COVID-19 vaccine distribution is in the rearview mirror. The Biden administration is looking ahead to the next big-ticket item from the campaign trail: Tax Reform.
On April 28, 2021, Biden announced his American Families Plan. Biden's plan included proposals for lower educational costs and paid family and medical leave support. Wealthy families who make over $400,000 are tasked to foot the bill via their taxes to afford these programs.
We've talked about Biden's proposed personal income tax plan here. Still, I want to discuss the financial planning opportunities high-income earners should consider. Though we don't know what will pass, it's critical to plan ahead. Let's dive in.
For families making over $400,000 in a year, income tax brackets are likely going up. As it's proposed, the new maximum ordinary income tax bracket will increase from 37% to 39.6% for those making over $400,000. That's a significant increase, but there are strategies available to lessen its impact.
One strategy for wealthy families to consider is pulling income they may receive from 2022 to 2021. Frontloading income allows you to take advantage of the Tax Cuts & Jobs Act (TCJA) income tax brackets. We expect the higher tax brackets proposed by Biden would take effect on January 1, 2022, at the earliest, and wouldn't impact 2021 taxes.
If you make over $400k, why not have more of that income earned in 2021 as opposed to 2022? Consultants, small business owners, and self-employed individuals with control over their income may benefit from pulling late-2020 income forward. Consider this, if Biden's plan passes and you perform business as usual, you could be paying at a higher tax rate for early-2022 income. Instead, consider sending out invoices early in the 4th quarter to ensure the income is taxed as part of the 2021 year using the lower TCJA brackets.
Suppose you're retiring from Shell, Chevron, BP, or another company where you may receive a hefty severance or non-qualified benefit payouts. In that case, you may want to consider when your last day should be. If you have flexibility on the timeline, consider when the best time to retire and receive the payouts is for your tax situation. For some people, it may be better to retire and have the payouts in the 2021 year in the max bracket of 37% as opposed to 39.6% — especially if the payouts are substantial.
Another group that can benefit from this approach is retirees or soon-to-be retirees. If you expect your RMDs will push your taxable income over $400,000 in future years, consider Roth conversions at today's attractive tax rates. We already know tax rates will go up on January 1, 2026, with the expiration of the Tax Cuts and Jobs Act. Suppose Biden can pass these changes in personal tax reform. In that case, those in low brackets today will get a double whammy — first, from the removal of tax-preferential TCJA brackets, and, second, with the increased tax brackets proposed by the Biden American Families Plan. To avoid this, retirees should consider leveraging the low tax brackets they face today by converting pre-tax retirement accounts to Roth accounts.
Advisor Tip for Retirees: If performing a Roth conversion or pulling income forward, watch out for how your Modified Adjusted Gross Income (MAGI) impacts your Medicare premium!
2. Determine Whether It's More Valuable to Push Tax Deductions Out or Pull Them Forward
As current tax laws are written, the value of itemized deductions can be calculated using all marginal tax brackets (including the 37% bracket). A key component of Biden's proposal is capping the value of itemized deductions at 28% for those earning more than $400,000 a year. How will this change impact your tax situation? Let's illustrate this concept through an example.
Let's suppose your total household income is $800,000 in a year, your tax rate for a Married Filing Jointly household is in the highest current tax bracket of 37%, and you have $130,000 in deductions. The value of your deductions using current tax laws would be calculated as such:
$130,000 Deduction x .37 Tax Rate = $48,100 Value of Deductions
If, however, Biden's cap for the value of itemized deductions passes, the calculation for the same example would look like this:
$130,000 Deduction x .28 Tax Rate = $36,400 Value of Deductions
That's a difference of $11,700 in the value of deductions by having the cap set at a maximum rate of 28% for those making over $400,000 a year.
In this situation, high-income families may benefit from pulling deductions forward before Biden's proposal is enacted to get a larger value in their tax deductions. However, we don't know what will get passed by Congress so let's consider an alternative possibility.
Suppose Biden's proposed tax bracket changes for those making over $400,000 in income passes (making the new highest bracket 39.6%), but Biden's proposal on capping the value of the itemized deductions doesn't. In that case, it may make sense to 1) pull income forward to leverage today's lower income tax brackets, and 2) push out deductions to the 2022 year to utilize those higher income tax brackets against deductions to be more tax-efficient. Until we have definitive answers for which components of Biden's tax plan will be enacted, it's important to work with an advisor on the various scenarios that could arise so you have a plan in place.
Charitable Giving
Let's consider a common scenario we see with our clients. Suppose you're planning to make a significant charitable gift. In that case, it's essential to pay attention to whether the proposed itemized deduction cap passes. If this proposal passes, it'd be wise to make your charitable donation in 2021 to take full advantage of current tax deductions. If the proposal fails to pass, you may decide to push your gift to 2022 to ensure you receive the best tax deduction for your charitable contribution.
Advisor Tip: Consider gifting appreciated stock to your charity of choice instead of giving cash. Given the run in the stock market throughout 2021, gifting appreciated stock might help you avoid paying capital gains taxes on the amount.
