President Biden’s proposal to increase the capital gains tax from 20% to 39.6% for people making over $1 million a year sounds aggressive. Add on the Net Investment Income Tax of 3.8%, and we’re talking a total long-term capital gains tax rate of 43.4%.
If this new long-term capital gains tax gets approved to pay for the American Families Plan, qualifying residents in California would pay a 56.7% combined state & Federal tax rate. New Jersey residents would pay 54.1%. New York residents would pay 58.2%. At the margin, people in these states with such means will relocate or find other ways to avoid taxes.
No matter how much you make or where you stand politically, I think most people agree we should keep the majority of our income and wealth (50.1%+) given we worked for it. Do you really think it’s fair if the government gets to keep more of your money than you do? I don’t. Maybe if the government managed our money better. But the government is inefficient and sometimes corrupt.
Given only about 0.3% of Americans make more than $1 million a year, this potential capital gains tax hike won’t affect the vast majority of us directly. However, it could cause rampant selling of assets by those who are affected, which would ultimately end up hurting most investor’s portfolios.
How Does A Hike In Capital Gains Tax Rates Affect Stock Market Returns?
This chart from UBS states there is “no apparent relationship between changes in capital gains tax rates and market returns.” However, unless my eyes are deceiving me, there is a downward sloping line indicating lower S&P 500 returns and higher capital gains tax rates. The year 2013 is the outlier where returns were especially high in a higher capital gains tax rate environment.
The thing is, President Biden is looking to raise the capital gains tax rate by almost 2,000 basis points (20%). Therefore, if a 1,000 basis point increase lowers the S&P 500 return from 12% – 8%, perhaps a 2,000 basis point hike would lower the average S&P 500 return to 4% – 5%. Nobody knows for sure.
The last time capital-gains taxes were hiked, in 2013, the wealthiest households sold 1% of their equity assets, according to Goldman Sachs. According to the Federal Reserve’s distributional financial account data, the top 1% held $17.79 trillion of equities and mutual funds in the fourth quarter of 2020. Therefore, a 1% selling of stocks this time would be about $178 billion. This selling could hit the markets leading up to the passing of a capital gains tax hike.
However, I don’t think a long-term capital gains tax hike to 39.6% will happen. Instead, there will likely be compromise to get some tax hike passed to help pay for all the stimulus spending.
For equity investors, at the margin, ETFs should benefit over mutual funds given ETFs are more tax efficient. ETFs’ unique “in-kind mechanism” allows them to avoid incurring capital gains during the year. See chart below of the largest ETFs with the lowest expense ratios.
The two headwinds for stock investors are higher taxes and Federal Reserve tapering (less monetary stimulus, less buying, etc.) on the horizon. Therefore, I am perfectly fine with de-risking my stock positions into strength and enjoying the YOLO Economy to the maximum.
How A Capital Gains Tax Hike Affects Different Earners
Beyond the implications of stock market returns for all investors, the other issue about the capital gains tax hike is how one should decide to earn money going forward.
Before we start, let’s clarify how the capital gains tax hike is applied. The capital gains tax hike will affect capital gains above the COMBINED income + capital gains threshold of $1 million.
For example, let’s say you earn $900,000 in income and $500,000 in capital gains. The capital gains affected by a potential capital gains tax hike = ($900,000 + $500,000) – $1,000,000 = $400,000. Sorry for folks who think making just under $1 million exempts you from paying a higher capital gains tax rate, if one gets approved.
1) The Startup Employee
Let’s say you join a startup for a $100,000 a year salary discount for lots of equity. Your income is $100,000 instead of $200,000 for a 1% stake in the company. At a $100,000 income, all your capital gains are taxed at a 15% rate if held longer than a year.
Let’s say 20 years later your company gets acquired for a handsome sum of $100 million. Further, there is no dilution in your stake. You receive a $2 million windfall.
However, instead of getting taxed at a 15% long-term capital gains tax rate, you are taxed at a 43.4% rate (39.6% + 3.8% NIIT) for the $1 million above the $1 million threshold. Let’s say you live in a state that doesn’t have state income tax or capital gains tax.
Let’s say your first $1 million gets taxed at 20%, which leaves you with $800,000. Your second $1 million gets taxed at 43.4%, which turns to $566,000. Therefore, you receive $1,366,000 after paying taxes on your $2 million capital gain. Your effective capital gains tax rate is 31.7%.
The $2 million in salary you would have earned over 20 years would have faced a 20% effective tax rate. Therefore, we can add $1,600,000 ($2 million X 80%) to $1,366,000 to equal $2,966,000 in net income and net capital gains after 20 years. Not bad. However, being a startup employee will get marginally worse if the capital gains tax hike is passed.
2) The Mature Company Employee
If you had spent 20 years working at a mature company for $200,000 a year with no windfall, you would have also made the same total gross income of $4 million.
