Planning Around Changing Tax Laws

Tax laws are not permanent. The Tax Cuts and Jobs Act (2017) lowered the top capital gains rate from 23.8% to 20% (before state taxes). Subsequent years have seen proposals to raise rates back to 28%, 37%, or higher. The step-up in basis has been repeatedly targeted for elimination. The preferential treatment of long-term capital gains is periodically threatened.

For long-term investors planning over decades, the uncertainty is real: what tax planning makes sense if rates might rise (or fall) significantly? The answer is to plan assuming rates will change, lock in current low rates when advantageous, but not become paralyzed by hypothetical future changes.

Quick definition: Tax-law planning around future rate changes means taking advantage of current favorable rates where possible (gain harvesting in low brackets, realizing appreciated assets before potential rate increases) while maintaining flexibility for uncertainty. The goal is not to predict tax law, but to be prepared for reasonable scenarios.

Key Takeaways

• Tax rates have changed significantly in recent decades: capital gains rates ranged from 28% (1987) to 15% (2003-2012, 2013-present).
• Proposals to raise capital gains rates (to 28%, 37%, or higher) are recurring; rates could increase during an investor's lifetime.
• Some provisions (step-up in basis, carried interest) are persistent targets for elimination; planning should reduce dependence on their permanence.
• Gain harvesting in today's 0-15% brackets is attractive partly because rates might rise; locking in favorable rates now hedges against future increases.
• Not all tax planning requires certainty: conservative strategies (loss harvesting, index funds) provide benefits across multiple tax-law scenarios.
• Over-planning around tax uncertainty can create opportunity costs; a balanced approach is better than paralysis.

Historical Tax-Rate Changes

Capital gains tax rates have been volatile:

Year	Long-Term Rate	Notes
1987	28%	Tax Reform Act of 1986
1991	28%	Omnibus Budget Reconciliation Act
1997	20% for gains >18 months	Taxpayer Relief Act (15% for 5+ year holds)
2003	15%	Jobs and Growth Tax Relief Act
2008	15%	Continued
2012	15%	Tax relief extended
2013	20%	ATRA added 3.8% NIIT; 20% top rate new
2017	20%	TCJA confirmed
2021-2024	20% (proposed increases to 28-37%)	Proposals only; not enacted

The trend shows rates rising and falling based on political cycles. The dramatic drop from 28% (1991) to 15% (2003) created enormous incentive to realize gains in the early 2000s. The recent rise from 15% to 20% (2013) similarly incentivized gain realization in 2012.

A 45-year-old investor today might face three different rate regimes over their remaining 35-year investment horizon:

1. Today (20% + 3.8% NIIT = 23.8%).
2. Age 55 (potentially 28% or 37% under proposed reforms).
3. Age 80 (uncertain, but possibly lower again).

Planning needs to accommodate this uncertainty without becoming paralyzed.

Structural Changes vs. Rate Changes

Rate changes (15% → 20%) are common. Structural changes (elimination of step-up in basis, end of long-term capital gains preference) are rarer but possible.

Proposals that have surfaced repeatedly:

1. Stepped-up basis elimination: Proposed by Biden administration; would require heirs to pay capital gains tax on inherited assets.
2. Carried interest reform: Change to private equity/hedge fund compensation; mostly passed in some states.
3. Elimination of preferential capital gains rates: Make all gains taxed as ordinary income.
4. Wealth tax or mark-to-market taxation: Require annual taxation on unrealized gains above a threshold.

Of these, the step-up in basis is the most likely reform (discussed periodically) and would most dramatically change long-term planning (favor gain harvesting in life over holding to death for step-up).

Preferential capital gains treatment is less likely to be completely eliminated but could face rate increases.

Strategies That Work Across Multiple Rate Scenarios

Some tax-planning strategies are robust to rate changes:

Loss Harvesting

Regardless of future capital gains rates, realizing losses today to offset gains is beneficial.

• If rates stay 20%: loss worth 20% of the harvested loss.
• If rates rise to 37%: loss worth 37%, much more valuable.
• If rates fall to 10%: loss still worth 10%.

Loss harvesting is a "no-regret" strategy: you capture tax benefits today, and higher future rates actually increase the benefit of past harvests.

Index Funds in Taxable Accounts

Index funds minimize turnover, deferring taxation. This strategy is robust to rate changes:

• If rates stay 20%: you save by deferring realized gains.
• If rates rise to 37%: deferral is even more valuable.
• If rates fall to 10%: deferring may be suboptimal, but index funds still outperform active funds on tax drag.

Asset Location (REITs in IRAs)

Placing tax-inefficient assets in tax-deferred accounts is independent of future rates:

• If rates stay 20%: REIT in IRA still worth much more than REIT in taxable account.
• If rates rise to 37%: REIT in IRA is even more valuable.

This is a robust strategy across scenarios.

