Alex Zagorski will be on the lookout for stock market bargains if President Joe Biden goes through with a reported plan to effectively double the capital gains tax rate on people who earn at least $1 million a year.
Biden is reportedly planning to follow through on a campaign pledge to apply a 39.6% capital gains rate for millionaires and above. Coupled with a pre-existing 3.8% tax linked to the Affordable Care Act, that would be 43.4% rate. The capital gains rate on profits from investment securities is currently 20% for top earners.
If history is any guide — and if Biden can even get the idea through Congress — there’s going to be a stock market sell-off in some form as some rich investors take advantage of lower rates before they climb.
And Zagorski, a 27-year-old mechanical engineer from Detroit, Mich. with years of investing experience, will be there waiting. “My opinion on investing is very long-term,” he told MarketWatch. “I look at something like this as an opportunity to buy and hold.”
“ My opinion on investing is very long-term. I look at something like this as an opportunity to buy and hold.” ”
Martin Sanchez, another relatively new investor, who started buying individual stocks in 2018, agrees. “I think there’s a buying opportunity for millennials if we do see a huge sell-off,” said the 27-year-old Winston Salem, N.C. resident, who works in the tech sector.
If Sanchez sees the opening, he might buy up some shares in companies that focus on web security, giving him a chance to spread out his holdings, which are heavier in stocks like Disney DIS, +0.43% and Tesla DIS, +0.43%. Sanchez is watching Biden’s tax proposals closely.
There are a lot of open questions about the possible capital gains rate hike. Will Biden include the idea in the “American Families Plan” that he’s expected to unveil on Wednesday? How many other tax hikes targeting rich household will that plan include? Will it pass Congress?
But another question is: What does this potential tax increase mean for a new generation of retail investors?
By now, newer investors have gone through the 2020 market’s fall and rise, and weathered the meme stock trading frenzy that put companies like GameStop GME, +3.27% on a share price rollercoaster. Do they stand to gain from an estimated $178 billion in selling that could occur prior to the rate increase?
“There are some who may view it as, ‘Oh, here’s my opportunity to get on board,’” said James Angel, a professor at Georgetown University’s McDonough School of Business.
“ “There are some who may view it as, ‘Oh, here’s my opportunity to get on board.”’ ”
But like so much else based on the potential rate hikes, there are big open questions on how new investors — and investors in general — will react. “Does it create opportunity? Well, maybe,” Angel said. “But you have to look carefully on stock-by-stock basis.”
Indeed, a share price might have little to do with the tax environment, one investor note said Friday. “Ultimately, other factors such as the outlook for economic growth, monetary policy, and interest rates are much more powerful drivers of equity market returns and valuations,” wrote Mark Haefele, chief investment officer for global wealth management at UBS.
‘One would expect people to start selling off’
When President Ronald Reagan signed the Tax Reform Act of 1986, he lowered the top income-tax rate from 50% to 28%.
The Republican president also changed the tax code in order to treat long-term capital gains as ordinary income, instead of giving capital gains a preferential rate. That bumped the capital gains rate up to 28% for rich households.
In the lead up to the changes during tax year 1986, there was a 60% rise in sales on all sorts of capital assets, according to researchers at the nonpartisan U.S. Congress committee Joint Committee on Taxation, and the Tax Policy Center, a think tank.
Ahead of a 2013 change — which brought the long-term capital gains rate from 15% to 20% and tacked on the 3.8% Net Investment Income Tax — there was a 40% rise in capital gains “realizations,” the researchers said, meaning investors were selling their holdings.
History could repeat itself, one of the authors told MarketWatch.
“Certainly, one would expect people to start selling off,” said Robert McClelland, a senior fellow at the Tax Policy Center. “How much, I don’t know.”
But McClelland noted it’s important to remember that many stock market buyers are foreign investors and retirement accounts, including 401(k) plans or pension plans, rather than individual investors operating through a brokerage account.
Foreign investors own about 40% of stock market equity and retirement accounts own about 30%, according to estimates last year from McClelland’s Tax Policy Center colleagues. Taxable accounts, like a brokerage account, own another 25% in stock market equity.
Another thing to remember is if rich people are selling, it hardly means they are walking away. “I would still be buying for my clients,” said David Haas, owner of Cereus Financial Advisors in Franklin Lakes, N.J. “In other words, selling does not mean getting out of the market. I would sell a client’s gains and buy something similar to continue participation in the market. The point is to take gains, not stop investing.”
As markets digested news Thursday of Biden’s possible capital gains tax hike, they ended the day on a down note. By Friday, they rebounded, with the Dow Jones Industrial Average DJIA, +0.05% ending 228 points higher, up 0.7%, and the S&P 500 SPX, +0.22% finishing up 1.1% higher.
Zagorski says he might be able to profit from any future sell off, but that still doesn’t erase his personal concerns about a rate hike. With any capital gains rate increase, in his view, “you’re just taking away money from people who would be investing in the market.”
But going forward, the buying opportunities might not be crystal clear. Some less experienced retail investors might not be able to determine if stock sales and potentially dropping prices have to do with tax strategy — and that might cause them to sell too, he said.
“When you see people at the top doing things, it’s instinctual to mimic them, even if it’s not in your best interest,” he said.