By Thomas E. Faust Jr.
Generations of Americans have invested their savings in the stock market to build assets for retirement and to fund educational costs, pay medical bills and meet other family needs. In the process, they’ve provided needed capital to American businesses to help the economy grow—thereby creating greater economic opportunity for all.
Consistent with our nation’s commitment to free markets and individual rights, American investors have always had the ability to decide for themselves exactly what stocks they buy and sell, without interference from the government. Believe it or not, the Senate version of the tax reform bill seeks to change that. For individual investors who hold multiple positions in the same stock purchased over time, the Senate provision would require them to sell—and make gifts of the oldest shares first. It’s called FIFO, or first-in, first-out.
Because most stocks increase in value over time, requiring stocks to be sold on a FIFO basis will cause investors to pay more capital gains taxes as they sell down their investments, which the government estimates as generating $2.4 billion of new tax revenue over the next 10 years. While that’s a lot more in taxes for investors to pay, it’s only a drop in the bucket towards offsetting the overall costs of tax reform.
Besides inhibiting investor choice and causing capital gains taxes to go up, the FIFO provision would also complicate the financial planning of millions of American investors and increase the extent to which taxes distort their investment decisions. If the provision is enacted, investors in successful stocks will be less inclined to sell down their investments—because they’ll owe more taxes—and be discouraged from buying more of the same stock —again, because their tax bill will go up when it later comes time to sell. Since tax considerations will increasingly influence what investors buy and sell, markets will become less effective in allocating capital appropriately to best support growth in the economy. By interfering with efficient capital formation, the FIFO provision ends up costing not just holders of successful investments, but all the beneficiaries of economic growth.
The burden of requiring investors to sell stock on a FIFO basis will fall especially hard on retirees. Consider a worker who has built up a nest egg in company stock acquired through payroll deductions or market purchases over a 30- or 40-year career. When it finally comes time to sell stock to pay for retirement, those specific shares would no longer be selected on an economically rational basis. Instead, the retiree will be forced always to sell the oldest—and often biggest gain—shares first. That means higher capital gains taxes and less income to pay for retirement. Whether or not the retiree’s nest egg proves big enough to carry all the way through retirement is increasingly called into question.
Here’s more. The FIFO requirement would not apply equally to all investors. Managers of mutual funds, ETFs and other “regulated investment companies” would continue to enjoy the flexibility to pick the specific share lots they sell. Individually managed portfolios would have that right taken away. That’s not fair. All investors should have the same freedom to manage their investments as they choose.
For advisors serving individual investors, the Senate proposal is a nightmare. They will be on the front lines trying to explain—and justify—to clients that, effective January 1, 2018, they will no longer be able to select the specific share lots of stocks or bonds they sell or give away. The few remaining weeks of 2017 will be occupied with a frenzy of activity to help clients position their portfolios for the prospect of this abrupt change in long-term tax policy. After the proposal takes effect, advisors will increasingly be hamstrung by the prospect of weighty tax bills as they advise clients on buy and sell decisions. Advisors will spend far more time thinking about, and planning for, client tax effects than ever before.
What’s more, administering the new FIFO requirements will be no easy task for advisors. It’s only for securities acquired after 2011 that tax authorities required custodial systems to maintain records of cost basis and holding period. For any client for whom transactions records in a given security are not complete, selling even a single share will trigger a need to immediately research and document the client’s full transaction history. Yes, this could really happen—and it’s only a few weeks away.
This sounds like a looming disaster. Is there any good news? Fortunately, yes. The mandatory FIFO provision of the Senate bill is not included in the companion bill passed by the House of Representatives in November. The final version of tax reform if enacted into law will be decided by House and Senate leaders to begin this week. Opponents of mandatory FIFO are scrambling to convince Congressional leaders that this unfair and destructive provision has no place in tax reform.
If you care about this issue—and you should—call or write your Congressional representatives today to let them know your point of view.
Thomas E. Faust Jr. is chairman and chief executive officer of Eaton Vance Corp., Boston-based investment managers.