Retirement and Capital Gains Tax

Retirement and capital-gains taxation are a matched pair of discussion topics. One study finds that retirement capital gains comprise nearly one-quarter of retirement income. This contrasts with a total of less than 10% for the general population.

A capital gain is realized upon the sale of an asset at a higher price than was paid for it. This gain has traditionally been treated as income by economists, accountants, and governments. Accountants and governments have generally been satisfied to compare nominal prices at purchase and sale. In economics, “income” is any form of compensation that increases the utility or satisfaction of the recipient. A capital gain meets this definition provided that the size of the gain is sufficient to compensate the seller for (1) any loss of purchasing power delivered by inflation between the time of purchase and sale; and (2) the use of the seller’s funds in their highest-valued alternative use.

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Capital-Gains Taxation in the U.S.

In U.S. tax law, a distinction is made between short-term capital gains (those earned over a 1 year-or-less time period) and long-term capital gains (those whose time horizon is longer than 1 year). Short-term capital gains are taxed at the taxpayer’s highest marginal rate, up to a maximum of 28%. Long-term capital gains are taxed up to a maximum of 15%. Tax treatment of capital gains varies very widely throughout the rest of the world, from a low of zero taxation all the way up to confiscatory levels in some countries.

One particularly dubious feature of capital-gains taxation is the failure to index capital gains for inflation. This failure results in the taxation of nominal “gains” that fail to keep pace with the inflation-induced decline in general purchasing power. In order to avoid taxing a gain that is not really a gain at all, the cost basis of the asset should be adjusted upward by the cumulative rate of inflation during the holding period. Only if this indexation still yields a gain would it be proper to apply the capital gains tax to the adjusted differential between sale price and adjusted purchase price. There is general agreement on the desirability of capital-gains inflation adjustment, which would complement the inflation adjustment applied to income taxation since 1985. Because of their disproportionate reliance on capital-gains income, retirees would particularly benefit from this reform. In practice, however, only a few nations – such as the U.K. and Australia – have experimented with it. Governments have proven unwilling to forego the revenue on phantom capital gains.

Inefficiency Caused by Distortions in Taxation of Business Income

Capital-gains taxation is part of a broader system of taxing income from assets. This system has profound implications for the well-being of all Americans. Corporations receive particular attention in this system. The law treats a corporation as a “fictitious person.” This provides a rationale for taxing net income (profit) at the corporate level via the corporate income tax. Corporate tax rates have varied throughout U.S. economic history and currently stand at roughly 46%, one of the highest rates in the world.

Income passed on to shareholders in dividend payments is technically separate from corporate profit because the corporation is treated as an individual entity. In economic fact, however, the corporation is its shareholders. Separate taxation of dividend income at the individual level means that corporate profits are taxed twice. Since individual income-tax rates are lower than the corporate rate, this provides an incentive to realize income at the individual level. That has stimulated the creation of business forms – such as S corporations and LLCs – that pass through profit to individuals rather than realizing it at the corporate level.

In the same vein, lower tax rates for long-term capital gains (LTCG) than for ordinary income provide an incentive to realize income in LTCG form. This represents an artificial, inefficient incentive for businesses to retain and reinvest profit rather than returning it to owners via dividends. (Indeed, the only respectable argument against capital-gains tax indexation is that it would worsen this distortion by widening the advantage enjoyed by capital-gains income over dividend and interest income.) Accordingly, dividend payout rates for U.S. corporations have fallen steadily for several decades. This same artificial incentive favors the creation of bond funds. Since bond-fund shares do not mature, shareholder income is weighted more towards capital gains than is true for owners of individual bonds, who receive coupon payments that are taxed as ordinary income.

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Retirement Capital Gains

Capital gains are of special significance to retirees because their “unearned” (non-employment) income sources take the place of “earned” (employment-derived) income. As noted above, capital gains are an important component of retirement income.

Formerly, retirees could hold “blue-chip” equities and take income from dividends, much as they earned interest on individual bonds. The declining rate of dividend payout has largely foreclosed this avenue and forces retirees to sell equities in order to realize the full value of profits as income.

Retirement Capital-Gains Income versus Annuity Income

In principle, annuities should represent an ideal form of retirement income. Their secure status comports well with the risk profile of the retiree, which accords security the highest value. Life annuities enable retirees to address the age-old and growing problem of longevity risk – the danger of running out of money before running out of life. Income in the form of equal periodic payments is very convenient and replaces the periodic stream of employment income enjoyed prior to retirement.

However, annuity income is not capital-gains income, since it is not derived from the sale of an asset. Annuity income is analogous to bond interest, with the exception that return of capital occurs gradually with each payment rather than in a lump-sum at maturity. (Obviously, this benefits the annuityholder since otherwise the holder of a life annuity could never “get their money back.”)

The marked divergence between tax rates on ordinary income and LTCG puts annuities at a disadvantage compared to equities, which can be sold to create LTCG. This greatly complicates retirement financial-planning because it requires weighing the importance of countervailing distortions. One thing seems clear: estate planning considerations tend to favor equity or mutual-fund investments compared to, say, variable annuities. Tax rates strongly favor LTCG and heirs benefit from the stepped-up cost basis for equities and mutual funds.

Avoiding Capital Gains Taxation

The basic strategy for avoiding capital gains is to hold the asset rather than sell it. Since this will require the asset holder to forego realization of the asset’s full value, the cost of avoidance can be substantial.

Most capital-gains tax-avoidance strategies are actually designed to defer or reduce the tax rather than avoid it entirely. Strategies include an installment or structured sale, which lengthens the period over which tax is paid and thus reduces the present value of taxation. Capital-gains losses can be used to offset gains and carried forward indefinitely to future years – this is not a strategy so much as simply taking maximum advantage of the existing tax structure. A 1031 exchange (named after the pertinent section in the IRS Code) allows an exchange of assets of like kind without triggering a taxable event; this is another postponement or deferral strategy. By contributing the asset(s) to a charitable trust, the holder can gain a tax deduction on the charitable contribution and defer taxation on the asset(s).


A capital gain is realized when the sale price of an asset exceeds its purchase price. Inflation and the alternative return on equivalent assets are seldom considered in computing a capital gain, despite their economic importance in calculating real income. In the U.S., a distinction is drawn between short-term and long-term capital gains (LTCG), depending on whether the asset is held for more or less than 1 year. Short-term gains are taxed up to a maximum of 28%, compared to the lower maximum rate of 15% for LTCG.

Tax policy has vastly distorted the allocation of capital in business. High corporate income-tax rates have encouraged the creation of business forms that pass through income to the individual-ownership level. High ordinary-income tax rates have influenced companies to reinvest earnings to provide owners with LTCG income rather than dividend income. They also influence retirees and estate planners to prefer LTCG income to annuity income, despite the advantages otherwise accruing to annuities as retirement-income devices.

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