The Best Capital Gains Tax Rate is 0%

President Biden is set to address the nation tonight to pitch his "American Families Plan" in front of a socially-distanced Congress.  As with all new spending plans, the funding has to come from somewhere, and it appears that increased capital gains taxes will be a significant funding source.

Major Capital Gains Tax Changes

According to the Wall Street Journal, Biden plans to ask Congress to approve two major changes to capital gains taxes:

  1. For households making more than $1 million, Mr. Biden would also raise the top rate on capital-gains and dividends to 39.6% from 20%. Including existing payroll and investment taxes—each 3.8%—the top rates on wages and capital gains would reach 43.4%, up from 23.8%.
  2. Mr. Biden would also adjust how capital gains are taxed at death. Unrealized gains would be treated as sold and taxable, with an exemption of $1 million a person, in addition to the existing exclusion of up to $500,000 for a married couple’s primary residence. Under current law, heirs only owe capital-gains taxes on gains after the original owner’s death and only when they sell.

Why Do We Even Have A Capital Gains Tax?

Capital gains are the result of an individual investor risking their money and finding success.  Think of the immigrant mother who starts a restaurant, works her tail off to turn it into a success and 20 years later sells the restaurant to finance her retirement.  The IRS says she has "capital gains" to the extent she sells the restaurant for more dollars than she put into it.  Never mind all the years of sweat equity she put in, that doesn't count for anything to the IRS.  And all the years of income taxes and payroll taxes she paid don't count, either.  Should we make her pay even more taxes for being a successful risk-taker?  Is this good economic policy?  Is it what most people would call "fair"?

Bank robber Willie Sutton, when asked why he kept robbing banks, is purported to have replied "Because that's where the money is".  It's as good of an explanation as any as to why Congress sees fit to tax American risk taking and success.  It's easy to spend other people's money.

Investment Success Is Taxed Three Times

Most people experience the capital gains tax when they sell an investment, usually a stock, for more than they paid for it.  This person scraped together some money, likely from their own personal income which WAS ALREADY TAXED (Tax #1), and put that money at risk by agreeing to give it to a company to help fund their business.  This risk-taking is an essential element of capitalism and it has driven untold innovation and growth in society. 

This investor could have lost their entire investment, but instead were rewarded with dividends along the way and a return on their investment when they sold the stock.  Under our current system, individual stock investors must pay tax on dividends as they are received and on capital gains when the stock is sold (Tax #2). 

Interestingly, while Congress is happy to take a cut of an investor's success when they win, they do NOT let allow investors to deduct the losses when things don't work out.  

But what about those dividends?  Should they be taxed? Dividends are generally paid out when a successful company generates more cash flow then they need to operate the business.  They add up their income minus their expenses, then they pay their state and federal income taxes (Tax #3), then they see if they have any money left over.  Any amount they don't reinvest into new factories or hiring new people may be returned to investors as dividends.  Companies can NOT deduct the cost of dividends paid out; this is merely a return of capital to the investors.

Taxing the same dollar three times.  Only Congress could think that makes sense.

Impacts of Changes - Tax Rate

Currently most Americans pay a 15% tax on capital gains incurred for assets held more than one year, with the current top rate being 20% plus the 3.8% Obamacare surcharge.  Biden's proposed top rate would raise capital gains tax rates to the HIGHEST RATES IN AMERICAN HISTORY.  History has proven that whatever you tax, you get less of.

Punishingly high capital gains rates would, logically, discourage long-term investment into American companies.  Why take the risk when you could be forced to share half of your winnings with the IRS?

Impact of Changes - Inherited Assets

This part of Biden's proposal is completely uncharted territory.  According to Wikipedia "Under the stepped-up basis rule, for an individual who inherits a capital asset, the cost basis is "stepped up" to its fair market value of the property at the time of the inheritance. When eventually sold, the capital gain or loss is only the difference in value from this stepped-up basis. Increase in value that occurred before the inheritance (such as during the life of the decedent) is never taxed."  

Stock ownership is more common and broad-based today than at any time in US history.  According to the Federal Reserve's Survey of Consumer Finances, 52% of American families own stock.  And with the rise of free online trading sites like Robinhood, the number is growing rapidly.   That means a lot more people are going to inherit some shares of stock when a loved one dies.  Under today's rules, the recipient can sell those shares at market price on day of death and not owe any capital gains taxes (although they will owe taxes on any future growth if they hold the stock).

Imagine the chaos Biden's proposed rule would unleash.  Now the IRS will expect you to somehow figure out what price Mom or Dad paid for the stock they left you, how long they held it, whether or not they bought additional shares or reinvested dividends over the years (all of which create an additional layer of accounting complexity), were there any partial sales along the way, etc.  The only way to figure this out is to hope that Mom and Dad saved every statement that was mailed to them over the years and kept those files organized in the basement somewhere. And if you're lucky you only have to do this crazy exercise for one stock.

I speak from personal experience on the matter.  My Dad died in 2005 and had owned some stock.  Subsequent to his death the IRS audited a prior tax return and suggested he owed some additional tax on a stock sale he had made.  In his final years my Dad was in very poor health and his mind was failing, and he wasn't as detailed as he had been earlier in life.  The IRS tasked me with crawling through old file cabinets and calling old brokerage firms to determine if my deceased father had properly calculated his capital gains taxes in a prior year.  Can you imagine how difficult that was?  And I'm a CPA for heaven's sake!

And now Biden is asking Congress to force each of you to become a CPA as well, just because somebody you love saved, invested, died and left you some stock.  How does that sound to you?  I hope your pencil is sharp and your calculator has extra batteries.

Looking Ahead

Look, I get it.  America has essential needs for defense, roads, postal service, courts, etc.  These things are to be paid with taxes and we all need to pay our share.  But there are a lot of ways to collect such taxes, and capital gains have shown to be a very poor method of doing so.  The logic behind them is fundamentally unsound and not at all tied to the activities those taxes are used for.  Even worse, raising capital gains taxes substantially can lead to a lack of investment in companies to empower their future growth.  Less investment means less growth which eventually means fewer jobs.

Instead of debating which punishing tax rate is best, why not just abolish the capital gains tax altogether?

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If you or someone you know has questions about how these potential tax changes may affect their retirement portfolio, click here to schedule a meeting.  We're happy to help.