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President Joe Biden on Wednesday unveiled a plan to increase capital gains taxes, and the numbers back up what the administration has been saying for some time: Unless you make a lot of money, you probably won’t feel any direct impact from the proposed changes.
But if you earn more than $1 million per year, listen up.
Under the proposal, the highest income tax rate would return to 39.6% (where it stood from 2013 to 2017), up from the current 37%. Along with that increase, the Biden administration's plan would tax capital gains — profits from the sale of certain assets or investments — at the same rate as ordinary income for households earning more than $1 million, and that’s where the biggest change would happen.
Currently, the country’s highest earners typically pay a 20% capital gains tax. If Biden’s proposal makes it through Congress, that rate would nearly double to 39.6%. And that doesn’t include the 3.8% net investment income tax that would apply to some or any state capital gains taxes, which would be added on top of the federal tax.
According to the Biden administration, very few Americans would feel the effects of a federal increase: A scant 0.3% of U.S. households earn more than $1 million a year.
Investors using a 401(k) — one of the most common investment vehicles in the country — are especially unaffected by the proposed changes for a specific (and extremely beneficial) reason, says Serina Shyu, a certified financial planner and an advisor with Delta Community Retirement & Investment Services.
“Your average person who has most of his or her wealth accumulated in a 401(k) plan shouldn't worry about this particular proposal because capital gains taxes don't apply to qualified retirement plans like 401(k)s,” Shyu said in an email interview.
Put simply, if this proposal makes it into law, and that’s still an if considering it would have to make it through Congress as is, it’s unlikely the capital gains component will affect the vast majority of U.S. investors.
But if this affects the broader market, should I sell now?
First, this increase is far from certain, so we’ll need to see how the proposal plays out.
“This is merely a proposal and Congress will absolutely adjust that proposed percentage as the two chambers compromise on what the final version will look like,” Shyu said.
Also, basing any financial decision on a politician’s plan likely isn’t a sound strategy. For the majority of investors, blocking out the headlines and sticking with an investment game plan is an unbeaten strategy, says Michael Murphy, managing partner of venture capital firm Rosecliff Ventures and a Fox Business Network financial market correspondent.
“Investing and staying invested in the overall market, say an S&P 500 low-cost index fund, has always worked,” Murphy says. “And regardless of where taxes go, that strategy’s still going to work.”
Yes, the market fell when news of the proposal made the rounds a week ago, but the S&P 500 was back up the following day, and by Thursday, the day after Biden's speech, it closed at a fresh high. In this instance, panic selling may have meant missing out on that gain.
Capital gains tax management for the rest of us
Even if Biden’s proposal won’t affect you, that doesn’t mean you should forget about capital gains taxes altogether. Here are a few things to keep in mind.
Think long term
There’s a big difference between long-term capital gains tax and short-term, and this is one area of taxes that’s firmly in your control. Generally, if you can hold an asset for at least one year, you’ll qualify for the long-term capital gains tax rate. That means if you make $40,400 to $445,850, you would pay 15% on capital gains. But if you sell before holding for one year, it would be taxed at your regular income tax rate, which, if you earn more than $40,525 per year, would be over 22%.
Patience is a virtue, but in the world of capital gains taxes, patience also pays.
Use tax-advantaged investment accounts
If you’re enrolled in your employer’s 401(k) plan, kudos — you’re already doing this. Tax-advantaged accounts, such as 401(k)s, individual retirement accounts, health savings accounts and 529 college savings accounts let your investments grow tax-deferred or tax-free.
Put more bluntly, if you sell investments in these types of accounts, you likely won’t owe capital gains taxes.
Let a robo-advisor handle it for you
Automated financial advisors, or robo-advisors, take on a lot of the confusing aspects of portfolio management for you, from helping choose initial investments to auto-rebalancing over time. And many will even use smart tax strategies such as tax-loss harvesting, which is a fancy name for selling investments that have dropped in value to offset the gains from those that have gone up in value. The strategy is helpful, automatic and available through many robo-advisors.