Democrats propose higher 25% capital gains tax rate — here are 3 ways to minimize the potential hit

A proposal unveiled by Democrats in the U.S. House of Representatives on Monday aims to raise taxes by up to $2.9 trillion over the next decade, including increased levies on corporations and high earners. Among the items mentioned in the plan is an increase in the highest tax rate on long-term capital gains and dividends, to 25 percent from the current rate of 20 percent.

Here’s how the plan could affect investors and what moves they can make to keep more of their profit — or at least defer the impact further down the road.

Higher taxes on long-term capital gains and dividends

House Democrats have proposed raising taxes on dividends and long-term capital gains, those investments held for more than one year. Here’s how this aspect of the House’s plan shakes out:

• The highest rate on long-term capital gains and dividends would rise to 25 percent from 20 percent for the highest tier of earners.
• Lower brackets for long-term capital gains and dividends would remain at zero and 15 percent for lower earners.
• Short-term capital gains would continue to be taxed at ordinary income rates.

The increase in the highest long-term capital gains and dividend rate is lower than that proposed by President Joe Biden, who has argued for a rate of 39.6 percent for high earners.

Currently the highest long-term capital gains and dividend rate hits individual filers with annual income over $441,450 and joint filers with more than $496,600 in income.

Importantly, the increase in rates would be effective as of Sept. 13, 2021 under the proposal, so investors would not have time to adjust their portfolios before the law goes into effect.

“The proposed higher tax on capital gains would be consistent with President Biden’s promise to limit tax increases to single filers making $400,000 or more as well as married filers with incomes of $450,000 and above,” says Mark Hamrick, senior economic analyst at Bankrate.

“The plan also represents the ambitions of the more progressive members of the party who want to make wealthier Americans pay substantially more in taxes, particularly those who have substantial investments,” Hamrick says.

Vocal Democratic members of the House, including New York Rep. Alexandria Ocasio-Cortez, have been calling for increased taxes on higher earners. Ocasio-Cortez recently appeared at the 2021 Met Gala in New York wearing a dress with the words “Tax the rich.”

Hamrick expects that, given the levels of federal debt and deficits, this round of tax increases may be the first in a series, so investors should start thinking ahead about what to do in order to minimize future taxes.

What investors can do to minimize the potential tax bite

Investors wanting to safeguard their wealth may be looking for alternatives, but the first thing to realize is that the House proposal is the opening bid on what could be a long and contentious process.

“At this point in the legislative process on Capitol Hill, it is important to know that it isn’t over until the president signs a bill into law,” Hamrick says. “There will be a lot of wheeling and dealing as this legislation moves from committee to the full House and the Senate.”

But investors looking to minimize the potential tax hit can already start making moves, including:

• Max out contributions to retirement plans. A traditional 401(k) allows workers to save money on a pre-tax basis, meaning they can deduct any taxes on their contributions. This tax-advantaged account allows investors to grow their contributions on a tax-deferred basis and pay taxes on the gains only when withdrawn. Meanwhile, a Roth 401(k) lets investors grow their money without taxes and withdraw it tax-free, too.
• Plan to hold investments longer. Consistent with current law, the proposal would tax only realized capital gains, meaning that if you do not sell your investments, you will not be taxed on gains. So investors can avoid the tax hit by holding their investments longer.
• Shift from dividends to capital appreciation. Dividends would also be hit by the proposal, meaning investors might prefer to put new money into investments that are focused on long-term growth rather than those paying income as dividends. However, they may want to avoid selling investments — and potentially incurring a tax hit — to do so.

In general, if taxes rise, investors can counter by thinking and investing longer term and by using accounts that are specifically designed to minimize taxes on investments.

Bottom line

Given significant federal deficits and the current government leadership, investors and others should be expecting higher tax rates in the future. Fortunately, investors have alternatives that at least minimize the tax hit, if not eliminate it outright. Finally, it’s important to note that the proposed changes, if enacted, do not affect the vast majority of Americans.

Learn more:

• 2020-2021 tax brackets and federal income tax rates
• Your 401(k) plan: 5 smart moves to make in 2021
• How much should you contribute to your 401(k)?

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.