In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses President Biden’s proposed capital gains tax hike and why investors should look into a Roth IRA to invest in capital assets.
In this bonus episode of Adam Talks, Adam Bergman wanted to discuss President Biden’s proposed hike to the capital gains tax rate. As it stands the capital gains tax sits at 20%. The proposal would see it skyrocket to 39.6%! Plus, there would be a 3.8% tax on net investment income. These changes would only apply to those earning over $1 million annually. That part is where the confusion sets in.
What is Capital Gains?
We recently wrote an article about this proposal from President Biden. We all know, based on his campaign, that he wants to increase taxes on the wealthiest of Americans. This proposal is just one piece of that puzzle. But we’re still unclear what the final legislation, if it passes, would look like.
Capital gains is essentially the amount your investment is worth now versus when you acquired it. When you purchase a capital asset, such as stocks, real estate or cryptocurrency, you must be aware of these rules. If the asset is held less than twelve months, you owe short-term capital gains; longer than twelve months, you will be subject to the long-term capital gains tax rate. To be clear, short-term gains are treated like income, and will be taxed at your current tax rate. However, long-term gains will be subject to the capital gains tax regime.
As we mentioned, the current advantage of holding assets longer is the lower tax rate (for many people) that you are subject to. Biden’s plan will change that, as it nearly doubles the current rate. It’s important to stress, that most Americans will not be affected. However, just how is the income calculated for the higher rate?
What is Considered Earnings?
What is unclear at this point is how the $1 million earnings threshold is going to be determined. Some experts predict it will be based on your AGI – adjusted gross income. The example Adam talks about in the podcast is a lawyer, who earns $250,000 annually, who sells a capital asset (in this case, a piece a real estate) for a $900,000 gain. Does that mean, he or she would be subjected to the higher tax since the sale breached the threshold?
Will the IRS simply look at your ordinary earned income? Our lawyer above would be in the clear since he or she is well below the million dollar threshold. It seems unlikely though. A betting man would lean towards AGI, which exposes much more people to the higher tax.
Eliminating the Step-Up in Basis
The proposal would also eliminate the step-up in basis upon death. If you buy and asset, which increased in value, and leave it to your heirs when you pass, the beneficiary would get a bit of a tax break. Instead of paying capital gains on based on the original price, you can use the higher price, which would lower the tax implications. For example, if you buy a house for $250,000 and, when you pass, it’s worth $500,000. Your beneficiary sells the property for $600,000. You would owe taxes on a $100,000 difference, instead of $350,000. This proposal would eliminate that step-up, and give you a bigger tax bill.
What Can You Do?
Obviously, no one wants to pay higher taxes. The best thing you can do in preparation for changes in the tax code, is invest with a Roth IRA. Pay taxes now, and never have to worry about them again. A Roth is funded with after-tax money, therefore there is no immediate tax break. However, high earners don’t get a tax break anyway. If you are worried about the capital gains tax hike, it makes sense to deal with the taxes now (while they’re still low).
If you have assets in a traditional plan, you can convert them to a Roth. Taxes would be due on the amount you convert. When you sell a capital asset, you won’t need to worry about the taxes. So long as you are age 59 1/2 and have a Roth IRA open for at least five years, there will be no taxes due when you distribute from the plan.
Plus, any contributions you make to a Roth can be withdrawn at anytime, without tax or penalty. This allows you to be flexible and invest in a tax-advantaged retirement plan, but still have access to those funds if needed. Keep in mind, earnings can not be touched early or you will owe taxes on them, plus pay a 10% penalty.
We know changes are coming as far as taxes are concerned. President Biden made that quite clear when he was running for office. We can totally expect a capital gains tax hike in the near future. Will it be as severe as proposed? Probably not, but there will be a hike for sure. Be prepared and work with a tax planner so you don’t get stuck with huge tax bill (or leave one to your heirs!).
Thanks for listening, and Mr. Bergman will continue to bring insight on any new legislation that gets proposed and/or enacted. Check out our SoundCloud page for all of our episodes, and we will see you next time!