Most investors in 2016 know that long term capital gains and dividends receive a tax break. Less well known is the fitful and turgid history of the exact discount applied to capital gains taxes. For instance President Reagan, in the great tax simplification of 1986, abolished the break, treating long term capital gains as ordinary income. About a decade later, President Clinton put in place a new sort of break, different from what had preceded 1986; later Clinton’s break was sweetened by President Bush, who also extended the break to qualified dividends. Next, in 2013 President Obama dialed back on Bush’s break with a new levy, the Net Investment Income Tax (NIIT).
If you go back before 1986, the history is just as tangled: http://www.taxpolicycenter.org/statistics/historical-capital-gains-and-taxes
My point: whether capital gains should be given any break, and how much of a break, is an object of political struggle. The gap between the capital gains rate and the regular tax rate has no necessary or fundamental value. The break is only whatever Congress decrees it to be.
And if Congress has been busily engaged in making the tax code more and more complex, as it has ever since 1986, then we should not be surprised if the exact rate paid on capital gains becomes more and more difficult to discern.
Bluntly: if you are an ordinary member of the prosperous middle class, you haven’t a clue how much you pay on your long term capital gains and dividends. Sadly, you may have made Herculean efforts to arrange your affairs to take advantage of a break that wasn’t anywhere near as sweet as you thought.
You can stop now.
Devil in the Details
Supposedly, there are three rates applied to capital gains:
- Zero, for married couples who would be in the 15% regular bracket or below, corresponding to taxable income of about $75,000 or less in 2016
- 15%, for couples with taxable income up to about $466,000
- 20%, for couples with income above that level, where the top marginal tax rate of 39.6% also begins.
If you are an alert investor, you may be aware that since 2013, a new overlay tax applies to some taxpayers who would otherwise owe 15%, and to all taxpayers who would otherwise owe 20%. Specifically, the NIIT of 3.8% is tacked on for married couples whose total adjusted gross income (AGI) is over $250,000.
On the face of it, a chart of the applicable capital gains and dividend rate should look like the bottom blue line in the chart below, with the rate topping out at 23.8% for families earning over half a million dollars.
You might be thinking, it’s still a great break to pay 23.8% instead of 39.6%. And you’d be right. Millionaires and billionaires l-o-o-ve the capital gains tax break. The hedge fund manager in Florida who takes a million dollars as capital gain rather than as ordinary income saves $158,000 in tax. The Texas billionaire saves $158 million in tax. Real money.
But you are not a millionaire, are you? What do you think you pay?
If you are a prosperous middle class person in a state like California, you pay quite a bit more, and benefit way, way less. Politically speaking, you’ve been snookered. Someone has to replace the $158 million that billionaire saved. That someone is you, across all the taxes you pay. See the end of the essay for the political implications.
Your capital gains tax rate
For this discussion I’ll take the worst case scenario: a married couple living in a state like California or New York or Oregon, which has a high state income tax and which offers no break on capital gains or dividends, taxing these as ordinary income.
Too narrow an audience? I submit to you that half or more of the population of prosperous middle class families, who I define as making between $100,000 and $500,000, live in states like California or New York.
State tax is not the only extra tax imposed on capital gains. In any zone where a tax benefit is phased out—most notably the Alternative Minimum Tax zone—the effect of the phase-out is to bump up marginal rates in the zone where the phase-out occurs (see this post for more on the baleful effect of phase-outs on tax burdens).
The middle red line in the chart shows the true total capitalgains rate for these folks.
Ouch. Except for a fortunate few, the rate on capital gains, among the middle classes who reside on the West coast and in the Northeast, runs about 35%. Almost as much as a Texas billionaire pays on ordinary income.
Let’s see how the 35% breaks down, for California couples with taxable incomes between about $200,000 and $400,000, corresponding to Adjusted Gross Incomes of $250,000 to $500,000. First there is the statutory rate of 15%. Next is the NIIT of 3.8%. Then comes the full 9.3% state income tax, which is not deductible for people in the AMT zone. Last, and most surprising, is the impact of phasing out the AMT exemption, at 7%. There you have it: 15 + 3.8 + + 9.3 + 7 = 35.1% tax rate on capital gains and dividends.