State and Local Tax (SALT) Deductions
A similar consideration arises for taxpayers with large property tax bills. Depending on your current cash flow and budget, it may make sense to pay in December or January, depending on the final bill amount. Still, there's one hiccup— Right now, state and local tax (SALT) deductions are capped at $10,000 per filer. Biden has not proposed getting rid of this cap, but many Democrats in Congress have. If Congress removes the cap, you may get to take the full deduction on your property tax bill in 2022 instead of a portion in 2021. If the SALT deduction is removed, taxpayers with state or local income taxes will likely benefit by pushing out paying their state income taxes owed for 2021 into the first quarter of 2022 because the $10,000 limit will be gone.
Beyond the income tax proposed for wealthy families, Biden's tax plan nearly doubles the dividend and long-term capital gains rates! Biden proposed raising the maximum capital gains rate from 23.8% to 43.4% for those with income exceeding $1 million.
Most people do not realize income above $1 million in an average year, so this is not a concern for many of our clients. However, he's also suggested removing the step-up in basis at death and forcing gains in excess of $1 million to be realized at death which are strategies many of our clients utilize to tax-efficiently pass assets to the next generation.
A key concern of Biden's proposal for our clients, especially for those with large non-retirement accounts, is the removal of step-up in basis and the forced realizing of gains above $1 million at death. The typical strategy for those passing assets to the next generation is to hold on to positions with gains to defer the tax until they pass away. The recipient gets a step-up in basis at the death of the position-holder.
A step-up in basis refers to the readjustment of an appreciated position or asset’s value over time to calculate the tax liabilities when inherited. In short, the cost basis for the positions or assets being left to the next generation resets at the time of death/transfer to today’s market value which becomes the new cost basis. If the asset appreciates over time, the person who inherits the asset after its previous owner’s death would typically pay capital gains tax on the difference between today’s market value of the asset and what the original owner paid (original cost basis). However, by stepping up the basis of the asset, the beneficiary's capital gains tax is minimized and the beneficiary doesn’t pay taxes until they sell the position or asset. Let's walk through an example to illustrate.
Suppose your father, John, buys a beach house in 1985 for $500,000. Over time, it appreciates in value until this year where it reaches $1.5 million. Given today's laws, when John passes away and leaves you the home, the cost basis will increase at his death, or "step-up", to $1.5 million from $500,000. If you choose to sell the beach house at a value of $1.5 million, you'll pay no capital gains taxes.
With Biden's proposal to eliminate the step-up in cost basis, upon John's death, the home's cost basis will stay at $500,000. Therefore, the gain on the home will be $1 million at the time you receive it. If you go to sell the home, you'd be taxed at your capital gains tax brackets for $1 million in gains. If Biden's plan passes, the elimination of the step-up in basis could cause a massive tax headache for those looking to give their assets to younger family members or organizations.
We're currently talking to clients about analyzing their total unrealized capital gains annually if Biden's plan passes. In certain situations, it can be advantageous to consider realizing and rebalancing accounts regularly while staying in their respective capital gains brackets of 15%, 18.8%, or 23.8%. Under Biden's new proposal, many families could significantly lower income taxes at death by realizing gains on non-retirement accounts, rebalancing the account's investments, and paying the taxes over time. Without the step-up in basis at death, though, the recipients of these gains will also have to pay taxes on whatever gains they inherit.
Advisor Tip If You're 63 or Over: Consider your Medicare premium tax bracket alongside your long-term capital gains tax bracket. Realizing too many gains in this situation can cause a massive tax headache.
A great way to mitigate and spread out the tax impact of these gains over time is tax-loss harvesting. Tax-loss harvesting is "harvesting" investment losses against income and using the loss for tax savings.
One of the major concerns we see coming from Biden's proposal is his announcement that, if passed, his tax increase for capital gains would be retroactive to the date of the American Families Plan's announcement, or April 28th, 2021. By making the capital gains brackets increase as of early 2021, it's tougher for investors (and quite frankly, their financial advisors) to prepare.
While many of our clients will be affected by the hike of ordinary income tax rates, families planning their estates or distributing wealth to future generations should discuss this potential change with their advisor or estate manager.
The first thing to understand about the American Families Plan is that it's in very early stages. Don't over-react. We don't know what, if anything, will get passed. We don't know how Biden's initial plan will change as it's passed along in Congress or what compromises will be necessary to get it passed. Until Biden's plan goes into effect, which would most likely occur in 2022, we still have time throughout 2021 to act. Based on his experience in the Senate, we see Biden as a negotiator. Biden may start from the extreme perspective of what he wants and negotiate to get a compromise. We think it is likely that we will see some of these proposed tax changes coming from the Biden administration enacted this year. Still, Congress will likely water down the initial proposal.
Considering what we know about Biden's tax plan now, the strategies discussed in this article are an excellent place to start for planning. Your unique individual circumstances and goals will determine what methods make sense for you. Discussing your situation with an advisor before taking action can give you peace of mind and clarity while waiting to see what happens next. We offer our clients tailored guidance about Biden's tax plan's potential impact on their specific tax situations. If you're interested in getting an expert opinion on your tax situation, reach out to our team for recommendations to make the most of whatever changes arise.