What is the inflation tax?
The inflation tax is a method by which the government indirectly finance’s it’s spending. It is impossible to quantify or calculate. Furthermore, it affects individuals based on the type of assets that they hold instead of their income or wealth. Most importantly, it doesn’t involve the taxpayer ever sending money directly to the government. Thus, most people are not even aware that they are being taxed!
When the government prints new money and circulates it into the economy, it leads to inflation. Inflation the addition of currency into the market which causes the purchasing power of each unit to diminish in value. For example, if I have a pie cut into ten slices, each slice is worth 1/10th of the pie. If I cut each slice of that pie again, each slice is now worth 1/20th of the whole pie. The slice that I had yesterday is worth more than the slice that I have today. This is because I didn’t make the whole pie bigger, I just created more slices of it.
You can think about inflation in much the same way. Each dollar is a slice of the pie, and the whole pie is the U.S. economy. If I have $100,000 in cash today, and the government prints 1 trillion dollars over the next year. Then, my $100,000 in cash today will not have the same purchasing power as it will next year. This is because the “pie” that is the economy has not gotten 1 trillion dollars bigger, the government just made more slices of it.
Why is this a tax?
This is a “tax” because the government is financing it’s spending by reducing the purchasing power of your savings. This creates an obvious problem for anyone who relies on liquid assets for their savings. This includes cash, money market accounts, or bonds.
Cash and cash-like assets are hit hardest by the inflation tax because the dollar is what is being devalued. Therefore, your savings will not appreciate with inflation unless it is tied to an investment with intrinsic value. Moreover, it is almost always better to have your savings invested rather than liquid. Typically, investments will account for inflation and rise in price accordingly. Remember, inflation lowers the purchasing power of the dollar. Thus, you can mitigate the tax by having your savings invested. However, the government will still use inflation to its advantage to tax those investments through the capital gains tax.
Inflation tax and capital gains
Now that you are familiar with the inflation tax, let us give a quick overview of the capital gains tax. If the price you paid for an investment (“cost basis”) is more than the price you sold it, it is considered a capital loss. You are not taxed on capital losses. However, if the cost basis is less than the price you sold said investment, then it is a capital gain. You will be taxed as much as 24% at the federal level on capital gains. Furthermore, depending on what state you live in, you could be taxed an additional 5-7% at the state level. Thus, bringing your total capital gains tax rate to around 30%.
Let’s put this in perspective:
- The government prints new money to fund its spending programs which leads to inflation of the currency.
- Financially prudent individuals invest their savings in order to mitigate the effect that inflation has on their assets.
- Their investments grow in part due to the inflation of the currency.
- They then sell their investment at a higher price than they originally paid for it. An amount of their gain is attributable to the inflation of the currency.
- The government then taxes all of the gain on the financially prudent citizen’s investment, regardless of the amount of the gain that is attributable to the government’s self-inflicted inflation.
How capital gains taxes work
In short, there is little you can do for yourself while you are alive in order to thwart the capital gains tax. However, there are many ways in which a well-crafted estate plan can completely eliminate the capital gains tax on the investments that you leave for your surviving spouse and heirs. Thus, helping to thwart the invisible inflation tax.
Normally, spouses hold title to their assets jointly with rights of survivorship. If you own a bank account or a brokerage account, and both you and your spouse’s name are at the top of the statements, it is likely that the account is held jointly. In the case of real estate, the deed may say “tenants by the entirety” but this is really just a fancy name for jointly held real estate between spouses (which in some states includes added perks).
At the death of one of the owners in jointly held property, the underlying assets receive a 50% step up in cost basis. For example, let’s say Spouse A and Spouse B still own 1000 shares of stock in Company X with a cost basis of $250,000. Spouse A dies, and on the date of Spouse A’s death the stock is worth $750,000. Now if Spouse A and Spouse B owned that stock jointly, Spouse B will get a 50% step up in cost basis, giving them a new cost basis of $500,000. This still leaves Spouse B with potentially $250,000 in tax liability on the sale of the stock. If Spouse B wishes to use this stock to fund assisted living or retirement, Uncle Sam is going to take a large chunk.
How can an estate plan help?
Now let’s assume the same facts as above, except this time instead of owning the stock jointly, Spouse A and Spouse B own the stock in a Revocable Trust drafted by Virtual Estate Attorney. When Spouse A dies, instead of Spouse B getting a 50% step-up in cost basis, as is the case with jointly held property, Spouse B will receive a 100% step-up in cost basis, thus completely eliminating their capital gains tax liability. Now if Spouse B wishes to liquidate the stock in order to fund their retirement, Uncle Same will only be able to take the appreciate between the date of Spouse A’s death and the date Spouse B sell’s the stock, which should be negligible.
This can be especially helpful in the case of real estate because surviving spouses often wish to downsize shortly after the passing of their loved one. Isn’t that a wonderful legacy to leave for your spouse?
