As the U.S. election nears, investors may want to consider potential tax policy scenarios based on different election outcomes, especially with the 2017 Tax Cuts and Jobs Act scheduled to end in 2025. The makeup of the White House and Congress will likely determine how tax and other policy decisions are resolved. To prepare, investors should evaluate the impact of different election outcomes relevant to their individual circumstances. Let’s take a closer look.
Higher tax rates lead to lower after-tax returns for taxable investors, assuming other factors remain constant. The impact can be directly seen in dividends, where a higher rate leads to a lower net dividend received. Increased capital gains taxes also impacts returns, but depends on variables like unrealized gains and losses, portfolio turnover, and market performance. However, taxes are just one part of a total return. Holding onto investments can defer gains but may introduce risks like tracking error against a benchmark or an overconcentrated portfolio. If capital gains taxes rise, selling assets becomes more costly while realizing losses becomes more beneficial. Carefully assessing these tradeoffs at the individual security, and the aggregate portfolio level, can help investors make strategic adjustments as needed.
While it may be premature to act before tax policies of the next administration are clear, investors may question if they should realize long-term gains prior to a potential increase in the capital gains tax. The answer depends on several variables and investor-specific details such as estimated market returns, time horizon, cash needs, and diversification needs. Historically, we’ve found that the results are highly dependent on inputs such as market rates of return and future cash flow needs. Because predicting these factors is challenging, we recommend a thorough analysis of each investor’s unique situation.
Since municipal bonds are exempt from federal taxes, an investor’s marginal tax rate plays an important role in their relative appeal. This rate directly determines the pretax yield a municipal bond would offer if it were taxable, making its yield comparable to taxable bonds. As a result, the tax-equivalent yields for municipal bonds are higher than their actual yields. This tax advantage means that all else being equal, a higher income tax rate actually increases the relative attractiveness of municipal bonds compared to taxable alternatives.
As the U.S. election decision approaches, potential tax changes could reshape after-tax returns, capital gains strategies, and the relative appeal of investments like municipal bonds. With uncertainty surrounding the tax landscape, we encourage investors to begin thinking about the impact of potential post-election changes to tax law on their portfolios.
IMPORTANT INFORMATION
Northern Trust Asset Management (NTAM) is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
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