Over half of capital gains are never taxed. This is because capital gains can often be easily avoided by refusing to sell the asset. While this tax avoidance is frequently the best course of action, it results in a great loss to the economy as investors refuse to move capital to where it will do the greatest good for the economy. Additionally, the tax on capital gains does not actually tax a gain in much real purchasing power.
Currently the top federal capital gains tax rate is about 23.8% and the top state capital gains tax rate is California at 13.3%. Officially inflation is currently reported as low, but in the past it has been as high as 14% or more.
Now imagine an investor in California at the top tax rates earning 13.5% on her investments in an 8.5% inflationary environment.
Starting with a $100,000 investment, by the end of the year our hypothetical investor will need to net $8,500 just to keep up with inflation.
Fortunately her investments are earning a real return of 5% over inflation hence a nominal return of 13.5% or $13,500.
Realizing $13,500 in capital gains will result in her having to pay $3,213 to the federal government (23.8%) and $1,795.5 to the state of California (13.3%) leaving her with just $8,491.50. Despite taking the significant risk of investing and earning a nominal return of 13.5%, she is left with a loss in her purchasing power of $8.50 and a negative real return of -0.01%.
Punishing people for inflation is neither fair nor good economic policy.
Obviously the fact that there is a capital gains tax makes tax planning critically important.
Our hypothetical California small business owner is not even keeping up with inflation. Those same investments growing in a Roth 401(k) or Roth IRA account would pay no tax and have a real return of 5%. The difference between a -0.01% real return and a 5% real return over 30 years is the difference between the purchasing power dwindling to $99,745 or appreciating to $432,194.
Getting your investments into a Roth account is one of the many ways to avoid the punitive tax policies associated with capital gains. Another way is for our congressmen to abolish the capital gains tax.
Photo by Almos Bechtold on Unsplash