When I saw the headlines talking about a new “45% Capital Gains Tax Rate,” expiring middle-class tax cuts, and otherwise bringing the “highest tax rate – for many – in a century,” I initially wanted to stay out of it, because I hate getting political and being taken out of context.
But I’m going on a limb to talk about this topic because there’s a ton of misinformation openly being spread as fact – and because the full proposal is 256 pages of fine print, I don’t want you to spend all your time trying to make sense of legal gobbledygook. So here’s my attempt at clarifying how this proposal impacts you in three ways:
- The capital gains tax increase
- An increase in the tax bracket for those making over $400,000 a year
- A 25% wealth tax on unrealized gains
Understanding this well could save you thousands of dollars in taxes, which is the same as earning extra money. Before we break it down, here’s some context on where we’re starting from:
The Tax Cuts and Jobs Act of 2017
The “Tax Cuts And Jobs Act” went into effect in 2017 and resulted in massive tax cuts, across the board, for a lot of people. For instance:
- Tax brackets in every income range were lowered
- The standard deduction was increased to $27,000 for those who were married
- Certain business expenses were 100% deductible
- The corporate income tax rate was reduced from 35% down to 21%.
Under this tax reform, some people got mega-crazy write-offs and saved a lot of money. Others saw really no change at all, and certain people saw tax increases depending on their situation. For example, this tax plan reduced the mortgage interest deduction by $250,000, it capped the state and local tax deduction at $10,000 maximum, and it imposed some other limitations that caused some people’s tax bills to actually go higher – even though the bill was called “tax cuts.”
In every tax plan, there will be "winners" and "losers." No matter what you do, some people will benefit more than others, some people will like it, some people won't like it, and there's no pleasing everyone. But here's what's in the current proposed plan, and how it’ll impact you:
1. The Capital Gains Tax
Right now, Capital Gains is broken down into two categories: Short Term and Long Term. Short Term Capital Gains are fairly easy to calculate. If you hold an investment for less than one year, and sell it for a profit, those profits are treated as “Ordinary Earned Income” and this falls under your normal tax bracket.
However, if you hold an investment for longer than a year, this is where the magic happens. If you're single, making less than $47,025, you'll pay no capital gains tax whatsoever. If you make under $518,900, you'll pay just 15% capital gains tax. And, for anything earned above $518,901, you'll pay a flat 20% capital gains tax.
If you live in a state with no income taxes, you could pull out $100 million worth of long-term capital gains, pay a flat 20% plus a 3.8% net investment tax on the income above $1 million, and, all of a sudden, you're paying at least 13% less than that same person earning a wage. But, as written in the latest filing, “Long Term Capital Gains ‘disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers’.” And this could soon change.
The new proposal would tax long-term capital gains at ordinary earned-income tax rates, which would be increased to 39.6%, if they have an income above $1 million dollars per year. In addition to that, the net investment tax would increase to 5% on incomes over a million a year, taking the total capital gains tax to 44.6%, up from the 23.8%, where it currently stands.
This only applies to federal income taxes, and any state taxes would be extra. So, if you live in a state like California, add in another 14.4%, and, you could be paying as much as 59% in capital gains for all income earned over $1 million dollars, which is wild.
Like, if your parents bought a house for $400,000 in 1995, and it’s now worth $3 million dollars because they hit the location lottery, they'd have to pay tax on $2,150,000 worth of profit if they sold for retirement funds, of which, more than half will be taxed at 59%. So, the state and government make more money than the actual homeowner who made the ongoing investment in the first place!
2. Increasing tax brackets
The second proposal would aim to increase the tax brackets on those making over $400,000 a year, from 37% to 39.6% by "correcting Inequities Created by Trump Tax Cuts and Raise Additional Revenues" in the 2017 Tax Cut bill. After all, according to their studies, it's said that "The wealthiest 5 percent of households received nearly half—42.6 percent—of the Trump tax cuts, with the top 0.1 percent receiving an average tax cut of $193,380 in 2018."
Even though it's said that this is primarily aimed at households making over $400,000 per year, if the Tax Cuts and Jobs act is eliminated, which was strongly implied, all tax brackets would be increased, no matter how much you make. Check the table below and you'll be able to see approximately how you might be affected:
Of course, there is some slight nuance to this that I'll mention shortly. I just figured it's important to get the major changes out of the way, first, before diving into my own thoughts. But, in addition to that, we have one of the most controversial proposals from all of this.
3. A tax on unrealized gains
And that would be... A 25% Wealth Tax, even on assets that you haven't sold. Coming from someone who this directly affects on many levels, here's the deal:
As they say, and I quote from their website, “Billionaires make their money in ways that are often taxed at lower rates than ordinary wage income, or sometimes not taxed at all, thanks to giant loopholes and tax preferences that disproportionately benefit the wealthiest taxpayers.” But there's a bit of a problem with that math. This would begin to tax “unrealized capital gains.” At best, that is unprecedented, and at worst, it’s unconstitutional.
