Tax law changes on the horizon – 5 things to conside
Tax laws are expected to change under the Biden administration. In addition, some previous tax cuts will be sunsetting in the next several years. Now is the time to prepare strategies that can be rapidly implemented if necessary. Although we cannot be sure if or when the changes will come, taking the wait-and-see approach may be more costly than ever, given how quickly things can shift.
With the Tax Cut and Jobs Act (TCJA) due to sunset in 2025, and potential changes to come even sooner, we have emphasized the importance of tax AND estate planning with our clients. We believe that we are likely in the most favorable tax environment we will ever see (estate tax included), and we do not want this opportunity to go to waste.
Some might say much of our talk could have been chalked up to a sky-is-falling mentality, but we know that to no longer be true. There could be significant tax changes afoot that would affect high-income earners ($400,000+) and those with highly appreciated assets, among others, and it is our job to be discussing these items with clients now.
Given the unpredictable political climate, and recognizing that each client’s situation is different, we have listed five potential tax changes to come (as discussed in Biden’s Tax Proposal) and actions to consider based on each item. Review these five areas carefully, and we can discuss at an upcoming meeting to review your specific situation.
Raising top ordinary income rates - Biden’s tax proposal calls for raising the top tax rate to 39.6%, from 37%, likely for those who earn more than $400,000, but it may apply only to those currently on the top tax bracket (MFJ $622,050 and Single $518,400). 39.6% was the highest rate before the 2017 Tax Cuts and Jobs Act, which lowered it to the current 37%. According to the White House, the 39.6% rate would apply to the top 1% of Americans.
Actions to consider
$1M+ in capital gains taxed at ordinary income rate - For households earning more than $1 million, Biden proposes taxing long-term capital gains and dividends at his higher top ordinary income tax rate of 39.6%—nearly double the current top 20% tax rate on such income. Biden’s plan means that the top federal tax rate for the highest earners would rise from 23.8% to 43.4% when you factor in the 3.8% Net Investment Income Tax (NII) on investment gains (or income) implemented as part of the Affordable Care Act.
Actions to consider
Limited step-up in basis at death - Under current law, when a property owner dies, the cost basis of an asset passed to a beneficiary is “stepped up.” This means the present value of the asset becomes the basis. For example, suppose you inherit a house purchased years ago for $100,000, and it is now worth $500,000. You will receive a step up from the original cost basis from $100,000 to $500,000. If you sell the property right away, you will not owe any capital gains taxes. Under Biden’s proposal, the untaxed gains on investments held at death—such as stock, land or a home—would likely be taxed, potentially up to 39.6%. And remember, especially punishing is the fact that death would become a taxable event, and the taxes would need to be paid even if the asset wasn’t sold. There is an exemption of $1 million per individual, plus $250,000 more for a home. The total exemption would be doubled for married couples, up to $2.5 million of gains.
Actions to consider
Decreasing of lifetime exclusion (and eventual sunsetting of TCJA in 2025) - After the Tax Cuts and Jobs Act (TCJA) passing, the gift and estate tax exemption were doubled from $5 million to $10 million (adjusted annually for inflation) starting in 2018. The exemption is up to $11.7 million per person in 2021. Biden’s tax proposal and other proposals indicate the possibility of the exemption being reduced to between $3 million and $5 million. If not now, the favorable estate tax changes in the TCJA are currently scheduled to sunset after 2025, and the exemption will go back down to $5 million (plus inflation) per individual.
Actions to consider
SECURE Act - Arguably the most significant change the SECURE Act presents is doing away with stretch IRAs for non-spouse beneficiaries. That is, the SECURE Act no longer allows non-spouse beneficiaries who inherit a retirement account to stretch out distributions over the beneficiary’s life when liquidating the account. Instead, the bill requires liquidations within 10 years of the newly inherited account, which inevitably will increase taxes and decrease the value of the inherited IRA. Also, anyone who has listed a trust as a beneficiary must review it, as the SECURE Act makes that situation problematic in many instances.
Actions to consider
Act now!
With significant tax changes on the horizon, now is the time to prepare and consider alternative strategies. Although we cannot be sure if or when the changes will come, taking the wait-and-see approach may be more costly than ever, given how quickly things can happen. Reviewing these five tax changes will ensure you are prepared for what lies ahead and that you will have the information you need to make an informed decision to best suit your needs.
With the Tax Cut and Jobs Act (TCJA) due to sunset in 2025, and potential changes to come even sooner, we have emphasized the importance of tax AND estate planning with our clients. We believe that we are likely in the most favorable tax environment we will ever see (estate tax included), and we do not want this opportunity to go to waste.
Some might say much of our talk could have been chalked up to a sky-is-falling mentality, but we know that to no longer be true. There could be significant tax changes afoot that would affect high-income earners ($400,000+) and those with highly appreciated assets, among others, and it is our job to be discussing these items with clients now.
Given the unpredictable political climate, and recognizing that each client’s situation is different, we have listed five potential tax changes to come (as discussed in Biden’s Tax Proposal) and actions to consider based on each item. Review these five areas carefully, and we can discuss at an upcoming meeting to review your specific situation.
Raising top ordinary income rates - Biden’s tax proposal calls for raising the top tax rate to 39.6%, from 37%, likely for those who earn more than $400,000, but it may apply only to those currently on the top tax bracket (MFJ $622,050 and Single $518,400). 39.6% was the highest rate before the 2017 Tax Cuts and Jobs Act, which lowered it to the current 37%. According to the White House, the 39.6% rate would apply to the top 1% of Americans.
