Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. A proposal from the Biden administration would change the way investment gains are taxed for some investors. Joining me to share some perspective on the proposal is Christine Benz. Christine is director of personal finance at Morningstar.
Hi, Christine. Thanks for being here today.
Christine Benz: Hi, Susan. Great to be here.
Dziubinski: Let's start with some stage setting. Can you sort of walk us through what's in the proposal?
Benz: Right. There are two main prongs to it. The first would affect the highest capital gains rate. It's currently 20%, 23.8% when you add in the Medicare surtax. It would go up to 39.6%, or over 43% once you factor in that surtax. So, this is a big jump up. This would only apply to people who have incomes of over $1 million. So, if you are selling highly appreciated stock in a year in which your income is over $1 million, you would be subject to this higher tax.
The second prong of the proposal relates to what's called the step-up in cost basis that heirs enjoy when someone dies and passes on an asset to them. As things stand today, each person who inherits an asset, if you inherit an asset from someone else and it has appreciated a lot since that person initially purchased it, those gains in the security while the person held it essentially get washed away, and your cost basis as the person inheriting the stock is the price of the security on the date of death. This proposal would eliminate the step-up for gains of more than $1 million. Those are the two main components of this proposal as we've seen it today.
Dziubinski: Now, what would need to happen, Christine, for this proposal to actually become law?
Benz: Well, a lot, because it needs to get through a deeply divided Congress. This is a proposal by the Biden administration, but, as we know, Congress is pretty evenly split by party and also philosophically. So, this proposal has a ways to go before there is any certainty around it, which is one reason why it really makes sense to sit tight, wait for more information, and don't proactively make changes to your portfolio--because this may or may not happen.
Dziubinski: Even if this proposal is enacted, you don't think it's really going to affect most investors. Walk us through that.
Benz: Well, it really won't. Most people, to be subject to this new higher capital gains tax, you'd have to tick two boxes. You'd have to be selling securities and your income would need to be over $1 million. That's a rarified subset of investors right there. Most investors aren't anywhere near that income level, and even if they are, they may have the opportunity to perhaps sell appreciated securities in lower tax years when they come in under that threshold. It's kind of a similar thing with this step-up that most people die, to the extent that they die and they have assets leftover, oftentimes those would be retirement accounts, which are not subject to capital gains tax rates, and to the extent that they might have taxable assets, well, they probably wouldn't have gains in excess of this $1 million threshold. So, this is not going to apply to most mainstream investors. It's generally crafted to affect the very highest-income, highest-portfolio-value investors the most.
Dziubinski: What tax planning or portfolio strategies would you recommend to an investor who may think he or she could actually be subject to this new higher capital gains right down the road or to the step-up in basis?
Benz: Right. These proposals generally embellish the case for using retirement accounts first--for maxing out those either tax-deferred or Roth vehicles, which are not subject to capital gains tax nor are they eligible for the step-up in basis. So, we knew that we should be maxing out those accounts, but this proposal, should it become enacted, would really underscore the benefits of doing so. It would also argue for charitable giving, to the extent that you are charitably inclined, to making sure that you are giving appreciated assets to charity. That makes sense really no matter what the tax regime, but it would be especially beneficial in a higher tax regime, where if you are gifting assets to charity, you are essentially able to remove the tax liability associated with those assets from your estate.
It also argues for being a bit artful about how you sell appreciated assets--that you'd want to really be thoughtful about disposing of them in years in which you wouldn't be on the hook for this higher capital gains tax. Those are a few different things that you might consider.
Dziubinski: Christine, thank you for your time today and for this thoughtful analysis of this proposal. We appreciate your time.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.