Rate-Contingent Strategies

Other strategies depend on rate expectations:

Gain Harvesting Now (Before Rate Increases)

If you believe capital gains rates will rise, accelerating gain realization now (at 20%) rather than later (at 28% or 37%) is attractive.

Example: A single filer with $50,000 of available 0% bracket space can realize $50,000 of gains at 0% federal tax today.

• If rates stay 20%: they later realize the same gain at 20%, wishing they'd harvested now.
• If rates rise to 28%: they saved 8% by harvesting now = $4,000 on the $50,000 gain.
• If rates fall to 15%: they wasted the opportunity, realizing at 0% when they could have realized at 15%. (But the difference is small.)

The asymmetric benefit (much larger if rates rise, small loss if rates fall) makes gain harvesting attractive when rates may increase.

Holding Appreciated Stock for Step-Up (Before Elimination)

If the step-up in basis is likely to be eliminated, holding appreciated stock until death to receive a step-up is attractive.

However, if the step-up is eliminated, you've foregone decades of gain harvesting and compounding benefits.

A balanced approach: harvest some gains in low-bracket years, hold core positions for the step-up. This captures both benefits.

Roth Conversions Before Rate Increases

If capital gains rates might rise, Roth conversions become more attractive:

• Convert now at today's rates (pay tax at 20% LTCG or 24% ordinary rate).
• Withdrawals in future at potentially higher rates are now tax-free.

If rates stay the same: conversions are neutral (pay tax now at 20%, would have paid 20% later). If rates rise to 37%: conversions were very valuable (paid 24%, avoided 37%). If rates fall to 10%: conversions were suboptimal (paid 24%, would only pay 10%).

The upside is larger than the downside, making conversions attractive before potential rate increases.

Strategies That Hedge Uncertainty

Rather than betting on specific rate changes, some investors use hedging strategies:

Partial Gain Harvesting

Harvest 50% of anticipated gains in low-bracket years now, hold the other 50% for potential future low-bracket years. This averages the tax rate across scenarios.

Example: Expect $100,000 in lifetime gains.

• Harvest $50,000 now at 0% federal bracket (0% tax = $0 cost).
• Hold $50,000 for potential future low-bracket year (worst case: 20% tax = $10,000 cost).
• Average cost: $5,000, or 5% rate.

Diversify Tax Scenarios

Maintain flexibility to realize gains in different years with different tax rates.

• Years with low income: realize gains (potentially 0% or 15% bracket).
• Years with high income: defer gains (use loss harvesting to offset gains).

Use Options for Hedge Exposure

Rather than buying appreciated stock directly, use call options to gain upside exposure while deferring taxation. However, this introduces complexity and is only suitable for sophisticated investors.

Recent and Proposed Rate Changes (2017-2024)

The Trump administration's 2017 Tax Cuts and Jobs Act set capital gains at 20% (+ 3.8% NIIT) through 2025. These rates are set to expire, with a debate whether they'll be extended or allowed to revert to higher rates (28% historically proposed).

Biden administration proposals (2021-2023):

• Raise capital gains to 37% (or ordinary rates) for high earners.
• Increase NIIT to 5% on investment income.
• Eliminate step-up in basis.
• Introduce mark-to-market taxation on assets above $1 million.

Status (as of 2024): None of these proposals have passed. The political gridlock has prevented major rate changes. However, the 2017 rates expire in 2025 unless extended, creating natural renewal points for debate.

Likely scenarios:

• Extension of current rates (status quo): 20% LTCG likely to persist.
• Partial increase: rates to 25% (compromise).
• Significant increase: rates to 28% or higher.
• Structural change: step-up in basis reformed or eliminated.

Most experts expect rates to remain stable or increase modestly, not decrease. This suggests a bias toward gain harvesting (locking in current rates) rather than deferring.

Real-World Examples

Scenario 1: Rate Increase Planning for a 50-Year-Old

A 50-year-old investor with $1 million in appreciated securities in a taxable account and $500,000 in Traditional IRA space (unfunded) anticipates rates might increase from 20% to 28% in the next 5-10 years.

Strategy:

• Years 1-2 (high income years): Harvest $100,000 of gains at 0-15% bracket using Roth conversions and low-bracket realization. Tax cost: ~$12,000.
• Years 3-5 (medium income): Use $100,000 of available IRA contributions to defer REIT and bond income, freeing taxable account capacity for more gain harvesting. Additional $50,000 realized at 15% = $7,500 tax.
• Cumulative tax on $150,000 of gains: $19,500 (13% rate), vs. potential 28% rate later = $42,000.
• Savings: $22,500 by proactive harvesting.

Scenario 2: Hedging Step-Up Elimination

A 60-year-old has $2 million in appreciated stock, mostly from decades-old positions. She's concerned the step-up might be eliminated.

