An unfortunate tax that can be a crucial element of investing is managing how much tax you will owe on your gains. Yes, ladies and gentleman, you are penalized monetarily for making good investment decisions that proved profitable. Well, profitable less the capital gains tax you owe. Don’t think about moving to Finland either, the “happiest” country in the world, unless you’re ready to pay its top marginal tax rate of 57% for your contentment.
Taxing the rich isn’t just a European thing. President Joe Biden proposed a top federal tax rate of 39.6% on long-term capital gains and qualified dividends. With average state taxes and a 3.8% federal surtax, the wealthiest people would pay almost 49% total. If the current administration has its way, the U.S. would tax capital gains and dividends at among the highest rates in the developed world. This is not a category you want to lead the world in. The proposed increases would look as follows.
Capital gains tax (CGT) is a tax that applies to the profit made from selling an asset that has increased in value. For example, if you buy a house for $300,000 and sell it for $400,000, you have a capital gain of $100,000. Depending on the type and duration of the asset, you may have to pay tax on some or all of your capital gain. Capital gains are profits from the sale of various types of assets, including stocks, bonds, real estate, and collectibles, and these profits are subject to capital gains taxes.
Several factors come in to play when considering how your asset gains will be taxed. The profits that are taxed and the rate of the tax will depend upon your filing status, taxable income, and how long you owned the asset. As mentioned, you are only taxed when you sell an asset, so you generally have the luxury of when to do so. According to Rob Williams, managing director of financial planning at Charles Schwab. “Many investors may not think about that return after-tax and really, that’s what you keep.”
Let’s take a look at some of the basics before we go into any pros and cons of the capital gains tax. To begin, capital gains are divided into two categories, short-term and long-term based upon the amount of time you owned the asset. Based upon the current tax levels and administrative policies, the government can influence how long you hold an asset and its basis for taxation. According to JR Gondeck, a Boca Raton, Fla.-based partner at The Lerner Group, a wealth-management firm, “The government doesn’t want to incentivize speculation.”
Short-term capital gains
Short-term capital gains (gains on assets held for one year or less) are taxed at regular income rates, while most long-term capital gains are taxed at no more than a flat 15% or 20% with a few exceptions. This could have a big impact on profits.
Long-term capital gains
Long-term capital gains, on the other hand, are the profits you make from selling an asset you’ve held for more than one year. If it fits into your financial plan, obviously tax wise it’s better to hold an asset for over a year. Williams goes on to say, “Before you sell any investment, it’s important to look at your holding period and if you can, if possible—assuming you’re not taking undue risks—wait 365 days to qualify for the long-term capital-gains tax rate.”
CGT is a controversial topic that has been debated for many years. Some people argue that CGT is fair and necessary to reduce inequality and generate revenue for public services. Others contend that CGT is unfair and harmful to economic growth and investment. Let’s take a look at some of the purported pros and cons.
Pros
- CGT can help to reduce wealth inequality by taxing the income from assets that are mostly owned by the rich. This can also improve social mobility and reduce poverty. Sounds a little bit like Robinhood, but, okay.
- It can help to raise revenue for the government to fund public services such as health, education, and infrastructure. This can also reduce the need for other taxes that may be more burdensome or inefficient.
- It can be used to prevent tax avoidance by closing loopholes that allow people to convert their income into capital gains that are taxed at lower rates or not at all. This can also improve the fairness and integrity of the tax system.
- Can encourage productive investment by taxing speculative gains from short-term trading or holding unproductive assets such as land or gold. This can also promote economic efficiency and innovation.
Cons
- Perhaps the greatest downside is that it can discourage saving and investment by reducing the after-tax return on assets that are subject to CGT. This can also lower economic growth and job creation.
- CGT can create distortions and inefficiencies by affecting the decisions of investors on when, what, and how to invest. For example, investors may hold on to their assets longer than optimal to avoid paying CGT (lock-in effect) or sell them sooner than optimal to take advantage of lower rates (bunching effect).
- It can increase complexity and compliance costs by requiring taxpayers to keep track of the cost and value of their assets over time and report their capital gains and losses. This can also create uncertainty and disputes with the tax authorities. It’s a long way from the Steve Forbes flat tax.
- CGT can double tax income that has already been taxed at the corporate or personal level. For example, dividends paid by a company are subject to both corporate income tax and personal income tax, and then again to CGT if the shares are sold at a profit.