*The AMT exemption phases out at 25 cents on the dollar where it applies, which will generally be from the point you become subject to the AMT, up until about AGI of $500,000, where the phase-out is complete. In the phase-out zone, any extra income, capital gains or otherwise, increases your marginal tax rate by 25% of the AMT rate of 28%, hence +7%. Remember that, next time you read someone asserting that the AMT is a model for a “flat tax,” or an exemplar for “tax simplification.” Idiots.
A lot of these families think they are in the 28% or 33% bracket for regular income, so that capital gains rate may come as a shock. But they are not; AMT victims in this income range (redundant, since almost every Californian in this income range must pay AMT) would pay 48.1% on interest from a bank CD or other ordinary, non-favored investment income (28% AMT + 7% AMT phase-out + 9.3% state tax + 3.8% NIIT).
So that’s some consolation, eh? You still get a 13% cut on capital gains versus ordinary investment income, 35% vs 48%, almost as good as the billionaire’s 15.8% break. Of course, your break is applied to the pitiful few thousand dollars of capital gains you might accrue in a good year, but hey, you contribute less to society than does the billionaire entrepreneur. Right?
Implications for your financial planning
Sometimes you will read statements like this: “one disadvantage of using tax-deferred vehicles like a 401(k) or IRA to save for the long term is that withdrawals will be taxed at ordinary income rates, rather than the more favorable rates that apply to long term capital gains.”
Now you know: your capital gains rate ain’t that favorable. You may want to redouble your efforts to maximize 401(k) contributions. You won’t be in that 48.1% bracket when you take withdrawals from your 401(k) many years hence.
The larger implication: how very difficult it is to materially improve on your middle class station by saving and investing in ordinary bank accounts, ordinary brokerage accounts, or mutual funds outside a tax-sheltered account. You won’t get anywhere paying 48% on interest from bank deposits or bond funds. You won’t get that far paying 35% on capital gains and dividends.
The secondary implication is that you can’t effectively save for college either, except by using one of the tax-deferred accounts available. In a Uniform Transfer to Minors Account, investment earnings are totally tax free up to about $1000/year, and incur very little state tax up to about $2000 of earnings. Your kids are in the 0% bracket for capital gains and dividends. Jump on that! For a larger accumulation, 529 accounts have their place. (Many families in my prosperous audience will not be eligible to contribute to Coverdell accounts, which would otherwise be a third option.)
A final implication: if you have capital gains, and you are charitably inclined, then your high capital gains rate makes it that much less painful to make donations by contributing appreciated investments, instead of cash. Here are two numerical examples to give you a feel for the math. In both, I assume a Californian couple in the 44.3% AMT bracket for most of their (wage) income, and the 35.1% bracket for long term capital gains.
Example #1: You bought stock for $1000 that is now worth $2000.
- If you took your gain, you would have your $1000 basis plus (1 – 35.1%) X $1000, or $1649, available to consume for your own pleasure
- If you donate the entire $2000 position, you would reduce your taxes by 44.3% X $2000, or $886, which would be the amount you could consume.
Had the tax table rates applied, you would have been in the 28% regular and 15% capital gains brackets, and instead of $1649 / $886, the ratio would have been $1720 / $560. In other words, low tax rates make charitable donations more “costly:” you give up $1160 to be charitable, under the statutory federal rates, as opposed to the $760 foregone under the actual California rates.
Example #2: You bought stock for $1000 that is now worth $10,000—a ten-bagger, as Peter Lynch called it.
- If you took your gain, you would have your $1000 basis plus (1 – 35.1%) X $9000, or $6841, available to consume for your own pleasure
- If you donate the entire $10,000 position, you would reduce your taxes by 44.3% X $10,000, or $4430, which would be the amount you could consume.
Note that when your gain is proportionately large, in this case 900%, your charitable donation leaves you with more cash, in the form of reduced taxes, than your initial investment: you started with $1000, and ended up with $4430 still available to spend—plus you donated $10,000 to charity.
