The IRS Could Soon Change How Capital Gains Are Taxed - And Retirees Could Save Thousands

A push to index capital gains for inflation could have a significant impact on where you stand financially. Indexing capital gains could mean that retirees with long-held investments are able to keep more of their money when they sell off those investments, leading to a potential boost for their retirement funds.

Here's what to know about how indexing for inflation might impact capital gains and how it might affect your investments.

How capital gains are currently calculated

Under current law, you have to pay a tax on capital gains, or your return on investment, when you sell an asset like a home, stocks, or bonds. If you've held the asset for more than a year, that tax rate is usually reduced, but it may still eat into your profits. The tax rate you pay also depends on your tax bracket. Some low- and middle-income taxpayers may pay no tax on a long-term capital gain, while those in a higher tax bracket may pay up to 23.8% in tax.

Capital gains may be calculated by subtracting the original purchase price of an asset, like a home, from the sales price. This calculation overlooks the fact that inflation could have on an asset's value. For example, if you bought a house 10 years ago, the house would naturally be worth more today simply because of inflation. The current calculation would require you to pay federal tax on the gains resulting from the entire increase in the home's value, so you would partially be paying taxes on the value increase caused by inflation, not real growth.

Proponents of reform call these 'phantom gains,' which are taxable profits that exist on paper but don't reflect any real increase in purchasing power.

What indexing for inflation might do

Indexing capital gains for inflation would involve using a more complicated formula to calculate capital gains. The formula is more precise and would account for how inflation had increased the asset's price.

Indexing could potentially save taxpayers tens of thousands of dollars in taxes. It might have a significant impact on retirees with substantial investments, allowing them to retain more of the investments' profits and ultimately meaning they have more cash to rely on in retirement.

An example of how indexing might work

Let's say a retiree invested in a $500,000 portfolio in 2010. According to the CPI Inflation Calculator, a 2.68% inflation rate per year would mean the portfolio would be worth about $763,611.18 today. The portfolio would have increased by $263,611.18 over 16 years, simply due to inflation.

Under current law, most retirees would pay 15% in taxes on the gains, while higher-income retirees would pay 20% tax plus a 3.8% net investment income tax. Since capital gains are taxed regardless of whether they're the result of inflation, most retirees would pay $39,541.68 in taxes on just the capital gains resulting from inflation. That's before accounting for any value increase the portfolio saw over that same 16-year period.

If capital gains were indexed, those retirees would only pay taxes on the portion of their gains that weren't caused by inflation, saving nearly $40,000 in taxes. The savings could be even greater for retirees who have held portfolios for longer periods of time, or who wish to liquidate larger portfolios.

The push for a policy change

Conservative advocates and Republican senators are pushing the Treasury Department to change its policy and index capital gains for inflation. In March, Senator Ted Cruz and Senator Tim Scott contacted Treasury Secretary Scott Bessent, requesting that he use executive power to index capital gains. Several House Republicans also submitted a letter in support of the request.

The Senators argued that inflation has distorted capital gains that consumers pay on assets.

Could the policy change happen

Cruz and Scott have asked Bessent to use executive power to implement the change, arguing that the change may be implemented without an act of Congress. But Article I, Section 8 of the U.S. Constitution specifies that Congress has the sole authority to collect taxes, duties, imposts, and excises, so the Treasury's use of an executive order to implement the change may not be permissible.

Who might benefit

Retirees stand to see significant benefits if capital gains were indexed. For example, if retirees hold appreciated index funds, they may pay a large amount of tax based on inflation, increasing their capital gains. Landlords who purchased rentals in the early 2000s may be ready to sell those properties, but inflation may have increased their value significantly.

Indexing for inflation could save retirees in these and similar situations large amounts of money, giving them more funds to rely on in retirement.

Bottom line

Whether the request to index capital gains for inflation might move forward is uncertain at this time. The Trump administration considered a similar executive action in 2018 and didn't move forward. The current requested executive action would likely face tremendous legal challenges, so while this is an issue worth monitoring, the request may not result in any actual changes to capital gains taxes.

If you've held assets for years and are considering liquidating them, it's best to consult a tax advisor beforehand, whether you plan to start investing again or want to keep cash on hand in retirement.

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