Part 1: Navigating Capital Gains and the New Tax Regulations
Capital gains taxes represent a cost of successful investments. They apply to profitable sales of assets such as stocks, real estate, businesses, artwork, collectible cars, gold, and other valuables. The Biden Administration has advocated for increasing the capital gains rate, a goal that remains unlikely to be achieved before the upcoming November elections. Next year, when the tax cuts implemented during the former Trump Administration expire, this matter is anticipated to become a focal point of discussion, potentially triggering a complete overhaul of the tax system.
1. How Are Capital Gains Taxed?
Capital gains taxes are assessed on the difference between the purchase price and the sale price of an asset. The federal rate for investments held for over one-year peaks at 20%, significantly lower than the top marginal rate of 37% on wages and salaries. For investments held for a year or less, the tax rate matches that of ordinary income. Additionally, a 3.8% tax on capital gains applies to individuals earning at least $200,000, or married couples earning $250,000, to support the Obamacare health-insurance subsidy program. A higher 28% rate is imposed on certain small business investments and collectibles such as art, antiques, stamps, wine, and precious metals. State-level capital gains taxes vary.
2. Who Pays Capital Gains Taxes?
While anyone can incur capital gains, the wealthiest taxpayers typically generate a significant portion of their income from these gains. Notably, capital gains taxes do not affect tax-favored retirement accounts like 401(k)s or IRAs, where withdrawals are taxed as ordinary income. Lower-income taxpayers might be exempt from capital gains taxes; for instance, individuals earning up to $47,025 pay a 0% rate this year. Homeowners benefit from an exemption on the first $250,000 of proceeds from the sale of a primary residence, or $500,000 for married couples.
3. Are US Capital Gains Tax Rates High or Low?
The combined top rate of 23.8% (including the Obamacare surcharge) positions the US in the middle range compared to Europe. Scandinavian countries like Denmark and Finland have some of the highest rates on investment gains. Countries such as Switzerland do not have a specific capital gains tax but treat investment proceeds as ordinary income. Others, including Belgium and Denmark, offer exemptions for certain long-held stock sales. Recently, Canada adjusted its rules to tax two-thirds of capital gains income, up from the previous 50%.
4. Why Are Capital Gains Taxed Lower Than Other Income?
Advocates for the lower capital gains rate argue that it incentivizes entrepreneurship and risk-taking, and encourages investors to sell assets periodically, thereby avoiding the lock-in effect where investors hold onto assets to defer taxes. Some proponents even call for the elimination of capital gains taxes. However, critics contend that the disparity between tax rates on wages and investments fosters tax rate arbitrage, allowing the wealthy to reduce their tax liabilities. A notable example is how private equity and hedge fund managers classify more of their income as investment returns rather than management fees, which are taxed at ordinary income rates.
5. What’s Being Proposed?
In the most recent budget proposal, The Biden Administration requested to nearly double the capital gains tax rate to 39.6% for individuals earning $1 million or more, aligning it with the proposed top marginal income tax rate. The additional 3.8% Obamacare surcharge would continue to apply to these higher rates.
If you’re looking for more insight and information on the topic of capital gains and how it could affect your investments, reach out to your Colmina advisor for more information.
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