You may have heard rumblings of a capital gains tax hike President Joe Biden is proposing for the wealthy.
If not, now you know! But don’t panic, it will mostly affect high earners.
If you’re earning under $400,000 a year, your tax bill isn’t likely to change. However, you may still be affected if the proposal passes, especially if you plan to sell a business or a valuable home. Here’s everything you need to know.
What’s Ahead:
What is President Biden’s tax proposal?
Biden’s American Families Plan has ambitious goals – the plan calls for free community college, universal pre-K, childcare assistance for lower-income parents, and more.
To raise the $1.8 trillion investment these goals require, Biden’s proposing higher taxes on capital gains for wealthy investors who earn over $1 million annually (only the top 0.3% of households), and higher income taxes for those who earn over $400,000.
Step-up in basis tax change
Another change in Biden’s plan will eliminate the “step-up in basis” provision that affects taxes you pay on inherited assets, like a home. The tax basis is the amount of the investment, which helps determine how much capital gains tax you’ll pay. The “step-up” readjusts the asset to its market value at the time of inheritance, so heirs don’t have to pay the large capital gains taxes they otherwise would.
Under the new rules, any inherited assets worth over $1 million (or $2.5 million if a couple passes them down) will be taxed as regular capital gains.
This may affect you if you stand to inherit property worth over $1 million, or if you’re planning to leave assets behind for others.
Marginal income tax rate increase
Included in the proposal is a move to raise the marginal income tax rate from 37% to 39.6% for taxpayers earning at least $400,000 a year. If you’re keeping track, the 39.6% rate was what this income bracket paid during the Obama administration.
That hike affects a lot more earners, but it’s more modest than the proposed increase on capital gains.
Medicare and net investment taxes
On top of the new 39.6% rate, long-term capital gain profits come with a few additional taxes for those in higher earning brackets. There’s a 3.8% tax to pay for national health care programs like Medicare and the Affordable Care Act, plus the 3.8% net investment income tax levied on earners who make $200,000 or more a year.
Add any state taxes on capital gains, and your overall tax bill could hover around 50% in some states.
How will capital gains be taxed?
Investors already pay annual taxes on any capital gains, or assets (mutual funds, stocks and bonds, and even your home) that you sell at a profit during the year. The current (as of June 2021) top-bracket long-term capital gains tax rate is 20%, plus a 3.8% surtax for Medicare.
The new plan practically doubles this rate to 39.6%; with the Medicare surtax, that’s a 43.4% rate. Long-term capital gains, essentially, would be taxed as ordinary income. The income tax rate would also be getting a bit of a hike for high earners, back up to 39.6% from the current 37%.
If you recently sold a lot of assets, don’t panic — the capital gains tax hike only applies to earners who make at least $1 million a year, or couples filing separately who each earn $500,000 a year. That’s about 0.3% of the American public. Most investors, particularly young ones, don’t fall into this category.
Short-term vs. long-term capital gains
The proposal would only affect long-term capital gains, or profit, on assets sold after you’ve held onto them for a year or longer. Short-term capital gains (gains from assets sold after less than a year) will continue to be taxed as ordinary income.
Which assets won’t get a tax hike?
Tax-deferred retirement accounts like 401(k)s won’t be affected by the new laws, so if most of your investment dollars are in retirement funds, you don’t have to worry about extra taxes.
Other exempt capital gains include:
- Assets of less than $1M transferred to heirs.
- Up to $250,000 on gains in the value of your primary residence.
- Any short-term capital gains (sold after less than a year).
Who will be affected by the capital gains tax hike?
People making over $400,000
If you earn over $400,000 a year, you’ll see a bump in your income tax rate. Those all the way up in the $1M bracket will pay the heftier long-term capital gains taxes on taxable brokerage accounts.
Small business owners planning to sell
Major one-time sales can tip someone over into the $1M tax bracket for a year, even if they don’t normally earn that much. If you’re selling a business or planning to pass one down to heirs, the sale is considered a capital gain. The higher taxes may affect your financial planning.
People selling their homes
Home sale profits are also considered capital gains. If you earn more than $250,000 from the sale (or $500,000 for a married couple), any additional profits will be taxed at a higher rate.
This may be an issue if your home has appreciated significantly in value; for instance, if you bought the house during an economic downturn and you’re now selling into a pricey market.
Investors (possibly)
Financial experts suspect a lot of big-time investors will sell their assets at once to avoid a tax hike — more on that possibility in a minute — and the volume of sales may lead to a short-term “market correction” where all investors feel the chaotic ripple effect. Portfolios might drop in value, but hopefully, the effect will be temporary.
Who won’t be affected?
Middle-class earners
Most of us won’t be earning $1 million a year anytime soon, so the capital gains proposal won’t change our financial planning. People who earn between $400,000 and $1 million a year will be affected by the income tax hike, but not the capital gains tax.
People in lower-income brackets (especially parents) may feel a positive effect since the higher taxes are intended to expand federal assistance programs.
Investors with tax-free or tax-deferred accounts
Most retirement accounts are in this category, so if you have a 401(k) or another retirement stash as your main asset, you won’t get a tax hike. Health Savings Accounts (HSAs) won’t be affected either.
Tax strategies to help lower your taxes
You can take action to lower your tax bill if you think the capital gains tax hike might affect you. Investors have control over when to buy and sell, so use this management discretion to your advantage.
One thing not to do is sell everything off in a panic because of the potential tax increase. Selling can be beneficial, but when used as a strategy as part of your long-term plans.
Lowering taxable income
You may want to increase charitable donations and other deductible expenses to lower your overall tax bill — chat with a financial professional to see what makes sense for you.
Tax-loss harvesting
This common brokerage technique “harvests” the losses of high earners by selling underperforming investments to reduce overall capital gains.
Converting to tax-deferred accounts
Maxing out your annual contributions to retirement accounts, health savings accounts, and other tax-deferred assets is a great way to lower the tax bill in the short term.
Summary
For most people, Biden’s capital gains tax hike (if it passes) won’t have much effect. If you are in an affected group, consider the tax hike in your financial planning, but don’t freak out; it’s smartest to stick with your previous investment plan and keep an eye out for new legislation.
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