What to Make of Recent Tax Proposals?

Sam Swift, CFA, CFP®, AIF®

May 3, 2021

President Biden recently released outlines of a tax plan that he will be asking Congress to convert into law and pass. Like any proposal, it is no sure thing that any of the headline changes make it into a final bill or whether a final bill even sees the light of day. Nevertheless, it’s been at the forefront of many discussions and people are wondering what the implications may be for them.

At TCI, one of our main goals is always to maximize after-tax net worth for our clients over their lifetime. After all, we achieve our goals and purpose with the dollars we have after taxes. I emphasized “over their lifetime” because that is not always the same thing as “minimizing this year’s tax burden”. Although those two goals may frequently align, too often we have seen individuals chase the latter at the expense of the former.

In any case, I thought it would be helpful to dive into some of Biden’s proposals and how it may change our strategies, if at all. For purposes here, I am focusing only on changes to individual taxes. Biden has proposed multiple changes to corporate tax structure, but nearly all of the relevant ones apply to very large corporations and are unlikely to be directly relevant to any reader of this blog. Please keep in mind, there is nothing worth doing currently as all of these proposals are far from being law. It doesn’t hurt to have some idea of how we would react, however, if they came to pass.

Breaking Down Proposed Tax Changes

Proposal:

Top tax rates on income over $400,000 would revert to 39.6% (the Tax Cuts and Jobs Act of 2017 had lowered it to 37%). There is also a proposed 12.4 percent Social Security payroll tax on income above $400,000 (currently, wages up to $137,700 are subject to this tax so this would effectively create a “donut hole” where the tax isn’t paid on wages over $137,700 until one is above $400,000). Itemized Deductions would be capped at 28 percent of value and the qualified business income deduction (section 199A) is phased out for those earning above $400,000.

What We Do Currently:

I lumped these changes together given they all would directly affect those with income above $400,000. Trying to manage income is something we look at with clients on a consistent basis, often in conjunction with their CPA. For those that are small business owners and may have more control over their wages, this can become an important point. The main planning that happens in this space is to be aware of fluctuations in income from year to year for those where that applies.

For example, if someone has an exceptionally high-income year that kicks them into higher tax brackets and/or income levels with extra taxes (think the 3.8% Medicare surcharge on income over $250,000), that may be a year worth looking at extra deductions to bring that income down. Think of “front-loading” future charitable donations by making one large donation in the high-income year to a Donor Advised Fund as one example. To the extent we can postpone capital gains in the portfolio to a year where income is lower, that would be something we’d consider. For the self-employed, it might make sense to implement a solo 401k or other retirement plan.

What May Change:

The current strategy doesn’t change much with these proposals, other than that it may become more valuable. The cap on itemized deductions could be relevant for those with a lot of charitable planning in terms of how we utilize Donor Advised Funds on a year-to-year basis. The additional Social Security taxes on earned income above $400,000 makes the smoothing of income (to the extent one has control over that) quite a bit more important.


Proposal:

Long-term capital gains and qualified dividends would be taxed at the ordinary income tax rate of 39.6 percent on income above $1 million. The proposal also eliminates step-up in basis for capital gains taxation.

What We Do Currently:

This has been the proposal that has gotten the most press in the financial world for its implications. Increasing long-term capital gains and qualified dividends rates would be a much bigger deal in how we need to plan if it was not for the fact that the proposal would only affect those with over $1 million in income in a given year. That just isn’t a large slice of the population.

Capital Gains on your taxable investments come in two flavors currently: short-term (investment held for less than one year) and long-term (investment held for more than one year). As law currently stands, short-term gains are taxed at your ordinary income tax rate and long-term gains get a special long-term capital gains rate. The long-term capital gains rates are almost always more favorable as most individuals would wind up paying 15% or 20% federally on long-term capital gains, whereas their income tax rate is almost assuredly higher than that. Fortunately, our investment philosophy lends itself to rarely, if ever, needing to take significant short-term capital gains.

We make every effort currently to only realize long-term capital gains, and only when it is necessary for the betterment of the long-term portfolio. We are also able to take capital losses when markets inevitably have their occasional downturn, and we use those losses to offset future capital gains.

What May Change:

It would become very important to make sure that we controlled capital gains such that one’s income stayed under $1 million in any given year. Again, that is unlikely to affect many people at all, but for those that are selling a business as they head into retirement, for example, it could become an important part of planning in how we choose to recognize the gains from that sale in addition to whatever we can control in the portfolio.

