Why a Potential Tax on Unrealized Capital Gains Could Be Disastrous
You buy $1,000 of Stock A at the price of $3.00 a share. The stock doubles to $6.00 a share in 1 month. How much money have you made?
Common sense would be to think that you have made $1,000. Why? The stock went up 100%. You invested $1,000 and if that goes up 100%, you now have $2,000 in your portfolio. You earned $1,000. The truth though, is that you haven’t actually earned that money yet. Why? Because you haven’t sold the stock. This is what we call “unrealized gains”. Until you sell the stock, you have not made that $1,000. If the stock drops from $6.00 a share to $5.00 and then you sell, you wouldn’t have made $1,000. You’d have a gain of $667. It is always important to remember when investing that, while your portfolio may go up in value, until you sell those stocks that have increased in price, you only have “unrealized gains”. Once you sell, those “unrealized gains” become “realized” and you have officially made that money.
This brings us to the current Secretary of the Treasury Janet Yellen. In January of this year, she flirted with the concept of a potential “unrealized capital gains tax”. Recent comments in the past week suggest that this idea may be more than a fleeting thought. As the US government ponders where to get the income to continually spend trillions a year, it isn’t out of reason to think they would attempt to find new ways of taxing individuals. One such way could be this type of tax. To further complicate matters, in a recent interview, Secretary Yellen referred to “unrealized capital gains” as “income”. Now that is frightening.
The fact that the US Government is even contemplating this type of tax is borderline preposterous. The important aspect to remember about “unrealized gains” is that they are “unrealized”. You haven’t made the money yet. Until one actually sells the stock, they have not earned that money. What the government is contemplating is essentially taxing individuals on money that they haven’t earned yet. Using the previous example, your unrealized gains on Stock A is $1,000. Though you haven’t sold it yet (unrealized gain), the government is considering taxing you on that $1,000 unrealized gain. Imagine the tax is 10%. You have to pay the government $100.
The issue with this proposal is that not all investors sell stocks immediately after making a gain. They might wait 1 year, 2 years, or even 15 years to sell a certain stock, especially if it continues to rise. The government would be taxing money you have not earned. What would happen if the government taxed you $100 on that unrealized gain of Stock A, only for Stock A to drop 50% a month later. Instead of a $1,000 gain, you only have a $500 gain. Would the government reimburse you? If so, when? What if you are selling a stock to help pay for a sudden medical emergency? The government is hoarding taxes you paid on income you never earned. Furthermore, for the millions of Americans who are saving for retirement, how will this impact their financial planning? Imagine now they have to incorporate not only taxes they’ll have to pay when they withdraw their money (for those in Traditional IRAs), but also taxes for any “unrealized gains” they earn inside non-tax-exempt accounts as well (assuming the tax is not also extended to retirement accounts, which would be another thorny issue).
It remains to be seen if this tax idea will gain fruition within the next year. Hopefully cooler heads will prevail and realize the disastrous consequences this type of tax could have on the average American, especially those attempting to save for retirement.
