Summertime usually offers a reprieve from taxes for most of the country. We are a few months removed from the April tax filing deadline and a few months away from the October extended filing deadline. We aren’t worried about year-end tax planning like we will be in December and we aren’t assessing the impact of new tax laws like we seem to be every January. In short, we don’t usually anticipate major tax news to hit in the summer.
Unfortunately, the never ending news stream appears to have affected the tax world just as it has every other aspect of our lives. There have been several developments in taxes this summer that we think you should be aware of, which we’ll outline below.
Capital Gains Inflation Adjustment
Under current tax law, when you sell an investment holding you are taxed on the difference between the selling price and the original purchase price, known as your capital gain (or loss). For years it has been argued the original purchase price should be adjusted for inflation when calculating the gain/loss on the disposition of an asset. Without this adjustment, an investment that merely keeps up with inflation over the holding period will generate a taxable capital gain, even if the investment didn’t really increase in value in real (net of inflation) terms.
This is the argument behind the inflation adjustment and on first glance it certainly makes sense. There are however some other factors to consider on this issue:
- Capital gains are already generally taxed at a lower rate than ordinary income. While there are now three levels of capital gains taxation (0%, 15% and 20%), most taxpayers will pay tax at a much lower rate on capital gains than they do on their wage income.
- There are other items in the tax law that are also not indexed for inflation - such as interest payments and depreciation deductions. To make capital gains taxation completely inflation-neutral these should ideally be adjusted for inflation as well.
- The logistics of calculating and implementing such an inflation adjustment could prove to be a nightmare. The IRS only recently began to require custodians to report the cost basis of investments and asking taxpayers to retroactively calculate inflation adjustments on investments that could’ve been held for many years sounds like a disaster waiting to happen.
- Depending on how such a rule is structured, it could open up a whole slew of tax planning opportunities for many taxpayers. As we saw with last year’s tax reform bill, there are always unintended consequences when changes like this are made to the tax law.
Indexing capital gains for inflation is a move that would be loaded with political ramifications as well. Treasury Secretary Steven Mnuchin has already mentioned trying to get such a proposal passed on a “non legislative basis”, which would effectively circumvent Congress. A recent Congressional Research Service paper indicated about 90% of the benefits from such a tax cut would go to the top 1% of households and it is estimated it would reduce federal revenue by about $102 billion over a decade. Proponents of the rule argue that it will have a significant positive impact on long-term investment of capital that could offset some of that lost revenue. It could also lead to a short-term tax revenue boost as people look to sell long-term investments with large unrealized capital gains.
This rule is still a long way from becoming a reality and there are many headwinds to suggest it will never happen. However, the ramifications of such a rule would be huge and it is clearly something we will need to keep an eye on in Washington.
Tax Reform 2.0
If your head is still spinning trying to wrap your head around the tax reform bill passed at the end of last year, you probably don’t want to think about round 2 yet. Unfortunately you don’t have a choice because in July House Republicans unveiled a plan they have dubbed “Tax Reform 2.0” to follow up on last year’s Tax Cuts and Jobs Act (TCJA). The primary piece of this legislation is an extension of last year’s tax cuts for individuals and pass-through entities. In order to get that legislation passed last year a number of the cuts were set to expire in 2025 but of course Republicans would like to make them permanent.
The other aspects of Tax Reform 2.0 are aimed at “promoting family savings” through a variety of different proposals:
- Creating a new universal savings account that can be funded with after-tax dollars but which would allow tax-free withdrawals for a variety of needs.
- Allowing 529 education accounts to be used more widely, particularly to cover the cost of homeschooling, to pay for apprenticeship fees to learn a trade and to help pay off student debt.
- Allowing families to access their own retirement accounts penalty-free after having a baby or adopting a child.Just as they did with the original tax reform bill last year, the administration released a “framework” for this new tax reform bill, which you can read here.
Like last year’s tax reform framework it is short on details and will likely change many times before a vote is cast. Most experts don’t expect anything to happen with the new tax reform bill until after the November elections but we’ll continue to monitor any developments.
Working on Withholding
The massive tax overhaul passed at the end of 2017 presented a logistical nightmare for employers trying to adjust withholdings for 2018 based on the new laws. The IRS released a detailed withholding calculator to help taxpayers determine if they were withholding the correct amount. However, as I discussed with Darla Mercado at CNBC, the calculator is complex and could lead to people making further errors on their withholding. A recent GAO report confirmed these concerns as it cautioned that many more taxpayers could be underwithheld this year than in past years.
In light of all the changes to the tax law and these issues over withholdings, the IRS released a draft of a new Form W-4 in June. This is the form that all new employees have to fill out before starting work so their employer can determine the appropriate amount of taxes to withhold from their earnings. In the past the form was relatively straightforward as taxpayers would determine the appropriate number of “allowances” to claim. On the proposed draft Form W-4 you would no longer claim any allowances but would be able to include much more information to more accurately calculate an appropriate withholding amount. That information includes non-wage income (dividends and interest income), itemized deductions, wages of other members of the household and expected tax credits.
While the additional information might help determine a more accurate calculation of withholdings, it also might be more information than some people would like to share with an employer. Luckily you won’t be required to fill out a new W-4 if you are comfortable with your current withholdings. And it remains to be seen what the final version of this form will look like, which is anticipated to be released in November.
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.Please see Additional Disclosures more information.