Understanding the Capital Gains Tax

High-earning investors could be paying around 40% in federal capital gains taxes in the near future.

U.S. President Joe Biden presented his American Families Plan to Congress on April 28. It includes a number of new initiatives that would be funded by raising taxes on high-income Americans. This legislation calls for increasing the top individual tax rate from 37% to 39.6%, and raising the capital gains tax rate from 20% to 39.6% for taxpayers with incomes higher than $1 million—and even higher for those required to pay the net investment income tax.

 

Understanding the Impact

Investors pay capital gains taxes on the sale and qualified dividends of stocks, bonds, real estate and collectible assets. And high-income investors don't just pay the base capital gains tax rate. The IRS charges high-income investors an additional 3.8% net investment income tax. So if the American Families Plan becomes law, many investors with income over $1 million could pay 43.4% in federal capital gains taxes. The same rate will apply to individual taxpayers or those married filing separately with income over $500,000.

"This does not include additional capital gains taxes imposed at the state level," explained Joe Goldman, a trust advisor with City National Bank.

 

When Might the Changes Take Effect?

Before any change takes place, legislation needs to be finalized and passed. It's not possible to forecast with any certainty when a law might be passed. However, with Democrats controlling both houses of Congress and the presidency, it is a legitimate possibility that some sort of tax legislation will be passed ultimately.

The U.S. Treasury Department's Green Book, which contains details of the administration's budget tax proposals, notes that the changes are requested to be retroactive to the date of proposal, which was made in late April 2021. But making a tax increase like this retroactive would be unusual, so many tax experts don't expect the changes to be retroactive.

However, Biden's request for retroactivity may signal that the changes won't wait until next year. “I think the president was throwing out a marker, letting people know, OK, you may not be able to get away until January," BDO tax partner Todd Simmens told Accounting Today. “You may not be able to plan around a capital gains increase over the next eight months. It's going to come sooner, but I'm not sure that the end of April is the sooner."

 

How To Minimize Tax Liability on Capital Gains

If the proposed increase takes effect, investment sales may become costlier for wealthy investors. But there are options for managing the tax impact, such as the following considerations.

Keep Your Income Below $1 Million

Should the capital gains tax rate increase pass, if you think your taxable income will be $1 million or more in a year when the higher rate is in effect, there are ways to reduce it, such as increasing itemized deductions. You can increase charitable donations, pre-pay mortgage payments with tax-deductible interest, take business expenses or medical and dental expenses. “Donor advised funds are particularly good vehicles to help time your charitable contributions in a tax-efficient manner," said Goldman. In addition, you can max out tax-advantaged contributions to a health savings account, 529 education savings plans and retirement accounts.

Time Investment Sales

If the implementation date of the tax increase is not made retroactive, an investor who would be subject to the higher rate can choose to sell investments prior to the effective date and lock in the lower capital gains rate.

Plan Carefully for Business Sales

The sale of a business can result in a capital gain worth millions of dollars. Business owners who may not normally fall into the category of income over $1 million might suddenly have to pay more than 40% of their earnings from a business sale in federal capital gains taxes.

However, there are options for structuring the sale of a business to lower tax liability, such as an installment sale, in which you take a portion of the payout annually for several years. If your business is in transition, it's a good idea to meet with a financial or tax advisor at least six to nine months ahead of the sale. He or she can help you determine the best way to structure the sale of your business to minimize capital gains tax liability.

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