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Capital Gains Tax Plan: Key Takeaways from Biden's Tax Plan


What to know about the Capital Gains Tax Plan.

President Biden’s election campaign ran on a promise to increase taxes on wealthy Americans and corporations. As part of the American Families Plan, the Biden administration has proposed substantial overall tax increases to fund its costs.

Here’s everything you need to know about Biden’s capital gains tax plan and what it means for you.

Capital Gains 101

A capital gain arises when you sell an asset at a higher price than you paid for it. In other words, the government expects a cut when you sell your investments at a profit. That cut is the capital gains tax.

Currently, capital gains are taxed at 0%, 15%, or 20% tax rate, depending on the overall income level of the taxpayer. The higher the taxable income, the higher the tax rate.

Capital gains are typically associated with the buying and selling of stocks, but they also apply to assets such as real estate, jewelry, collectibles, and mutual funds. Not every capital asset qualifies for capital gains tax. For example, business inventory and depreciable business property are excluded from the capital gains treatment.

What makes a capital gain? To answer this question, it’s important to understand the difference between realized gains and unrealized gains. Your income in any given year is the difference in value between the assets you own and the debts you accrue. Anything that raises your net worth is subject to tax, be it your home or investment portfolio. A gain is not realized on these investments until it’s sold for a profit.

In essence, as long as you hold on to an investment, you don’t have to pay capital gains no matter how much it appreciates in value. It’s also important to note the longer you hold on to an investment, the less you’ll have to pay in tax. The tax system is set up to benefit the long-term investor.

Capital gains are classified as either long-term or short-term. This depends on whether you've owned an asset for longer than a year. Short-term capital gains are taxed as ordinary income and according to the federal income tax brackets.

Inside the Biden Capital Gains Tax Plan

Historically, the long-term capital gains rate has been much lower than the top ordinary income tax rates. Biden's capital gains tax plan seeks to eliminate this gap in its entirety. If the proposed legislation pushes through Congress, the top rate for realized gains will stand equal to the top marginal income tax rate, which will rise from 37% to 39.6%.

The capital gains tax plan was made retroactive to the date of announcement to prevent wealthy taxpayers from quickly selling off assets to avoid the tax hike.

One important caveat: the capital gains tax plan is ambitious, but it's not set in stone. Negotiations are in the early days, and the precise tax rates are likely to change as Congress hashes out the particulars of the legislation.

Here’s a breakdown of what Biden’s tax plan accomplishes.

  • Will the Federal Tax Brackets Change?

Yes, but only for individuals with an income exceeding $400,000 per year. In addition, if you earn more than $1 million annually, you’ll see a notable increase in the long-term capital gains tax rates as the top-tier tax bracket rises to 39.6% from the current 20%.

Coupled with the additional 3.8% Medicare surtax on Net Investment Income Tax (NIIT), the tax rate could rise to 43.4% and 48% if you include state income taxes.

These higher tax rates will only apply to taxable brokerage accounts. Tax-sheltered investments, such as 401(k)s, will continue to be exempt. The tax hike also won't impact endowments held by tax-exempt organizations such as non-profits and colleges.

You should also note that the proposed tax rates do not apply to gains on small business stock and property or collectible assets such as coins, art, antiques, or gold and silver. The tax rate on these assets maxes out at 28%. Short-term gains are still taxed as ordinary income.

  • How Does the Tax Plan Impact Inherited Wealth?

The Biden tax plan also seeks to eliminate a loophole that enables people to avoid paying capital gains tax on inherited wealth. Capital gains on inherited assets are currently subjected to a tax break known as "step-up in basis."

Typically, an asset is more valuable when passed on to a beneficiary than it was at the point of acquisition. For tax purposes, the step-up in basis provision readjusts the value of an inherited asset when it is passed to its fair market value at that point.

Essentially, the wealthy could bequeath assets to their heirs tax-free, which worked as a great tax avoidance strategy since investors don't pay tax on unrealized capital gains. The Biden tax revision means wealthy Americans will pay a higher tax on their inherited assets.

  • Why Raise Capital Gains Taxes Now?

The vast majority earn most of their money from wages and salaries. In contrast, for the highest of earners, capital gains make up a significant portion of their annual income, up to two-thirds for the exceedingly wealthy.

Imposing higher tax rates on assets held is meant to help the economy recover from the current recession and simultaneously combat income inequality. Whether or not the capital gain tax plan will increase economic efficiency is a topic for tax scholars.

How Can High-Income Investors Lower Capital Gains?

There are a number of ways tax advisors can help clients minimize their capital gains taxes. Here are the four best strategies.

  1. Invest in your retirement. You can hold assets subject to capital gains in retirement accounts. Roth IRAs and 401(k) s are exempt from capital gain taxes, unlike other investment portfolios. But, withdrawals from these accounts are still taxed at the ordinary income tax rate.
  2. Time your sales. Selling your assets slowly over time can keep your annual income beneath the $1 million threshold. Doing so allows you to avoid taxes on your long-term capital gains.
  3. Continually harvest your losses. When balancing your portfolios, you can use capital losses to offset capital gains. Currently, you can claim up to $3,000 and carry the loss forward to other tax years.
  4. Donate to charity. By donating appreciated assets, you qualify for a charitable tax deduction, and you get to avoid capital gains taxes altogether.
  5. Reduce your taxable income. To keep your income below the $1 million threshold, you might want to max out all the tax-advantaged contributions at your disposal, including your health savings accounts (HSAs) and your 529 plans. You can also reduce your taxable income by itemizing deductions such as business and medical expenses.

Stay Vigilant with BAAP CPA

By raising the top capital gains tax rate, the American Families Plan could significantly impact your finances. While it’s tough to predict whether the Biden tax plan will survive Congress negotiations, it’s advisable to stay vigilant and get a tax advisor on board to help you craft the optimal financial plan for you.

BAAP CPA is the leading business advisory and accounting firm offering comprehensive business tax planning and business advisory services in Clearwater. We can help you take a proactive approach towards achieving your financial goals. The tax code is complicated; let us navigate through the logistics for you. We're here to save you money and take the hassle out of tax planning and preparation.

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