Actions to consider
- Look for tax diversification and tax deferral opportunities such as Roth IRAs, annuities, 529s and HSAs.
- Make use of tax bracket management, taking advantage of low-income years to take IRA distributions or sell appreciated stock.
- Consider all tax-efficient investments and strategies, such as tax-loss trading, maximizing retirement contributions, and so on.
- Consider purchasing cash value life insurance for tax-free growth and death benefits.
- Consider asset allocation strategies and investing in individual stocks and ETF’s, and municipal bonds as most are exempt from federal taxes and some are exempt from state and local taxes.
$1M+ in capital gains taxed at ordinary income rate - For households earning more than $1 million, Biden proposes taxing long-term capital gains and dividends at his higher top ordinary income tax rate of 39.6%—nearly double the current top 20% tax rate on such income. Biden’s plan means that the top federal tax rate for the highest earners would rise from 23.8% to 43.4% when you factor in the 3.8% Net Investment Income Tax (NII) on investment gains (or income) implemented as part of the Affordable Care Act.
Actions to consider
- Consider increasing contributions to 401k’s, IRA’s, defined benefit/cash balance plans and Roth accounts.
- Leverage property and investments (borrow against appreciated property and lending back) instead of taking withdrawals.
- Consider accelerating sales and income into 2021, buy and hold, tax-loss trading, tax gain harvesting and other tax-efficient investment strategies.
- Consider all strategies to drive down income in future years.
Limited step-up in basis at death - Under current law, when a property owner dies, the cost basis of an asset passed to a beneficiary is “stepped up.” This means the present value of the asset becomes the basis. For example, suppose you inherit a house purchased years ago for $100,000, and it is now worth $500,000. You will receive a step up from the original cost basis from $100,000 to $500,000. If you sell the property right away, you will not owe any capital gains taxes. Under Biden’s proposal, the untaxed gains on investments held at death—such as stock, land or a home—would likely be taxed, potentially up to 39.6%. And remember, especially punishing is the fact that death would become a taxable event, and the taxes would need to be paid even if the asset wasn’t sold. There is an exemption of $1 million per individual, plus $250,000 more for a home. The total exemption would be doubled for married couples, up to $2.5 million of gains.
Actions to consider
- Consider obtaining life insurance to create estate liquidity and for tax payments.
- Consider tax-loss trading, gain harvesting, and basis management during life. Consider transferring highly appreciated assets to the spouse—the reverse of what we do now.
- Evaluate assets to be left to beneficiaries and determine if certain assets make more sense than others regarding potential taxation.
- Those that are charitably inclined may want to gift highly appreciated assets to charity.
- Instead of leaving highly appreciated assets to the children so they could get the step-up in basis, leave highly appreciated assets to the spouse and leave assets with little appreciation to the children.
Decreasing of lifetime exclusion (and eventual sunsetting of TCJA in 2025) - After the Tax Cuts and Jobs Act (TCJA) passing, the gift and estate tax exemption were doubled from $5 million to $10 million (adjusted annually for inflation) starting in 2018. The exemption is up to $11.7 million per person in 2021. Biden’s tax proposal and other proposals indicate the possibility of the exemption being reduced to between $3 million and $5 million. If not now, the favorable estate tax changes in the TCJA are currently scheduled to sunset after 2025, and the exemption will go back down to $5 million (plus inflation) per individual.
Actions to consider
- Use it or lose it! Use the large gift exemption now as the IRS announced at the end of 2020 that there would be no retroactive tax on gifts made using the exemption in prior years should the exemption be reduced.
- Consider gifting or transferring assets out of your estate when interest rates and asset values are low.
- Gift before estate tax laws change to prevent any planning mistakes or challenges that can come if you are forced to rush the process.
- Consider charitable giving strategies and other advanced gifting strategies, including trusts.
- Instead of holding until death, gift assets sooner, before they appreciate too much in value.
SECURE Act - Arguably the most significant change the SECURE Act presents is doing away with stretch IRAs for non-spouse beneficiaries. That is, the SECURE Act no longer allows non-spouse beneficiaries who inherit a retirement account to stretch out distributions over the beneficiary’s life when liquidating the account. Instead, the bill requires liquidations within 10 years of the newly inherited account, which inevitably will increase taxes and decrease the value of the inherited IRA. Also, anyone who has listed a trust as a beneficiary must review it, as the SECURE Act makes that situation problematic in many instances.
Actions to consider
- Consider drawing down large traditional IRA balances in lower-income years and paying taxes on the IRA monies now.
- Consider annual partial Roth conversions.
- Consider leaving Roth (after-tax) retirement assets to non-spouse beneficiaries.
- Review retirement account beneficiaries to ensure a trust is not listed as the beneficiary.
- Consider life insurance to replace the stretch IRA and/or to pay income taxes.
- Consider multiple beneficiaries for IRA accounts or whether IRAs should be left to lower tax beneficiaries.
- Consider charitable beneficiaries, including a charitable remainder trust if you are so inclined.
Act now!
With significant tax changes on the horizon, now is the time to prepare and consider alternative strategies. Although we cannot be sure if or when the changes will come, taking the wait-and-see approach may be more costly than ever, given how quickly things can happen. Reviewing these five tax changes will ensure you are prepared for what lies ahead and that you will have the information you need to make an informed decision to best suit your needs.