However, the $4 million in salary would have paid an effective federal tax rate of about 20.5%. Therefore, after 20 years of working at a mature company, your $4 million in salary would have netted you $3,180,000.
$3,180,000 is higher than the net proceeds of $2,966,000 by the startup employee. And the reality is, the startup employee probably has less than a 20% chance of getting a $2 million windfall. Even if the company was sold for $100 million, the startup employee would probably see his stake diluted by at least 20%.
Finally, given the time value of money, the mature company employee could have easily saved and invested some of his income for greater returns. For example, let’s say the mature company employee invested $35,000 a year of his salary in the S&P 500. If the S&P 500 returned 8% a year for 20 years, the contributions would be worth $1,729,802 versus $700,000 if he had left it all in cash.
The mature company employee is now ahead of the startup employee by about $1,214,000! The odds are already against you to strike it rich at a startup as a common employee. A long-term capital gains tax hike will only make your odds worse.
Therefore, if there is a long-term capital gains tax hike, you may want to join a company that pays you the highest salary up to where income tax rates go up. In other words, if income tax rates go up for $400,000+ income earners, then the ideal income may be $400,000. You can then spread out your capital gains to ensure you never hit the income limit where you must pay a higher capital gains tax rate.
3) The Small Business Owner
Let’s say you agree with me the easiest way to make money from home is to start your own website. You don’t want to be at the mercy of a government shutdown if another pandemic hits. You also want to one day have a sustainable family business to leave to your children. Therefore, you go ahead and start the next great blog.
For the first three years, you make about $2/hour on average after grinding away for 40 hours a week. But you don’t give up because you know the secret to success is 10+ years of unwavering commitment. So you keep on working on your side hustle before and after work.
Then, in year five, your website starts regularly generating $5,000 a month in profits before tax. And by year 10, your website starts generating $20,000 a month in profits before tax. Someone tries to low ball you and offers 5X operating profits, or $1.2 million. You decline!
Assuming you unrealistically had $0 salary, your first $1 million would turn into $800,000 after paying 20% long-term capital gains tax. The remaining $200,000 would turn into only $113,200 due to a 43.4% long-term capital gains tax over $1 million. Your after tax proceeds are about $913,200. Even if you could get a steady 4% annual return, that’s only $36,528 a year in investment income.
A More Reasonable $4.5 Million Offer
You keep grinding away for three more years. Then another company offers you a more reasonable 15X operating profit offer for your website. Your website is now generating $300,000 a year so that’s $4.5 million!
You’re tempted to accept. But if you do, you’d only be left with $1,981,000 ($3.5 million X 56.6%) on the $3.5 million above the first $1 million. Again, let’s assume the first $1 million pays a 20% effective long-term capital gains tax rate. Your total proceeds after tax would be about $2,781,000 ($1,981,000 + $800,000). Not bad. But can you imagine paying a $1,719,000 tax bill on your $4.5 million sale? What an economic waste!
Further, $2,781,000 in net proceeds still only generates $111,240 a year at a 4% rate of return. That’s not much compared to the $300,000 in annual operating profits you were generating. And if you lived in California, the $3.5 million above the first million would be taxed at 56.7%. Ugh.
Forget it. No rational person would ever sell their cash cow business, especially in a low interest rate environment. The more millions you get, the more you will pay in taxes. It is much more efficient to earn a reasonable salary + distributions to pay less taxes. Less inventory of small businesses to buy means the overall value of small businesses should go up.
4) The Long-Term Homeowner
Finally, we have the long-term homeowner who is sitting on more than $1 million in capital gains beyond the $250K/$500K tax-free profit exclusion. Think about your grandparents buying homes before the 1970s. Does the homeowner sell, pay a high capital gains tax rate, and then downsize to a smaller home or apartment? Or does the homeowner keep the long-time home and pass it down to his or her children through their estate?
It seems clear a capital gains tax hike would encourage long-term homeowners to keep holding their homes, thereby lowering inventory. It’s already difficult enough to move out of a home you’ve lived in for 40+ years. So many wonderful memories! Why would you then sell it to pay a 43.4% capital gains tax?
Besides, it is reported President Biden may not touch the estate tax threshold limit, which currently stands at $11.7 million per person. Although the “step-up basis” may be eliminated, it probably won’t matter since only about 0.1% of American households ever have to pay a death tax. However, without the step-up basis, may also never want to sell given the large capital gains tax bill.
Therefore, an increase in the long-term capital gains tax rate may actually serve to boost the housing market even further. In addition, if the 1031 Exchange rule remains intact (under fire), I suspect more people will roll over their capital gains into new properties or Opportunity Zone Funds.
Personally, I plan to continue investing in rental properties and private eREITs for capital and rent appreciation. In an inflationary environment, I want to be long real estate as much as comfortably possible.
