The US financial organization has weighed on the debate about the impact of potential tax increases on asset returns, noting that areas such as private equity could be hit in particular.

Proposed tax hikes from the Biden administration, if they become law, could hit investment returns by an average of 1.4 per cent, while some asset classes would suffer more than that, according to a study from the Northern Trust Institute. 

It suggests ways in which investors can shield themselves from some of the impact. 

The report – echoing views of other financial firms – notes that investors’ top concerns center on a few major areas: Raising the top income tax bracket (for those earning more than $400,000 per year) to 39.6 per cent from 37 per cent; cutting the estate tax exemption; raising the tax rate on long-term capital gains and qualified dividends to 39.6 per cent from 20 per cent; and eliminating the step-up in tax basis upon death. (The “step-up basis” is the readjustment of the value of an appreciated asset for tax purposes upon inheritance. The higher market value of the asset at the time of inheritance is considered for tax purposes. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary's capital gains tax is minimized. Changing that system could hit inheritors with heavy tax bills.)

The Institute reckons that, given the usual speed of Congressional policymaking, it is unlikely that changes will take effect until 2022.

The document adds to a run of commentaries (see example here) from wealth managers on how the Democratic administration, coupled with a Democrat-led Senate and House, could push through tax increases on wealthier Americans to help pay for skyrocketing public debt, worsened by the COVID-19 pandemic. There have even been calls for a wealth tax from Elizabeth Warren, the Massachusetts  senator (D). 

As the Northern Trust Institute report notes, while the rise in income tax doesn’t vary much from historical levels, the hike in taxes on dividends and capital gains is “more significant."

Within the overall mix, some asset classes such as private equity will take a bigger hit than others, the study says. 

The CGT changes, for example, could cut returns on global equity investments by an additional 1.1 per cent for a total hit of 2.0 per cent, relative to the Institute’s pre-tax forecast. Asset classes with particularly favorable capital market assumptions such as private equity (-2.6 per cent) and real estate/infrastructure (-2.5 per cent) will be affected more sharply.

What to do about it?
Financial goals – rather than tax specifically – should drive asset allocation. That said, if a change such as ending step-up to tax basis is eliminated, low-basis assets might be more suited to paying to philanthropic goals rather than wealth transfer goals, Northern Trust Institute’s study says. 

As for capital gains, clients should avoid realizing capital gains unnecessarily. For example, longer holding periods give investors more options if policymakers cut CGT rates in future, as has happened before. 

Clients should also consider “asset location” to spread risks. For example, interest income, dividend income and realized capital gains aren’t taxed in tax-favored accounts, such as IRAs, the study says. “Place less tax-efficient assets, such as high-yield and other taxable bonds, real estate investment trusts, high-dividend equity and high-turnover active strategies, in tax-favored accounts,” it says.