuit of pretax excess returns. As a result, negative tax consequences frequently wipe away pretax alpha, or excess return relative to a benchmark.

Given the recent increase in capital gains tax rates and the possibility they may increase in the future, taxable investors should consider active tax management in their portfolios. Tax-managed investing may help defend against the tax drag on equities. Given the cyclical nature of capital gains, tax-managed equity investing may provide several advantages, including:

It can help cushion the effect of recent (and possible future) increases in income tax and capital gains rates.
A long-term, buy-and-hold strategy with appreciated stocks can reduce the frequency and dollar value of capital gains distributions, and the rate at which they are taxed.

Disclosure

Eaton Vance does not provide legal or tax advice. This material is not intended to act as such advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel prior to investing.

Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance.

About Risk

Equity investing involves risk, including possible loss of principal. Investments in equity securities are sensitive to stock market volatility. The ability to utilize various tax-managed techniques may be curtailed or eliminated in the future by tax legislation or regulation. Market conditions may limit the ability to generate tax losses or to generate dividend income taxed at favorable tax rates. There is no assurance or guarantee that any company will declare dividends. There is also no assurance or guarantee that, if declared, dividends will remain at current levels or increase over time. There is no assurance that the objective of any investment strategy will be met. Diversification cannot ensure a profit or eliminate the risk of loss. Past performance is no guarantee of future results. Indexes are unmanaged. It is not possible to invest directly in an index.

About Eaton Vance

Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company's long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today's most discerning investors. For more information, visit eatonvance.com.

The views expressed are those of the authors and are subject to change at any time based upon market or other conditions. Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

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