If you dislike paying taxes, or the thought of paying taxes makes you grind your teeth or go into fits of rage, I'd strongly suggest you have a stress tool handy before you proceed.
Last week we looked at 10 countries around the world with the highest income-tax rates and discovered that the list was dominated by European countries, many of whom charge marginal tax rates of 50% or more at the highest income bracket. I also received quite a bit of admonishment from readers for not pointing out that VAT taxes and select U.S. state income taxes can skew the results, which is indeed true.
So today, we're going to turn to a different page of the tax code and strictly examine long-term capital gains taxes, or taxes that are assessed on individuals or business for profits earned on the sale of investments or through the disposition of property. For this data I'm relying on a study conducted by The Tax Foundation that includes all member countries of the Organization for Economic Cooperation and Development, as well as all 50 U.S. states, broken down by their state long-term capital gains tax and adding in federal taxes as well. By doing this, we should be able to get a more realistic view of which 10 states and countries (between the U.S. and OECD) really are the most stringent when it comes to capital gains taxes, and I'll discuss why this is so important.
Here are the 10 places that ranked highest according to The Tax Foundation's analysis:
Combined Federal and State Long-Term Capital Gains Rate
For those of you who think the U.S. could indeed be overtaxed, when it comes to paying taxes on capital gains you may indeed have a point!
Only three countries – Denmark, France, and Finland – fall among the top 10 highest long-term capital gains rates, with seven U.S. states making up the difference. Comparatively speaking, the average capital gains tax in the U.S. (27.9%) when taking into account all 50 states, is 70% higher than the average capital gains tax rate of all OECD countries (16.4%). In fact, 21 OECD countries are boasting a lower capital gains tax rate than the lowest rate you'll find in any state in the nation!
"Why is this important?" you might be wondering. Well, higher capital gains taxes can act as an investing deterrent in these countries and states, since investors would much prefer tax shelters rather than forking over 30% or more of the earned gains when they dispose of an asset. That's one very plausible reason we've seen California, which boasts the second-highest capital gains tax in the study, struggle to rebound from the recession. Although home prices have moved higher recently in California, investment in the state is difficult to encourage, since state taxes are so high. As a general rule, higher capital gains taxes make the U.S. a potentially shaky investment opportunity for some overseas investors.
To add, capital gains taxes discourage saving because few people want to be taxed twice on their same earned dollar. When Americans earn money through work, they're taxed on a federal, and potentially state, level. Then, if they purchase stock or buy a house, for instance, and then turn around and sell that asset at a later date, they have to pay taxes again if they make a profit on their investment. This type of double-taxation can discourage savings, and I'd suggest it's at least partially responsible for this country's dismal savings rate.
What you can do
Clearly, there's not a lot you can do as a U.S. citizen to avoid long-term capital gains taxes unless you move out of the country. However, I do have two ideas that should at least help you reduce your potential taxation.
First things first: Hold your investments for the long term! Although the market volatility of the credit crisis and Internet bubble may still be fresh in your mind, resist the urge to day-trade stocks or flip your investments, as you'll wind up being penalized for a significantly higher tax rate.
For those of you with a low-risk tolerance, I'd suggest looking at a large consumer goods-driven company that will generally be immune to large swings in the market. Procter & Gamble (NYSE:PG), the company behind Tide detergent, Crest toothpaste, and dozens of others consumer products, is a shining example. Demand for Procter & Gamble's products is generally inelastic, meaning simply that people need detergent, toothpaste, and other household goods regardless of whether the U.S. economy is expanding or contracting. This gives P&G strong pricing power, which helps generate consistent cash flow. It's the type of company you can buy and not lose sleep over.
For even less risky investors, electronic-traded funds, or ETFs, are a possible solution. The Vanguard Large Cap ETF (NYSEMKT:VV), for instance, has a microscopic expense ratio of just 0.1% and a yield of nearly 2%, as well as 645 different stocks in its portfolio. With that kind of diversity and low expense ratio, investors can sleep easy owning the Vanguard Large Cap ETF.
The second tax-saving method that investors should consider is opening a Roth IRA or converting their Traditional IRA to a Roth IRA. Again, each situation is different, and making that conversion may actually prove disadvantageous for some people. For the majority, however, a Roth IRA is going to save them in a big way over the long run.
Unlike a Traditional IRA, which allows you to deduct up to your maximum contribution each year ($5,500 in 2013, depending on your income level), Roth IRAs offer no upfront tax relief. The advantage, though, can be seen years or decades down the road. Once invested, as long as you don't make any unqualified withdrawals before age of 59 1/2, you will not have to pay taxes on any of your capital gains! Just using the compounding gains of dividends and share price to your advantage, you can see how rapidly the tax advantages of a Roth IRA can build up. Plus, it's a great tool for encouraging saving as well as investing discipline.