The GOP's tax bill would hit individual investors with next capital gains tax rules, while allowing mutual funds and exchange-traded funds to operate under the old rules.
The proposed changes will make it more difficult for smart individual investors to reduce their tax burden with tax-loss harvesting, while forcing investors to pay more in capital gains tax when selling shares in taxable accounts.
Here's how a change to capital gains taxation could impact individual investors in a big way.
What's at stake
Capital gains tax is very different from most types of taxation because it is the only voluntary tax. You pay capital gains tax only when you sell an investment and realize the gain, thus many people try to defer selling their winning investments for as long as they can.
Under the current tax law, investors have the ability to choose which tax lot they want to sell when selling shares of a stock. If you own shares of Apple you bought at $20 per share, and some you bought at $120, it would be smart to sell the higher-priced lot to realize the smallest gain, and thus pay the lowest amount of tax.
The table below illustrates the point. The difference is material, as selling the lot with the lower cost basis results in more than three times more capital gains tax ($22.20 per share) than selling the lot with a higher cost basis ($7.20 per share).
| Purchase price | Current share price | Capital gain | Taxes (15% rate) | Net proceeds |
|---|---|---|---|---|
| $20 | $168 | $148 | $22.20 | $145.80 |
| $120 | $168 | $48 | $7.20 | $160.80 |
Source: Author calculations.
The proposed GOP tax plan would change the rules, and require that investors use a "first in, first out" policy, or FIFO, in which their oldest lots have to be sold first. Investors' oldest lots are usually those with the most capital gains, thus selling them would trigger the most capital gains tax.
Image source: Getty Images.
Who it affects
This change primarily affects people who invest in taxable accounts. People who only invest through tax-deferred accounts like 401(K) plans and IRAs wouldn't be affected. Neither will Registered Investment Companies (RICs), which include mutual funds and exchange-traded funds, as they were carved out from the FIFO rule.
However, investors who own mutual fund and ETF shares won't get the ability to choose which tax lot to sell when they cash in their shares -- they'll have to comply with the FIFO rule and sell their oldest tax lots first. (Read: Fund managers will be able to be tax smart with the investments a fund holds, but investors will have to comply with the FIFO rule when selling shares of a mutual fund or ETF.)