Investment Taxation Uncertainty
by Donald R Chambers
President Trump has proposed numerous tax changes that could affect investment income and investment decisions. Proposed tax changes that relate directly to investment income taxation include elimination of the estate tax, elimination of the 3.8% Obamacare tax on investment income, and the possibility that some or all tax payers will be unable to pass on “stepped-up” bases to their heirs. Proposed tax changes that would likely affect investment values through indirect affects include reduction of corporate income tax rates, and reduced overall income taxation. But other major changes cannot be ruled out.
Investors should focus much of their investment analysis on taxation when making investment decisions. Good decision-making with regard to income taxation of investments can exert much higher effects on long-term investment success than other factors such as lowering transactions costs and investment fees. Good tax-related investment decisions are very likely to generate long-term success. The success of attempts to buy underpriced securities are usually based mostly on luck.
The general idea is to make investment decisions based on the most likely scenarios in terms of changes in future tax rates and other tax changes. But the risk remains that actual tax rates may differ from those anticipated. Unexpected tax changes create risk. And as with many other risks, the key is diversification. Simply put, investors should diversify their portfolio with respect to various potential risks of adverse tax rulings:
1. Make investment decisions based on the most likely tax scenarios, but
2. Diversify your portfolio with regard to major tax uncertainties such that each potential tax rate uncertainty has modest implications for your long term financial health.
For example, if your investment plan relies heavily on retention of the basis step-up in estate planning, perhaps it would be better to harvest some long-term capital gains over the next few years so that your exposure to elimination of that tax break is lessened. Another risk is that the Obamacare 3.8% investment income surcharge will not be repealed. An investor can reduce that risk by investing in municipals.
So they key is to spread out your investment taxation risk so that your portfolio is moderately exposed to each potential tax change rather than highly exposed to some and unexposed to others. Diversification against tax risk changes means spreading out a portfolio’s exposure to various risks such as good asset allocation means spreading out a portfolio’s exposure to equity risk, interest rate risk, credit risk, and so forth.