On the other hand, if there was no chance of someone staying under $1 million in income, then there is no point in waiting for a short-term gain to go long-term since the tax rate would be identical. In that case, we may get more aggressive with rebalancing a portfolio if circumstances dictated that we should. Currently, we would likely put off a rebalance if gains were going to go long-term in the next couple of months, but the proposed change would make that irrelevant for high-income individuals.

If the capital gains rate does become law and effective in 2022, it would be likely we take capital gains this year at the current tax rates before the higher tax rates kick in for those with high income in the future.


Proposal:

Eliminate step-up in basis for capital gains taxation.

What We Do Currently:

The advantage to deferring capital gains for as long as possible may lead to never realizing them at all. That is because the current law states that upon one’s death, one’s heirs would receive a “step-up” in cost basis. Let’s say I have purchased something for $10,000 and it has grown to $50,000 over the years. When I die, my cost basis does not pass on to my heirs. They inherit my $50,000 with a “stepped-up” cost basis of $50,000. If they chose to sell right then, there would be no capital gain and thus, no taxes. Obviously for older individuals, this is a reason to continue to defer whereas it may not be that relevant for those earlier in life.

What May Change:

Depending on an individual’s situation, we may intentionally take capital gains in a portfolio prior to their passing such that their heirs would end up paying less taxes. Of course, the reverse may be true if the heirs were likely to be in lower tax brackets than their predecessor. Finally, it may just make the most sense to continue to defer capital gains for as long as possible. Planning will get a bit more complicated in looking at a family’s entire situation (individual tax brackets, etc.) to determine the best course of action.

This is where generational planning becomes important. We already take into account children and grandchildren when it comes to the long-term plan. Should this part of the proposal make its way into law, that part of the plan would certainly move up in priority.


Proposal:

Expand Earned Income Tax Credit, increase renewable energy related tax credits, expand the Child and Dependent Care Tax Credit and Child Tax Credit (making it fully refundable), and reestablish the First-Time Homebuyers Credit up to $15,000.

What We Do Currently:

These are questions better left to the accountants as there isn’t a lot of planning to do—you either get the credits or you don’t in most cases. There is the exception of whether those credits are phased out based on certain income levels, and to the extent we can help manage that, we do.

What May Change:

Not too much will change in the way of planning. The reestablishment of the First-Time Homebuyers Credit may be interesting in terms of those deciding between renting and buying. In some cases, it may be enough of an impact to tilt the decision in favor of buying.


Proposal:

Reduce estate and gift tax exemption back to 2009 levels which is $3.5 million per individual. The estate and gift tax would increase to 45%

What We Do Currently:

This is a question where we work closely with estate attorneys to determine the best course of action depending on a client’s goals and how they may want to pass along their wealth to heirs or charity. The current exemption is $11.7 million per individual, which makes it effectively $23.4 million for a married couple in most cases. As this exemption has risen over the years, estate planning for most has focused on protection for heirs and making sure one’s wishes are carried out. Tax consequences have taken a back seat as most are unaffected thanks to the high exemption amount.

What May Change:

The more advanced estate planning techniques for those estates potentially above the exemption will become more relevant for a larger swath of the population. There remains an annual gift exemption of $15,000 per individual which would likely come into more use for those with estates that may cross the proposed $3.5 million number ($7 million for a couple). Purchasing life insurance to help with liquidity and estate taxes after one’s death may be more relevant for some.

The good news on this front is that this proposal brings us back to the landscape of just a decade ago. Estate attorneys recently worked in this environment and are well-versed in techniques that will help support client goals.

The Bottom Line

Once again, I must emphasize that there is still a long path ahead before any of these proposals become law. The President has power to encourage certain legislation and always has the threat of veto, but it is ultimately Congress that writes the laws. Nothing indicates there are actions that need to be taken today.

Many of the Biden tax proposals simply reverse, to some degree, changes that were made with the Tax Cuts and Jobs Act of 2017. Many other changes simply adjust rates or credit amounts as opposed to fundamentally altering how our tax law works. The ultimate takeaway is that the techniques we currently use are unlikely to drastically change. It’s more that the techniques may become more relevant for some and the magnitude of the impact they make may increase. This is not the first-time major changes to tax law have come into play, and it definitely will not be the last. Rest assured that we are thinking about it and prepared to hit the ground running if any of this does ultimately pass into law. We’ll be ready for it next time and the time after that!

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