Capital Gains Tax Changes Hurt Mom and Pop Investors

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).

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.)

One very big problem: Retirees who hold investments in taxable accounts will have to sell more of their holdings in the early years of retirement to receive the same amount of after-tax cash. Currently, retirees can sell their newest lots early in retirement to reduce their tax burden, thus reducing the amount of assets they have to sell to fund their retirement expenditures.

Big winners and losers

Online discount broker TD Ameritrade wrote to its clients to advise them of the change, writing that "we strongly oppose this provision. We believe it will harm individual investors by eliminating their freedom to decide when to take losses or gains on their investments, potentially resulting in an increased tax burden." 

Investors who use robo-advisors to manage their taxable investments would also lose out. A key feature of robo-advisors is that they automatically make tax-efficient moves by harvesting tax losses to offset gains, thus generating higher after-tax returns for their clients.

Under the proposed FIFO rule, robo-advisors would have fewer ways to realize losses for their clients and generate tax savings. On its website, Betterment's model shows that tax loss harvesting could increase its highest taxed clients' returns by 0.77% annually on an after-tax basis. In a world where people move assets to save as little as 0.10% on fund fees a year, a 0.77% improvement in after-tax returns is massive. 

The only winners appear to be managers of mutual funds, ETFs, and other registered investment companies. That's because individual investors may ultimately decide that it's smarter to invest in funds than a portfolio of self-selected stocks in taxable accounts, since funds will retain tax advantages that individual investors won't retain if the FIFO rule ultimately makes its way into tax law.