Capital Gains Changes

The below article is from Forbes Advisor, published on May 5, 2021.

President Biden’s Capital Gains Tax Plan

President Joe Biden announced in a speech before a joint session of Congress that he wanted to raise taxes on the richest Americans—by a lot.

Jacking up the obligation to Uncle Sam on the top 1% of earners is politically popular, and will ostensibly be part of Biden’s plan to spend more money to help less affluent Americans. Proponents also emphasize how a higher tax rate will help reduce income inequality.

Opponents of the plan—including some squeamish Democratic Senators—are wary of raising taxes during a recession. They also claim the bill won’t actually raise that much revenue, may cause economic growth to slow and could hurt stock prices.

People in the middle may not know what to think. Policy proposals aren’t laws, after all, and even if the bill passes with the rates Biden champions, any direct or indirect impact will probably be less than the talking heads are letting on.

What Biden’s Tax Plan Accomplishes

Part of a larger bill uncontroversially titled the “American Families Plan,” Biden would raise taxes on the well off in a few different ways:

• The top marginal income tax bracket would rise to 39.6%. The change would apply to 2022 income above $452,700 for individuals and $509,300 for a married couple, according to a report in Axios. This will end up raising taxes on some individuals who earn less than $400,000 and also happen to be married, which Biden promised not to do during his presidential campaign.

• Those earning income above $1 million would have their capital gains—whether short-term gains or long-term gains—taxed at 39.6% as well. Currently all long-term capital gains are taxed at 20%. When you include the 3.8% net investment income tax (NIIT), that rate jumps to 43.4%. If you include state income taxes, the tax rate could rise to as much as 48%.

• Inherited assets that have gone up in value by more than $1 million since the time they were bought would be taxed upon death of the owner. Right now, the basis of those assets—aka the baseline that determines the amount of capital gains or losses—is stepped-up to the fair market value at the time of the owner’s death.

One important caveat: Negotiations are in early days and the exact numbers and stipulations are likely to change as Congress hashes out the legislation.

Why Raise Capital Gains Taxes Now?

There are two main reasons why Biden is proposing to raise taxes, even as the economy recovers from the current recession: the need to raise revenue and a desire to combat income inequality.

On the former, the Biden administration’s full plan includes more money for lower-income families with children, greater subsidies for those buying health insurance and free community college, among other priorities. To help offset some of the cost, Biden is raising taxes on some of the nation’s highest earners.

There’s also a commitment to spend $80 billion to beef up the IRS so they can go after rich households that have improperly evaded taxes.)

But his aims are higher than simply raising revenues. In talking about the changed stepped-up basis rules, his administration wrote, “our tax laws allow these accumulated gains to be passed down across generations untaxed, exacerbating inequality.”

Why the Biden Capital Gains Tax Increase Is Controversial

So, what’s the problem? What could be the downside of raising the taxes on a small portion of Americans to help needy children and kids go to college? Just 0.7% of households would face a tax hike, according to the Institute on Taxation and Economic Policy, with almost the entire burden being felt by the richest 1%.

Nevertheless, there are some issues to be concerned about—even putting aside how Biden plans to help poor children with these tax hikes.

First of all, it’s not altogether certain that raising capital gain tax rates will reap that much revenue. One analysis out of the Wharton Business School at UPenn found that raising the capital gains rate could actually lower federal tax revenue by $33 billion between 2022 and 2031. That analysis dovetails with findings from the Tax Foundation, which said the policy would cost the Treasury $124 billion over 10 years.

How can that be? Well, a lavish stock portfolio isn’t taxed annually. Unlike with your home, there isn’t a county tax collector who appraises its value every year. You only pay taxes when you realize a gain, i.e. when you sell. The key is that you get to decide when to sell, so affluent stock owners adjust to the new rules.

“Folks could accelerate realizing gains before the higher rate is applied,” said Dana D’Auria, co-chief investment officer at Envestnet PMC. They could use this change in tax policy as an “opportunity to rip the bandaid off, sell shares with low cost basis, and better diversify their portfolio.” Or they could just hold onto their assets as much as possible, passing on wealth to their heirs.

The Biden administration tries to offset this problem through increasing taxes on inherited assets by nixing the stepped-up basis rule. The same Wharton study found doing so would take in more than $110 billion over 10 years, and Biden would count on increased IRS enforcement to tackle the logistical headache of demonstrating the cost basis for every asset you’ve purchased. This hurdle is one of the reasons the rule exists in the first place.

But it takes a long time to hire and train more IRS staff and the rich will enlist a bevy of estate attorneys and esoteric trusts to lower their tax bills. Moreover, some middle class earners might be subject to the tax if they, for instance, inherit real estate or a home from their parents or another relative that has a very high valuation.

Another concern is that higher taxes could imperil the creation of new business, which is especially troubling since there are fewer startups than in the past.

“The doubling of taxes would hurt the returns on private investment into venture capital and private equity funds,” said Mace McCain, chief investment officer at Frost Investment Advisors. “These funding sources have been a primary source of funding for new drug discoveries and technology innovation.”

How Biden’s Capital Gains Tax Plan Affects You

Unlike with the 2017 Tax Cuts and Jobs Act, you might not have a dog in this fight. That bill doubled the standard deduction for most filers, got rid of personal exemptions and dramatically increased the child tax credit for working Americans with wages up to $400,000.

Unless you earn more $1 million you won’t pay more in capital gains rates anytime soon. You may be affected by the stepped up basis rule, but remember that the bill is far from becoming law and will likely change long before it’s signed.

Still, the recent short-lived stock sell-off after details of the tax emerged may have unnerved you. Will your 401(k) suffer as a result of rich investors balking at higher rates? Almost assuredly not.

It’s not as if demand for the future earnings of big-time American companies will go poof. Equities are still the most consistent, highest earning assets, especially for those with a long time before they retire. In any case, you don’t want to make a hasty bet that will harm your long-term wealth.

“By not being disciplined,” said D’Auria, “ you stand the risk of making a wrong decision.”

Link to full article: https://www.forbes.com/advisor/investing/biden-capital-gains-tax-plan/