Inflation and Capital Gains Taxes, 4/21
Something for investors to worry about
In Peter Thiel’s rabble-rousing speech at the Bitcoin conference, he makes a point that I have been making about how capital gains taxes interact with inflation. If you buy a stock at $100 and sell it in a year for $200, 20 percent of that $100 gain is taxable. That is true even if all of that gain reflects general inflation, meaning that your purchasing power of $200 when you sell is no higher than the purchasing power of $100 when you bought.
One way to defend yourself is to not sell the stock. As the laws exist today, you are not taxed until you sell. Instead of selling, you could borrow against the stock. And as the laws exist today, you could leave the stock to your heirs, who will not have to pay capital gains tax on it.
But if you own a mutual fund that enjoys a capital gain, you do not have a choice to defer that gain for tax purposes. Mutual funds are required by law to distribute gains to shareholders.
I don’t mind getting capital gains distributions in a non-taxable retirement account. But if the mutual fund is in a taxable account, I would rather not receive a capital gains distribution.
My understanding is that ETFs are less likely to generate capital gains distributions than are ordinary mutual funds. So ETFs may dominate mutual funds as investment vehicles in taxable accounts. But in a high-inflation environment, perhaps even ETFs will find it more difficult to avoid realizing capital gains. If so, then buying the stocks yourself might be better for tax purposes than buying an ETF. But only a tax advisor would know for sure, and I am not one of those.
Note that this year the Democrats floated the idea of taxing capital gains that have not yet been realized. So if the stock you bought a year ago for $100 is now worth $200, you have to pay capital gains, even if you do not sell it. At today’s inflation rate, if a tax on unrealized gains were adopted, investors would be in a world of pain. I would expect a massive shift away from equities into tax-advantaged investments, such as government-issued securities.