Consider this: If you make a $1000 investment and, over time, it grows to $5000, you don’t pay tax on that $4000 profit because you haven’t sold. After all, your investment could just as easily decline the next day, so until you click “sell,” those profits aren’t guaranteed. Almost everyone reading this has some type of “unrealized gain” in one way or another, whether that be in stocks, a home that's worth more than you paid, or interest in a business that's just grown in value. As it is right now, those gains are not taxed until you lock in and realize that profit, because, as I’m sure you’ve seen, a lot can happen that changes those values on a moment-by-moment basis.
In this case, however, they want to tax the unrealized profit on individuals who are worth more than $100 million dollars, which would not only be impossible to implement – but imagine being forced to sell shares to pay a tax on assets that you had no intention of selling!
Of course, the White House does address this by saying that if you're worth $1 billion, your $250 million tax bill would be paid upfront in annual installments, and then when you actually sell, the amount you “pre-paid” would be credited towards the final bill, which they want to be 44.6%.
Now, in terms of how they’d calculate someone’s net worth, it’s a bit of a mess.
They say that “Taxpayers with wealth greater than the threshold would be required to report to the IRS on an annual basis, separately by asset class, the total basis and total estimated value as of December 31st.” But on a more practical level, let’s be real: taxing unrealized capital gains is going to be an impossible task. The Supreme Court previously ruled that under the 16th Amendment, there must be some actual transfer of rights before Congress can tax appreciation as income, and it’ll be a massive waste of resources for everyone involved if they decide to move forward with this.
My thoughts
Raising the top tax bracket from 37% to 39.6% isn't that big of a surprise on the surface. The Tax Cuts and Jobs Act was only meant to be temporary and it expires at the end of 2025 if nothing is done. Yes, I'd rather have more money left over, but this isn't enough to concern me at all. So, I think raising the overall tax brackets back to where they were in 2016 is completely fine.
However, the biggest impact would likely be from raising the capital gains tax to 44.6% for people making over $1 million per year. And, again, this is something that impacts me directly. Like, right now, one of the big reasons to invest my money long term is because of the preferential tax treatment on investment income. After all, if I make money working, I'm taxed federally at 37%. But, if I make money investing, I'm taxed at 23.8%. So, there's a big push to invest long-term and get my money working for me.
There's a reason capital gains are taxed at a lower rate than earned income. Like:
- Any investment returns carry risk and aren't guaranteed
- Your returns are eaten away by inflation
- The income you invest was already taxed, to begin with.
So, you wind up paying more tax, on income you were already taxed on, that's constantly losing purchasing power to inflation. Ultimately, if this passes, it will affect a lot of people in terms of how they invest and how they structure their taxes. Although, the way I see it, this tax is easily avoided if you just don't sell your investments.
For instance, one of the biggest tax strategies out there is just to borrow against assets you already have, and then spend that money, without ever actually selling anything: If I have $10 million dollars in the stock market, and I want to spend some of that money, I could just go to the bank, take out $1 million dollars as a loan against those assets, and then freely spend that money, without paying 44% in tax. I might pay 6% in interest on that borrowed money, but that's a lot cheaper. This strategy would become a lot more prevalent if capital gains tax rates were increased, prompting a lot of people to borrow against their assets, instead of selling.
Beyond my opinion though, studies have actually shown that the optimal tax rate for long-term capital gains is 28%. This is found to be the point of maximizing cooperation and tax revenues, without causing people to run for the hills. And, I tend to agree with this as well, anecdotally. I think a progressive long-term capital gains tax of 24% on incomes over $1 million would go over perfectly fine, but 44% is just too big of a jump, too soon.
I think a better outcome here would be to fully audit all government expenditures, evaluate the net benefit versus net cost of each item, reduce spending as needed, or apply more funding into areas that could eventually save us more money, and then, tax more if needed, if seen as a long term investment in all of us a society. This way, we know our money is going as far as it can, we know where it's going and how it's spent, and we can see where we're headed. Maybe I'm just idealizing here, but, I'd like to think that one day, that's possible.
The final aspect I'd like to talk about is the likelihood of this actually passing because the truth is, it's probably going nowhere, and a lot would have to happen for this to get pushed through. But, the Tax cuts and Jobs Act is expiring at the end of 2025, so, something will have to be done. This really doesn't solve the core issue at hand, which is that spending is out of control, for both Republicans and Democrats. This isn't a political issue, this is a spending issue, and I think we need to address it for what it is: incredibly wasteful.
If we can solve the excessive spending, great, but, as it stands right now, I just think there's very little chance of this passing, both Republicans and Democrats would have to agree on this to slide it by, and, instead, I think this entire thing is a giant game of political theater.
That's it for this week. I hope you enjoyed this article. Let me know your thoughts by responding to this email - I read every single comment :)
Stay safe, stay invested and I will see you next week – Graham Stephan.
113 Cherry St #92768, Seattle, WA 98104-2205
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