Revisiting the Preferential Tax Treatment of Long Term Capital Gains and Qualified Dividends

Revisiting the Preferential Tax Treatment of Certain Types if Investment Income

Long Term Capital Gains, and Qualified Dividends – The 0, 15, 20 Batch

As Benjamin Frankling noted “…in this world nothing can be said to be certain, except death and taxes”. Given the historical and likely future permanence of taxes (whether they be in the form of a value added [consumption] tax or an income tax) it would serve purpose to explore ways in which they can be best designed to serve their larger purpose of funding our federal and state governments. In this article I will be reviewing and exploring both our (U.S.) personal income tax as well as the [long-term, since short-term are the same as personal income] capital gains taxes and perhaps another way to view them and approach them from a policy discussion and personal belief lens.

Let’s first start with the graphic below, which relates to the [Federal] personal income tax rate and a brief example of how the impact of these progressive rates differs among individuals. Having a progressive personal income tax regime means an individual’s taxable income is taxed in “buckets”. The gets higher as the overall income increases, however, the higher tax rates only apply to income not taxed in the lower buckets.

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Using the 2024 tax tables (The Tax Foundation) a married couple [filing jointly], with $100k of taxable household income would pay ~$12,100 in federal income taxes (an effective tax rate of 12.1%), while the same couple with $400k in taxable household income would pay ~$83,334 (an effective tax rate of 20.8%). This is all to illustrate the progressive nature of the tax system before we examine the [beneficial] tax regime related to investment income (specifically qualified dividends and long-term capital gains).? Below we can see how these two scenarios are much more different than words can really explain.?

One family makes 4x in terms of taxable income while only having an effective tax rate of ~1.72x. Taking this further and purely for illustrative purposes see the following chart (below).

The debate about the personal income tax brackets is not new. The current brackets are however, by historical measures, low (the top marginal tax rate peaked in 1975 at 70% on all income over $200k (The Tax Foundation & Wolters Kluwer), or ~ $1.16M – $1.18M (US BLS CPI Calculator, Amortization.org, Federal Reserve Bank of Minneapolis) today. Under the current tax regime married [filing joint] households only pay 37% in federal income taxes on taxable income over $731.2k.

Now that we have established an understanding on progressive tax rates and how different levels of household income are impacted y them lets examine a segment of income which receives less attention, investment income, specifically qualified dividends (as explained by Fidelity) and long-term capital gains (gains on the sale of [most] investments [think stocks, ETFs, and mutual funds] held for more than 12 months). Tax rates on this income vary from 0% to 20% (progressive rates which are based on total taxable income), with an additional 3.8% net investment income tax for individuals meeting additional income criteria (based on a modified adjusted gross income calculation (not taxable income) [SmartAsset & IRS topic 559] TurboTax explains progressive capital gain buckets).

Consider our two families we used earlier. If each family had a total of $50k in qualified dividends and long term capital gains, the first family ($100k taxable income) would see this $50k additional investment income taxed at 15% ($150k total taxable income, ~$20k in total taxes, and a ~13% effective tax rate). Our second family would have $450k of total taxable income with ~$91k in taxes, and a ~20% effective tax rate. Be honest with yourself though and think about whether both of these families are likely to have that same level of investment income, or even consider that the first family saw there effective tax rate increase, while the second family actually saw their effective tax rate shrink (this is the impact of beneficial tax treatment in an already wealthy household). In terms of the ability to build up a portfolio or be in a position where you could have $50k in investment income as outlined, consider the BLS consumer expenditure survey (CE Survey or CEX), which in 2023 found that housing units making $200k or more annually, saw, on average, $16.8k in income from interest, dividends, rental, and other property income. This is 12x housing units making $50k - $69.9k and 4x household making $150k to $199.9k. Households with more overall income, likely have more investment income and that investment income represents a higher percent of the total household income. One must then ask, whether the example above with two families so widely separated in income would really have the same investment income (broadly speaking).

Having investment income is a by product of having income to invest, let alone save. Assuming all else equal, higher income households will (at the very least have the freedom to choose) (1) invest larger amounts into assets (stocks, real estate, bonds, or other business ventures), and (2) have a less immediate need for that invested capital given that their (2a) emergency funds accumulated are larger and their (2b) essential expenses are easier to cover [chicken is chicken, baby formula is baby formula, a flat tire is a flat tire, items of this nature generally hold the same dollar value regardless of the consumers income, within reason] and as a result represent a progressively smaller percentage of household expenses.

Again we can refer to the BLS’s CE data (below).

Given the information outline above, beneficially taxed income is more accessible to, and a progressively larger portion of, income for higher income households (which should come as no surprise). While this is not an indictment of the progressively more well off, it is clear that broadly speaking, the more income a household makes (wages / salary) the (generally speaking) easier it is for them to set money aside to build a portfolio of investments and build large amounts of passive income in the future. This portfolio provides beneficially taxed income sources that can simultaneously increase total income (and wealth) while also reducing the overall effective household tax rate (due to the low beneficial tax rates).

This preamble is meant to highlight how the tax treatment of certain income seems flawed. Investments and their derived income (in general) are just that, investments. Appreciation in an investment (whether it be stocks, or perhaps a home, or a plot of land, among others) is a return (of value, or in the case of dividends, income) the investor did not work for. If you bought $1,000 of any of the following stocks or ETFs – PG, VTI, JPM, AMZN, or NFLX (to name a few stocks) – 10 years ago [01-02-2014], that $1,000 would now be worth, $2,001, $3,020, $4,100, $11,000, or $16,950, (respectively). This increase in wealth was generated through no (broadly speaking) actual work on the part of the investor. While we might consume Proctor & Gamble (PG) products such as Crest Toothpaste, perhaps we subscribe to Netflix (NFLX), and I’m confident many of us utilize many of the services offered by and through Amazon (prime, video, etc.), most of us do not in fact work for these companies. Even if we did work for these companies that work is rewarded and reflected in the wages we receive and/or stock that vests (stock that again we don’t put in any work to directly impact its appreciation in value or issuing of dividends). That increased value of the original $1,000 investment was a result of the American and global economy, along with the magic of compounding growth. Taking this into consideration does it not make sense to reconsider taxing this (essentially “free”) wealth/income at a higher rate (perhaps having tax brackets of 0, 20%, 40% and 60% instead of 0%, 15%, and 20%)?

Before shutting down the argument with the response that higher income tax rates on these types of income would “…discourage people from investing in assets, leading to slower economic growth… (US World News)” consider that the other options (broadly available to the public) such as placing money in a savings account would provide you with (1) a massively lower rate of return (even a high yield savings account won’t match the returns from something as simple as a broad market index such as VTI – saw a compounded annual growth rate of ~11.7% over the past 10 years), (2) ordinary income (already without any beneficial tax treatment), and (3) a gap in wealth accumulation. $1,000 in a savings account 10 years ago would have, at best, provided a CARG of between 2% - 3% [Business Insider - List of Lowest and Highest Interest Rates on HYSA] which wouldn’t have even outpaced Proctor and Gamble’s growth (CAGR of 7%). The higher tax rates (I believe) could actually result in individuals leaving their money in investments longer, or at least limit the ability to increase household income while decreasing the effective tax rate. Higher tax rates on passive (unearned, requiring no work) income could bring some logic and parity into the treatment of income worked for and income not worked for.