Hybrid strategy:

• Years 1-5: Harvest $50,000 of gains annually in low-bracket years (after Social Security, before RMDs peak). Total: $250,000 at average 15% = $37,500 tax.
• Remaining $1.75 million held until death for potential step-up.
• If step-up is eliminated: She's already harvested $250,000 (limiting future tax exposure).
• If step-up survives: She harvested only 12.5% of gains, keeping 87.5% in appreciated form for step-up.

This strategy reduces regret across scenarios.

Scenario 3: Roth Conversion Before Rate Increase

A 55-year-old with a $500,000 Traditional IRA anticipates retirement in 5 years and expects capital gains rates to rise from 20% to 28%.

She converts $100,000 of Traditional IRA to Roth in years 1-5 (while still employed, in the 24% bracket). Tax cost: $24,000.

In retirement (age 60+), she withdraws from the Roth tax-free.

• If rates rise to 28%: Roth withdrawals save 4% vs. taxable withdrawals = $4,000/year × 30 years = $120,000 in savings.
• If rates stay 20%: Roth withdrawals save 0% vs. taxable withdrawals (she paid 24%, would have paid 20%). Slight loss of $4,000.

The upside ($120,000) is 30x the downside ($4,000), making the conversion attractive.

Common Mistakes

1. Over-reacting to rate proposals that never pass. The step-up in basis has been threatened dozens of times; it survives. Focus on actionable changes, not hypothetical ones.

2. Deferring all gain realization, hoping for rate decreases. Rates are more likely to increase than decrease over the next decade. The "wait and see" approach usually costs money.

3. Harvesting all gains in a single year, assuming rates will rise. If rates don't rise, you've accelerated taxation unnecessarily. Spreading harvests across multiple years hedges uncertainty.

4. Assuming the step-up will disappear. The step-up has survived multiple reform attempts. Planning entirely around its elimination is premature. A balanced approach (harvest some gains, hold some for step-up) is more prudent.

5. Not diversifying tax scenarios. Different life phases (high income, low income, retirement) create different tax rate opportunities. Planning should exploit these, regardless of overall rate changes.

FAQ

Q: If I believe rates will increase, should I realize all my gains now? A: No. Realizing all gains in one year triggers high tax brackets and likely capital gains surtax in high-income states. Spread harvests across multiple low-bracket years. Even in high-bracket years, harvesting losses (which are always beneficial) and using available 0-15% bracket space is smart.

Q: How much should I rely on the step-up in basis in my planning? A: Moderately. The step-up has survived reform attempts for decades, but it's increasingly criticized. Include it in planning, but don't build your entire strategy around it. A 50/50 split (harvest some gains, hold some for step-up) is balanced.

Q: Should I do a Roth conversion before rates increase? A: If you're in a relatively low bracket today and expect higher income (or rates) later, conversions are attractive. The tax cost today (24%) is potentially lower than future ordinary income tax (37%) or capital gains tax (28%+). However, don't over-convert; it creates current tax liability and might be suboptimal in early-retirement scenarios where future income is uncertain.

Q: What if tax rates fall instead of rising? A: You'll regret some gain harvesting. However, the probability of rates falling significantly is low (political climate is toward higher rates, not lower). And even if rates fall to 15%, you've only "overpaid" 5% on the harvested gains. The insurance benefit of harvesting before a potential rise outweighs this risk.

Q: Should I time my retirement to a specific tax-law scenario? A: No, don't retire late to time tax law. But if you're between jobs or have flexibility in retirement timing, a year with low income (sabbatical, job change) is valuable for gain harvesting. Capture these low-bracket years strategically.

Related Concepts

• Capital gains tax rate: Federal tax rate (currently 20% top) on long-term capital gains; subject to change via Congress.
• Bracket creep: When inflation or ordinary income pushes taxpayers into higher tax brackets without legislative change.
• Tax reform: Change in tax law, often involving rate changes or structural changes (step-up elimination, new taxes).
• Roth conversion: Move funds from Traditional IRA to Roth, paying income tax; useful before rate increases.
• Gain harvesting: Realizing capital gains in low-bracket years to lock in favorable tax rates before potential increases.

Summary

Tax laws change, but the direction is uncertain. Rather than becoming paralyzed by uncertainty, long-term investors should employ robust strategies (loss harvesting, index funds, asset location) that work across multiple rate scenarios, while also taking advantage of current low rates through selective gain harvesting.

A balanced approach:

1. Lock in current low rates via gain harvesting in available 0% and 15% bracket space.
2. Maintain flexibility by spreading harvests across multiple years, leaving room for unexpected low-bracket opportunities.
3. Use robust strategies (loss harvesting, low-turnover investments) that benefit regardless of rate changes.
4. Avoid over-planning around unlikely scenarios (rates falling to 5%, step-up disappearing overnight).

The key insight: take advantage of today's favorable rates where possible, but don't sacrifice current flexibility or opportunity costs chasing hypothetical future rate changes.

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