End Long-Term Capital Gains Taxes

In this year’s State of the Union address, President Trump promised to expand access to employee retirement plans. It’s a laudable goal. The surge in ownership of individual retirement accounts stands as one of the more notable public policy successes of the past half-century. 

But as individual accounts have grown, so too has the complexity of navigating the rules governing these federally authorized savings plans. There’s a simpler way to encourage investment than adding another program with restrictions that inevitably limit participation: bring long-term capital gains taxes to zero. 

Congress has already carved out limited circumstances where capital gains taxes are effectively zeroed out. Policymakers should draw on these examples to design policies that better incentivize wealth creation.

Consider homeownership. Owner-occupied housing has long enjoyed a special relationship with elected officials. For generations, the American Dream has been defined by owning your own home. Various federal tax provisions are shaped with that goal in mind. 

For example, homeowners can exclude the first $250,000 ($500,000 for married couples filing jointly) of capital gains from the sale of their primary residence. Investors in stocks, bonds, and other investment vehicles receive no such benefit. Furthermore, Congress made it easier, in a number of ways, for many homeowners to pay no capital gains tax when they move. Staying in the same home for long enough to make an impact on the neighborhood isn’t necessary to get the tax write-off. Sellers need to have lived at the premises for at least two of the past five years. With the average homeowner currently staying put for 12 years, just about every homeowner (except investors and long-term “accidental landlords” who rent out homes for income) meets the minimum time threshold.  

The ceiling on the exclusion is also tax-friendly. Owners get to step up the basis – the effective purchase price of the home – by the amount of capital improvements they made to the property. From a nuts-and-bolts perspective, this makes sense: a buyer who puts $100,000 into a home and later sells isn’t unloading the same asset but one that’s been enhanced by the owner’s post-purchase expenditures. By the same token, the family that installs a pool may be motivated more by the enjoyment of a refreshing dip in the backyard than by a higher future sale price for the home. Under current law, homeowners get to have their cake and eat it too: they capture the consumption value of home improvements and deduct it from their capital gains when they sell. 

Policy preferences for homeownership aside, there are sound reasons to increase the $500,000 cap. More and more long-term homeowners face a “stay-put penalty.” They’d be happy to downsize, move to a warmer climate, pay lower taxes, and sell their home to a young couple who remind them of themselves when they bought it decades ago. The problem is that they’d be hit with a big tax bill. According to the National Association of Realtors, more than one-third of homeowners already have paper – or perhaps, Zillow – gains of more than $250,000, and one in 10 are north of the half-million threshold. 

The inability of Congress to increase the exclusion cap has caused many to find a partial workaround to the old adage: you can’t avoid death, but you can get a pass on large real estate gains if you’re willing to stay put in your primary residence until you depart from these earthly bounds. Your heirs will benefit from stepped-up basis, meaning that no taxes will be paid on the run-up in value during your tenure in the home. 

Roth IRAs are another case study on how to increase investment by reducing long-term capital gains to zero. Enacted as part of the Taxpayer Relief Act of 1997, signed into law by President Bill Clinton, Roth IRAs allow taxpayers to avoid paying capital gains on stocks and bonds. Roths are subject to annual contribution limits, which Congress has raised from $2,000 in 1998 to $8,600 for individuals over 50 and $7,500 for everyone younger under current law.  

Since their creation, Roths have surged in popularity. In 2022, the Investment Company Institute found that twice as many Americans contributed to Roth IRAs as traditional IRAs. According to data collected by the asset management firm Vanguard, younger workers are flocking to Roths. The Center for Retirement Research at Boston College reports that the share of Roth participants under 40 jumped nearly 50 percent from 2016 to 2022.

It’s not hard to see why. Often bucketed with Traditional IRAs, Roths serve distinct policy goals from their retirement account cousin. Traditional IRAs were created in 1974 as part of a sweeping Congressional response to the mismanagement and abuse of pension programs. Judge Glock of the Manhattan Institute has neatly summarized the broad policy shift behind Traditional IRAs: these retirement plans replaced employer-centered “defined benefit” plans with employee-centered “defined contribution” plans. As a key element of defined-contribution 401(k) plans, traditional IRAs proved responsive to changes in the U.S. workforce. Most importantly, these accounts moved with their holders. Their portability proved attractive to many workers who no longer planned to stay long enough at a single company to vest in its pension plan. 

