In his first Congressional address, President Biden unveiled his proposal to impose heftier taxes on high-earners to pay for economic reforms and his large-scale infrastructure initiative as part of the American Families Plan. What’s being suggested is likely to change as political disputes continue. And in reality, some of the potential changes may never even come to fruition as they may be too difficult to pass.
However, we have found that many of our clients and friends are harboring some misconceptions about these changes and feel it’s time to clear things up.
Yes, Biden is targeting the rich to fund his reforms. Will it affect you? Perhaps. But, it could be less than you think.
Let’s take a look at what’s on the table and discuss possible planning tips that could help mitigate potential impact.
1. Corporate gains in the hot seat
Under this new plan, the corporate tax rate could increase from 21% to 28%. There could also be an additional increase in taxation of corporate income earned by US based companies, and these changes could take effect as early as January 2022.[i]
Biden also plans to levy a 15% minimum tax on their book of income rather as opposed to the income reported the IRS. The book of income is usually the larger of the two numbers corporations release to investors, so you can see why this would be a concern to those affected.
Even if you aren’t a multinational corporation, though, these changes could trickle down in the form of reduced earnings per share on the S&P 500 by 9%. The hope is that Congress will end up passing a smaller rate increase of 25%, which would only depress earnings by 3%.
2. Raising long-term capital gains rates on income over $1 Million from 20% to 39.6%
With the 3.8% Medicare surtax, individuals with an income over $1 million could potentially pay a 43.4% rate on long-term capital gains.[ii]
Currently, gains from the sale of stocks, mutual funds, and other capital assets that are held for at least one year (i.e., long-term capital gains) are taxed at either a 0%, 15%, or 20% rate with the highest rate paid by wealthier taxpayers – single filers with taxable income over $445,850, head-of-household filers with taxable income over $473,750, and married couples filing a joint return with taxable income over $501,600.
Under the Biden plan, anyone making more than $1 million per year would have to pay a 39.6% tax on long-term capital gains plus the 3.8% surtax on net investment income for an overall top tax rate up to 43.4%. This is almost double the current top rate. In effect, millionaires could completely lose the tax benefits of holding capital assets for more than one year.
But, all is not lost. If you fall into this category, one planning strategy is to reduce the size of the capital gains budget, limiting it to 23.8% versus the 43.4% top rate. How? There are a few options. You can accomplish this by accelerating gains into this year, tax-loss harvesting, gifting highly appreciated assets to charity, increasing retirement contributions, or even increasing business expenses. Finding ways to level the income will be the key to (1) avoid being in the highest tax bracket the next year and (2) to not exceed the $1 million capital gains threshold.
3. Increase the top income tax rate for income over $400,000 to 39.6%
This is a reversion to pre-2017 rates for this bracket. But, in reality, this shouldn’t come as too much of a hit as most of the provisions of the bill were always set to expire in 2025 anyway, by which time all brackets would go back to their pre-2017 rates. So, while the increase may come sooner than expected, it isn’t an idea that is completely out of left field.
Individuals affected (though it is yet unclear who that will be) or on the edge of this threshold will want to find ways to strategically reduce income such as funding retirement plans, bunching deductions, charitable giving, or even opening defined benefit or profit-sharing plans.
4. The elimination of step-up basis for estates
This essentially means that heirs could get stuck paying taxes on inherited gains over $1 million even if nothing has been sold. Houses being passed down that have appreciated in value, for example, may most easily fall in this category. Again, note here that the tax event is triggered by gains exceeding $1 million, not on assets valued over $1 million. Re-balancing with an eye on transferring highly appreciated assets to retirement accounts, gifting, and transferring low-basis stocks to lower-income family members are all ways to avoid this potential tax liability.
5. Replace deductions for contributions to IRAs, 401(k)s, and similar retirement accounts with a flat 26% credit
This provision incentivizes lower income Americans to contribute to their retirement accounts, but places high-net worth individuals in the position of losing their full deduction. High-earning individuals, then, may lean more heavily into Roth conversions or the utilization of other retirement savings vehicles rather than contributing an amount over what would be commensurate with the 26% credit.
From a Planning Perspective
Of course, we never want the tax planning tail to wag the investment dog; but, tax laws and tax planning ultimately affect the longevity of wealth so they must be considered simultaneously.
So, will you be paying higher taxes? Perhaps. But, at this point, these are just proposals. There are many steps that must be taken before some or all of these are enacted into law.
Even if all of the above changes are enacted fully as proposed, there is still hope to avoid a significantly larger tax bill. A study done by Wharton Business School suggests that completely legal tax mitigation strategies could help avoid 90% of the proposed tax increases on capital gains. The proposal could be more bark than bite.
Change is the only constant, especially in the world of tax law. This we know and should not be surprised by. The advisors at RiversEdge continue to pay close attention to the process and will contact you should we feel you will be affected.
In the meantime, we hope that these explanations have been informative and helpful, but please feel free to contact us should you still have concerns. We are always here to support and guide you in the right direction.