Biden’s Capital Gains Tax: Explained

By Dr. Sylvia Kwan

April marked a month of record highs for the markets, with the Dow surpassing 34,000 for the first time on April 15th, and finishing the month up 2.7%. The S&P 500 ended the month up 5.2%, and the NASDAQ, up 5.4%. The US economy is rebounding faster than expected, driven by an increase in consumer spending as evidenced by an annualized 6.4% growth in US Gross Domestic Product (GDP) in the first quarter — the highest since 1984. And the stock market is on pace to reach one of the best first 100 days of a new presidential administration.

So markets are up and investors are happy — except now, Uncle Sam wants a bigger share of those market gains, particularly from the country’s wealthiest. Last Thursday, President Biden unveiled the American Families Plan (AFP), which proposes $1.8T in new federal spending over the next decade, to be paid for, in part, by increased taxes.

This news isn’t a surprise. As a candidate, President Biden campaigned on his plans for higher taxes for corporations and the wealthy, so it was never really a question of if, but of how much and when. As for how much, here are some of the specifics being proposed in the AFP:

  • The top marginal tax rate on wages would increase from 37% to 39.6%.

  • The 3.8% Medicare surtax would apply to all income over $400,000, not just investment income.

  • For those with incomes greater than $1 million, taxes on capital gains and dividends would increase to 39.6% (thereby taxing both earned income and investment income at the same rate).

  • Capital gains on inherited assets over $1 million would be subject to estate taxes.

Currently, any capital gains that are unrealized when a person dies are not taxed; instead, when they’re passed on to their next owner, those assets get “stepped up” to their fair market values, and the heir(s) keeps all of those gains, tax-free. The AFP proposes eliminating the “step-up” on gains over $1 million. (The first $1 million in gains would still be passed on to heirs tax-free.)

Bottom line: The total tax rate on capital gains and dividends for the wealthiest Americans would rise from 23.8% to 43.4%. And that’s just federal taxes. Tack on state taxes, and the total tax bill for the wealthy in high income–tax states like California, New York, Hawaii — and most recently, Washington — could increase to over 50%. And if the step-up elimination passes, that means wealthy Americans would be paying those taxes on inherited capital gains, as well.

Benjamin Franklin is often credited with saying that nothing is certain except death and taxes. If the AFP proposal passes as is, we can add one more certainty to the list: taxes on death and taxes.

But it’s still early days.

It’s unlikely Biden’s proposal will be passed as-is; even fellow Democrats have voiced concerns that higher taxes might slow economic growth. And the step-up tax break for heirs has been in the tax code for 100 years, so eliminating it will be an uphill battle.

Also, even if the proposal were to pass as is, the proposed tax rate increases would only impact 0.3% of Americans, according to the National Economic Council. Washington watchers believe that, after all is said and debated, the top rates on capital gains taxes will end up somewhere around 28–30%, about halfway between the current and proposed rates.

While it’s unlikely that every tax increase in President Biden’s proposal will pass without modification, it’s almost certain that taxes will increase by some amount. And that raises two major questions for investors:

1. How will markets react?

History tells us that there is no relationship between stock market performance and capital gains taxes. In the 1950s, when the capital gains tax rate was relatively high at 25%, investors saw better stock market returns than in the 70 years since. Meanwhile, the ’00s tech bubble and the 2008 global financial crisis happened while capital gains were being taxed at one of the lowest ever rates, 15%.

Moreover, only 25% of stocks are held in taxable accounts. The remaining 75% are held in pensions, endowments, and IRAs — none of which are subject to capital gains taxes. Stock prices don’t necessarily drop when investors sell in anticipation of higher capital gains taxes, because other investors may buy up those shares in accounts not subject to those taxes.

So tax rates don’t tend to drive market behavior over the long term. Other factors — valuations, geopolitics, monetary policy, and economic and business cycles — impact market performance much more.

2. What should investors do now to prepare for higher capital gains taxes?

There’s still plenty of uncertainty about how much taxes will increase and when. So acting now, without clarity, would be premature.

The first step is to determine whether these proposed increases would apply to you — is your income over $1 million? Then, if so, you can start by exploring options and available strategies that could help reduce your tax bill, if the need arises.

For example, you may be able to shift, defer, or lower your income from year to year by:

  • bunching multiple years of charitable contributions into one year

  • deferring part of your salary to future years (if that option is available from your employer)

  • managing income generation and recognition (if you’re self-employed)

Investors may also want to consider shifting some of their asset allocation or using municipal bonds in a more strategic way. For example, municipal bonds remain one of the few asset classes that are exempt from federal (and, in some cases, state) taxes. While bond yields remain low, the tax-equivalent yields for municipal bonds (the returns that a taxable bond would need to yield in order to ultimately yield as much as a tax-exempt municipal bond, post-tax) will rise as tax rates increase. Tax-exempt income is also excluded from the calculation of your gross income. So increasing allocations to tax-exempt bonds may enhance after-tax returns and help lower your gross income — and, by extension, your tax liabilities.

Later, if there are investments or assets that you plan to sell in the next year anyway, you might consider selling them before the date any tax increases take effect. You may also consider gifting highly appreciated assets to charity. Investors with large estates may consider some trust and estate planning this year to avoid future increases to estate taxes.

Or, you could simply hold and wait for a future Congress to inevitably change the tax rules again.

Each investor’s financial situation and tax posture is unique, so speak with your financial, tax, and estate professionals to determine what strategies would be most suitable for you. But while careful tax planning can reduce your tax liabilities, it’s important to remember not to let the tax tail wag the investment dog. Your investment decisions should be based first on the merits of the investment, its prospects for growth, and its risk and return characteristics; tax implications should always come second.

After all, paying taxes on a gain beats taking a loss any day.


© 2021 Ellevest, Inc. All Rights Reserved.

Sources of claims of fact: surpassing 34,000, S&P up 2.7%, increase in consumer spending, annualized 6.4%, best first 100 days, American Families Plan, assets get “stepped up”, wealthy in high income–tax states like Washington, Democrats have voiced concerns, 100-year step-up tax break for heirs, tax rate increase only affects 0.3% of Americans, top rates on capital gains taxes end up at 28-30%, no relationship between stock market performance and capital gains taxes, 1950s capital gains tax, 25% of stocks are held in taxable accounts

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

The information provided does not take into account the specific objectives, financial situation or particular needs of any specific person.

Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

Dr. Sylvia Kwan

Dr. Sylvia Kwan is the Chief Investment Officer of Ellevest.