In general, as gain balloons, the cost ratio—what you’d keep after sale, versus what you’d receive in tax breaks for the donation—will converge on the ratio of (1 – capital gains rate) / (regular tax rate), or 649 to 443 in our running example.
Big gains + high tax rates = lots of charitable work, at minimum out of pocket cost to you.
And that’s the end of my good news.
Back to more bad news. Take a look at the black line on the chart, which shows the tax rate paid on Treasury bond interest and similar Federal obligations. These are not subject to State income tax, but are subject to the NIIT and are otherwise treated as ordinary income subject to regular and AMT tax rates.
As a testament to the absurdity of our tax system, and the higher-than-you-knew tax rates that apply to long term capital gains and qualified dividends, look closely at the middle of the chart. Yep, you got that right: Some Californians pay a higher rate on capital gains and dividends than they pay on Treasury bond interest. That’s your reward for taking entrepreneurial risk.
The victims occupy a narrow range of income above the $500,000 AGI level, for about the next $100,000 or so. The victims include not just Californians, but couples in that income range in any state where state and local income tax rates sum to 8% or higher (quite a few states, actually).
This oddity results from a wrinkle in the AMT tax system. Immediately above $500,000 AGI, where the AMT exemption phases out, the nominal AMT rate of 28% applies. Here additions to ordinary income are taxed at 28%, and capital gains / dividends at 20%. After another $100,000 or so, the couple will emerge from the AMT zone, because the regular tax rate, which went to 39.6% above taxable income of $466,000, begins to exceed the AMT calculation.
Within that transition zone, a Californian pays as follows on long term capital gains and qualified dividends: 20% + 9.3% State + 3.8% NIIT = 33.1% (increasing to 34.1% when the Californian couple enters the 10.3% bracket a little above $500K).
But on Treasury interest, that couple pays 28% AMT + 0% State + 3.8% NIIT = 31.8%—a lower rate.
Weird, huh?
Political implications
Hedge fund millionaires, and billionaire entrepreneurs, benefit hugely from a reduced tax rate on capital gains. They can make occasional, huge outsize gains, beyond the ken of ordinary wage slaves, and Congress decrees that they can keep more of those gains than if they had been paid out as earned income.
Of course, put nakedly in those terms, special breaks for capital gains would not be politically supportable. An ideological overlay is required. You know the drill: “an economy that rewards investment will receive more investment. More investment means more wealth creation, and a wealthier economy brings benefits to all.”
Or, slightly more strident: “Entrepreneurs are the engines of economic growth, which is the only hope for us all. Their outsized rewards match their outsize contributions.”
Or, when the curtain slips and true feelings come out: “Investors of capital are makers; everyone else is a taker.”
Is it good governmental policy to promote savings and investment? Probably. I’m receptive to the idea that when I save and invest for the long term, I should get a break, so that I can better accumulate capital, and be able to invest more …
I stuck a new word in the previous paragraph: savings. When I save money in a bank, I enable that bank to lend, which is also a form of capital investment, which should be encouraged too, right?
And here we see the naked politics behind the current capital gains rate structure. Capital is fungible. It doesn’t matter if 1000 small savers each put $1000 on deposit with a bank, which is then lent out, versus having one capitalist invest $1,000,000.
But in terms of political contributions and lobbying power, the two situations are night and day different. That’s why we repeatedly see a break for capital gains enter the tax code. The millionaire investor has much more clout in Washington than the small saver.
Any capital gains break, formulated as a lowered rate, will disproportionately benefit those with disproportionate wealth. That’s as certain as arithmetic.
The solution—the way to balance the equities between encouraging investment, and exacerbating inequality—must take the form of a break for capital gains that is not a break on the rate. The next post offers a modest proposal to that end.
For although capital is fungible, justice is not. As a society, we should prefer an arrangement where capital comes from 1000 small savers, and the tax break goes to those small savers, to one in which capital comes from a few big fish, who swell up further with the rewards paid by tax-favored investment.
IMHO.
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