The Sustainability Of Income Is Important
Having a $1+ million financial windfall is nice. But it depends on how long it took you to get it. To then have to pay a huge capital gains tax rate would be unfortunate. This is especially true if your income plummets the following year, as is the case with most business owners who sell.
In my opinion, you aren’t considered a top 1% income earner if you cannot sustainably earn a $1+ million income for years. You would need to earn $1+ million for three years in a row to not consider your income a fluke or a financial windfall.
If you are a typical W2 employee, making over $1 million a year is extremely difficult. You must put in way more than 40 hours a week. Further, you likely must produce at least $10 million in attributable revenue for your firm. Finally, you probably also need the economic conditions to be fantastic to enable you to produce and earn so much.
Some people can hit a top 1% income every once in a while. But to consistently earn over $1 million a year for decades is practically impossible at the moment.
Despite only 0.3% of Americans earning $1 million a year, only 0.1% of estates pay a death tax. This goes to show that accumulating a top 1% net worth may be even harder.
A Look Into Investment Banking
In investment banking, less than 1% of employees make Managing Director. Managing Directors usually have a salary between $400,000 – $500,000. Therefore, a Managing Director needs to generate enough revenue or have a team that generates enough revenue to warrant him or her a bonus of at least $500,000 – $600,000 to hit $1 million.
Making $1 million is definitely doable for a Managing Director during a bull market. But as we know, bear markets sometimes happen. Further, your firm could randomly lose billions from a bad prime brokerage relationship.
Just observe what happened with Archegos Capital costing $10 billion in prime brokerage losses to various investment banks. Bonuses for those employees likely will get hit this year, even if they had nothing to do with Archegos Capital. Land mines are everywhere.
The other issue is longevity. To make $1+ million, the pressure is always on to produce. Randall Dillard, the former head of investment banking at Nomura said, “Managing directors in investment banking last around 18 months. Most people simply cannot handle the amounts of revenue they are expected to generate year after year.”
I find Dillard’s comment to be true. I had a revolving door of Managing Directors during my 11 years at my old firm. A MD almost has a lifecycle of the median NFL player of 3.3 years!
Instead of making $1+ million a year, it may actually be better to earn $400,000 a year divided by two working parents and “cruise.” When it comes to money, it’s funny how everything is relative.
The Easiest Way To Sustain A Big Income
The easiest way to sustain a $1 million income is by having $50 million in investments generating a risk-free 2% a year. In this scenario, you will likely be able to generate $1 million in income forever. Too bad amassing $50 million is almost impossible for all but the lucky few.
Of course, you don’t need to generate $1 million to be happy. You just need to generate enough passive investment income to cover your desired living expenses. Achieving this goal gets you 90%+ of the way there to living a great life. The marginal 10% really isn’t going to make much of a difference to your happiness.
Therefore, in a positive way, raising the long-term capital gains tax might save overworked people from trying to work even more for the elusive $1 million income mark. I find there’s an unhealthy desire in this country for excessive amounts of money. Post-pandemic, hopefully all of us have considered how to better utilize our time.
A higher capital gains tax rate might also encourage more people to hold onto their investments for longer. Instead of selling your big gains, borrow from them to avoid paying a high capital gains tax rate.
Aiming For A Much Lower Income
Our family should be comfortable living off $300,000 a year in passive income once we peace out again. At the moment, it’s enough income to give us a savings buffer of at least 20%. As someone who has saved aggressively his entire life, I can’t help but not want to continue saving post-retirement.
$300,000 in capital gains is taxed at a favorable 15% long-term capital gains tax rate. $300,000 in active income is also taxed at a reasonable 24% marginal federal income tax rate. To me, once a total effective tax rate starts surpassing 30%, it starts to feel uncomfortable. And once the effective marginal tax rate rises above 35%, my desire to go above and beyond disappears.
Unfortunately, if you are a startup employee or an exhausted small business owner who has a favorable exit, you will likely have to pay a lot more in taxes. However, that’s still better than not having a financial windfall at all!
To build real wealth, it’s generally a good idea to hold onto your assets for as long as possible. Let the power of compounding work its magic. Extending my holding period is one of the reasons why I invest in private real estate, private equity, and venture debt. 5-10 years from now, I’m confident there will be gains.
Let’s hope a higher capital gains tax rate changes investor behavior for the better. May the potential increase in tax revenue actually go towards helping the poor and middle class prosper.
Readers, what do you think about the potential capital gains tax hike? What do you think is a reasonable long-term capital gains tax rate? Who else gets hit by this capital gains tax hike? I like that the American Families Plan will subsidize childcare and pay for 12 weeks of parental leave.
If my math tax is wrong, let me know! Everything is just an estimate. I will be updating this post when there is new information. Bottom line: avoid $1+ million windfalls and spread them out if possible. Sign up for my free private newsletter for more insights.