While the long-term return outlook appears positive, there is volatility ahead. There are tax changes on the horizon as well with many scheduled to go into effect in 2026. For example:
Income taxes—Today’s highest marginal income tax rate of 37% is set to increase to 39.6% in 2026 without intervention from Congress
Transfer taxes—While in 2024 the lifetime exemption (amount that any individual can transfer to a non-spouse free of transfer tax) is $13.61 million per person, starting in 2026 it is slated to be reduced to $5 million per person (indexed for inflation) without intervention from Congress
What can you do to take control and protect your finances?
Consider assigning assets to their tax-compatible accounts
It’s not just what you own, but where you own it. The type of account in which a specific asset is held can dramatically impact your tax exposure.
A quick account location suitability test is this: Your portfolio may not be tax-optimized if (a) all your assets are in one kind of account (i.e. taxable or tax-deferred), or (b) you have all of the same holdings in different types of accounts.
The general rule is that, all else being equal, you may want to consider holding tax-inefficient assets (especially those with higher growth potential) inside tax-advantaged accounts such as a 401(k), deferred compensation, IRA, Roth or annuity.
The reason behind the rule is simple: Tax-deferred accounts, such as 401(k)s, deferred compensation, traditional IRAs and annuities, all delay income tax liabilities until assets are withdrawn. This delay allows them to grow and compound tax-free. With a Roth IRA, you pay the income tax on the assets upfront, but then the money in the account gets to grow tax-free, and there is no tax bill upon withdrawal.
Good candidates for tax-deferred accounts are usually high yield bonds, high-turnover equity strategies, hedge funds and other investment products that tend to generate taxation at ordinary income rates via interest or net short-term capital gains, as compared to assets that generate qualified dividend income or long-term capital gains, the latter of which are taxed at a preferential rate.
Prioritizing asset classes in tax-deferred accounts
In contrast, private equity is generally a less efficient asset to hold in a tax-deferred account because most (if not all) of the returns it generates will likely be taxed at preferential long-term capital gain rates. You should consider putting your private equity holdings in a taxable account, such as an individual, joint or (even better) a grantor trust where future growth is shielded from transfer tax.
Of course, to put your dollars and investments in the right accounts, you have to know the types of accounts you may need and for which you are eligible. In general, maximizing your contributions to qualified plans (401(k), 403(b)) and deferred compensation arrangements can be a great first step in creating account diversification.
Understand the tax implications of trades in advance of execution
Markets’ increased and likely prolonged volatility creates opportunities for more active tax-loss harvesting.
It can be costly to wait to do your tax-loss harvesting at the end of the year or even the quarter. A better practice is to have your portfolio reviewed regularly for embedded losses.
You also might benefit from a so-called “separate, tax-managed account”—one that is specifically designed to constantly look for losses and harvest when opportunities arise.
Of course, to harvest tax losses, you sell a stock in which you have experienced a loss so that you can claim that loss against gains (already realized or future). Then, if you like the stock sold and/or want to preserve your portfolio’s asset allocation, you can consider purchasing an equity with similar, but not exact, characteristics (e.g., sell Coca Cola, buy Pepsi), and strive to avoid “Wash Sales”.
Similarly, if you are transitioning your portfolio to a new strategy, you’ll want to make sure to do so tax-efficiently. This means weighing the tax costs of changing vehicles versus the new position’s potential return; it also means seeing if any positions of your current strategy can be transferred “in kind” to the new strategy in order to defer realizing a gain.
Consider if contributing highly appreciated stock to a Charitable Lead Trust (CLT) or Charitable Remainder Trust (CRT), and/or asset(s) that you expect to appreciate to a Grantor Retained Annuity Trust (GRAT) supports your objectives while simultaneously producing desired tax benefits
Grantor Retained Annuity Trusts (GRATs)
GRATs are a well-established estate freeze and gifting strategy for reducing future estate taxes by transferring assets to your beneficiaries (children) without utilizing one’s lifetime gift tax exclusion.
A GRAT is a trust that is funded by the grantor in exchange for a stream of annuity payments, over a predetermined period of time, at a predetermined interest rate (the “7520 rate,” after its code section). After the final annuity payment occurs, whatever remains in the trust is transferred to the named beneficiary (say, children). Generally, GRATs are “zeroed-out” which means that the amount contributed to the trust is equal to the present value of the future annuity payments to the grantor, and therefore is does not result in a "gift".
GRATS are particularly attractive in the current extraordinarily low interest rate environment.
Charitable Remainder Unitrust (CRUT)
A charitable remainder unitrust (CRUT) is an irrevocable trust that generates income that will be distributed to trust beneficiaries over the life of the trust, with the remaining trusts assets being distributed to a designated charity at the end of the trust term. Charitable remainder unitrusts (CRUTs) are often used to capture immediate tax benefits, including but not limited to avoiding capital gains taxes.
Charitable Lead Trust (CLT)
Charitable lead trusts can be a tax-efficient way for a taxpayer to minimize taxes, and fulfill charitable giving and family wealth transfer goals.
Charitable lead trusts are split-interest trusts that can be created during life or at death, under a revocable trust or will. "Lead" income interest is paid to the charitable organization, and the remainder interest (assets) are transferred to a noncharitable beneficiary (e.g., the donor, the donor's family). The income interest can be in the form of a "guaranteed annuity" interest (a charitable lead annuity trust (CLAT)) or it is a "unitrust interest" (a charitable lead unitrust (CLUT)).
For income tax purposes, CLTs can be drafted either as a grantor trust or as a nongrantor trust. If it is structured as a grantor trust, the donor receives an upfront charitable income tax deduction on formation of the trust and is then responsible for income taxes on future trust income. If it is structured as a nongrantor trust, a separate taxpaying trust is created and allowed an unlimited charitable income tax deduction under Sec. 642(c) for the income paid to charity. It is important to note that donors to a nongrantor CLT do not receive a charitable itemized income tax deduction.
The CLT is composed of the charitable interest, which is wholly deductible for gift and estate tax purposes, and the noncharitable remainder interest, which is wholly taxable for gift or estate tax purposes. The value of the charitable interest is calculated as the present value of the stream of payments to the charity over the charitable term (the computation of this present value is discussed next). The value of the taxable remainder interest is the difference between the trust's initial value and the value of the charitable interest.
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We are here to help. If you have questions and would value professional insight and guidance regarding 2024 year-end tax planning, efficiently filing your 2024 individual, business or trust tax returns and 2025 - 2026 tax planning, give our office a call or send an email to napapgni@cobaltpacwestadvisors.com to schedule a complimentary consultation.
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