Everyone is talking about capital gains taxes these days. To give you a baseline to understand the news on this topic, I’m going to walk through some key details around what capital gains taxes are and how they impact your portfolio. Also, in light of President Biden’s proposed capital gains tax increase, we’ll dive into the ways you might be impacted (even if only indirectly).
I’ll caveat as I usually do – I am not a tax professional / CPA…just an avid google-user and taxpayer.
What are capital gains taxes
Capital gains are the taxes you pay on the profits from the sale of any type of asset (stocks, bonds, real estate, etc.). It’s important to note that you won’t pay these taxes on assets like stocks unless you actually sell them (e.g., realize the gain), so if you prescribe to the buy and hold strategy with investing you will likely have no capital gains taxes (you will still likely have to pay taxes on dividends).
So basically, you take your Sale Price minus your Purchase Price and in most scenarios that is the capital gain you are on the hook to pay taxes for. You pay taxes on the rest of your income, so logically follows that you’d pay taxes on your investment income. HOWEVER, the amount you pay is very different from income you earn from your day job and understanding these differences can be critical to your financial planning.
Let’s look at an example to illustrate this:
You sold your NVIDIA shares in retirement after holding for many years for a $100K profit (and your total taxable income for the year is $100K). You would pay ~20% with state and federal taxes, which would be ~$20K in capital gains taxes. Not an insignificant amount.
There are a variety of considerations for what tax rate you’ll pay with capital gains, but here are the major ones:
- How long you have held the asset (greater or less than a year)
- Your income bracket
- Your marital status
- The type of asset (certain assets have special rules around them)
Short vs. Long-term capital gains
The first consideration with capital gains are whether you have held the asset for more or less than a year. If you have held the asset for more than a year you will qualify for the long-term capital gains tax rates listed here:
Posted on: Bankrate.com
The dollar thresholds are the amount of taxable income you have that qualifies you for a given tax rate. So Individual filers making less than $40,400 won’t pay any capital gains taxes, the rate will jump to 15% if an individual filer makes between $40,401-$445,850, and maxes out at 20% above that.
In addition, you may owe an additional 3.8% tax under the Net Investment Income Tax if you have above a certain quantity of adjusted gross income (>$200K for a single filer – IRS).
If you have held the asset for less than a year you will simply treat the investment income like regular income and pay taxes accordingly (from 10%-37% depending on your income / situation). You don’t get the 0% tax bracket and you are no longer capped at 20%, which is a huge downside to short-term capital gains.
Let’s take our earlier example where you sold your NVIDIA shares for a $100K profit in retirement, however, you sold them before a 1 year holding period. You would be on the hook for an additional ~$17.5K in taxes because you didn’t hold the asset for more than a year! (SmartAsset Capital Gains Tax Calculator)
As a result, there can be serious advantages to holding a particular asset for the longer term.
Minimizing your capital gains / special situations
There are several ways to minimize your capital gains
First – Hold your investments longer than a year
Covered above
Second – Tax-loss harvest
One interesting caveat with capital gains is you’ll only pay taxes on your net investment gain or loss. Meaning if you earned $100 in profit from selling stock A after 2 years and lost $100 from selling stock B after 2 years, you would have $0 in net investment income to pay gains on.
You can only deduct losses from similar types of capital gains (e.g., long-term losses can offset long-term gains and the same for short-term gains and losses).
As a result at the end of the year, if you knew you had $100 in long-term capital gains and you had another long-held investment that had a loss, you could sell that other investment to lower your tax burden for the year.
Third – Real estate is always an exception
As with most things, real estate is special to incentivize homeownership. If you own a house and live in it for 2 of the 5 years leading up to a sale, you can exempt up to $250K of capital gains as an individual or $500K as a joint couple.
For rental properties that you haven’t been living in this wouldn’t be the case. In addition, you may have been claiming depreciation expenses to reduce your tax liability over the years and might have to pay capital gains on the depreciated quantity, which could be quite high if you have owned the house for a while.
What we know about the current tax proposal
We will learn more over the course of the day on Wednesday, but I will outline the basics of what we know so far about the proposed tax increase. (This is not a commentary on whether or not I think the proposed tax increase is a good idea, simply things to keep in mind as you pay attention to changes in the financial world).
Markets took a (temporary) dip on Thursday on news of a potential increase in the capital gains tax rate. While details are still being released, it would increase the top bracket long-term capital gains tax rate from 20% to 39.6% (and raise the top income tax rate to 39.6%). This would only apply to investment income >$1M, bringing the total tax bracket to 43.6% with the added NIIT. Given that this change would only impact the top tax brackets and many investors have money primarily in their tax-advantaged retirement accounts, this would not directly impact that many investors (directly being the operative word).
I’ve said in a few prior posts that the difference between the taxes you pay on investment income vs. W-2 income makes it a no brainer that you should be optimizing for your investment income as you are paying only around half away in taxes and that is part of the reason it is so difficult to become financially independent with just W-2 income.
Now given the high threshold here you may think this won’t impact you, however, if it’s actually passed, there would likely be a pretty massive impact on the market as people who would be in that threshold represent a significant portion of the invested base and that could change their decision making around investing substantially. In addition, other portions of the proposed bill (e.g., changes in how carried interest is taxed) would substantially change the investment behavior and success of other stakeholders in the market, all of which could have a direct impact on your portfolio.
All of this is purely theoretical for now. With a pretty much 50-50 senate and a lot of pressure on moderate democrats, it seems unlikely that this will pass in its full nature. That being said, some iteration of tax hikes are likely to pass and it will be important to pay attention to how they may or may not affect you so you can be ready for the impact.
As I said, I am certainly not a tax professional so if you can think of anything I am missing here, let me know!
RWM