Much as defined-benefit plans gave way to IRAs in response to the economic and social shifts of the 1970s and 1980s, Roth accounts are gaining ground today because their flexibility matches the expectations of today’s workers, who expect to live longer, work longer, and earn more later in life than generations past. By contrast, while Traditional IRAs correctly predicted several key facets of the modern labor market, including the mobility of today’s workers, they also assumed other aspects of the post-World War II era that are fading away. Hence, Traditional IRAs let workers delay paying taxes when they invest on the front end, but hit them with taxes on every dollar they withdraw. The logic behind these rules is that income peaks during an individual’s prime working years and then drops off dramatically later in life, allowing account holders to pay less taxes over time (and earn greater investment returns by putting untaxed dollars in the market over the long haul). 

The problem with Traditional IRAs is that, either by choice or necessity, Americans are working later in life. According to Pew, roughly 20 percent of Americans over the age of 65 were employed in 2023, nearly twice the share in 1987. The Bureau of Labor Statistics has estimated that almost 60 percent of labor force growth over the next decade will come from older workers. Surveys also show that older workers are earning higher wages. 

Unfortunately for today’s “employment extenders,” however, Traditional IRAs aren’t retirement plans in name only. These plans favor retirement over income-earning later in life. Putting aside the obvious need for stable public finances, income taxes penalize productive activity and the benefits that accrue to the worker and to society more broadly from active participation in the labor market. Traditional IRAs are particularly punitive on individuals who choose to work later in life because of the annual payouts these plans require starting at age 73. These mandatory distributions are added to the worker’s wages and taxed at ordinary income tax rates, which can be higher than capital gains taxes depending on the taxpayer’s bracket. 

Roths, by contrast, are called retirement accounts but function more as long-term investment accounts. The tax benefits of these accounts are tied to the amount of time the money is invested, not whether the investor is earning income elsewhere at the time of sale. For those who want long-term, truly tax-free growth, Roths offer a unique advantage: money put into these accounts has already been taxed and therefore grows tax-free, provided funds are not withdrawn before the age of 59.5. The allure of avoiding all taxes on investment growth is why tax professionals are already talking about the best way to convert Trump accounts – which follow traditional IRA tax rules – to work like Roths.  

The existing tax rules for owner-occupied real estate and Roths should inform policymakers as they consider ways to incentivize long-term investment across income levels. The effect of taxes imposed on real estate that appreciates in value over decades illustrates a pitfall to avoid: high taxes on long-term gains may send the correct virtue signal, but their practical effect is to freeze current asset owners in place by making the cost of selling prohibitive. This locks out would-be buyers and makes assets subject to high long-term capital gains taxes less attractive to own. As Congress considers raising the cap on real estate capital gains, it should also consider creating a new exclusion for long-term capital gains on stocks, which have outperformed real estate by a wide margin since 1995.   

Alternatively, Congress should significantly expand access to Roths. There are several ways that this can be done: the annual contribution cap could be increased, the income limits could be raised such that single taxpayers earning more than $153,000 (and married filers earning more than $242,000 jointly) can contribute to these accounts without having to execute a “backdoor” Roth conversion, and the eligibility age for distributions could be lowered so that workers who start contributing to a Roth in their 20s can take out cash tax-free in their 40s without paying an early withdrawal penalty. 

Changes along these lines will be most attractive to policymakers seeking to encourage long-term savings over investment. There are progressive policy aims that could also be served by a Roth expansion package as well. Support behind programs such as the recently passed Trump accounts has traditionally come from both sides of the political spectrum: progressives support the direct federal contribution that provides the seed capital for these accounts. Conservatives champion the personal agency these accounts support as seed capital grows and is supplemented by additional worker contributions.

A similar dynamic could work to expand Roths. Congress could authorize the universal seeding of Roths for a segment of the population: individuals who already have a Roth would receive the federal seed money into their existing accounts. Those without access to a Roth would receive the funds in a new account managed by an existing private IRA provider. Eligible workers who have a Traditional IRA through their employer but no Roth would receive seed money in their Roth and would have the option to move their existing 401(k) into their newly established Roth when they leave their current job, or keep both accounts open. 

The federal seed could be paired with other reforms to facilitate the growth of long-term asset growth, such as higher Roth contributions and income limits. In the end, both Right and Left could claim victory: there would be more tax-free investment growth, and the divide between the asset-rich and the asset-less would be narrowed. It’s time for a Roth Revolution. 

Michael Toth is the Director of Research at the Civitas Institute at the University of Texas at Austin.