The news is abuzz with the new proposals by the Democrats to greatly expand the Federal budget. A lot of the news isn’t actually about what is in the budget but how it could get paid for, because paying for it means tax law changes. Like all legislation, the current tax proposals circulating Congress will likely be subject to significant debate and revision, and given the Democrats’ slim margins in the House and Senate – including very early pushback from Democratic Senator Joe Manchin – what may ultimately be passed, if anything, could be significantly different than the preliminary proposals Democrats released over the weekend.
Given that context, we would recommend being patient and letting the legislative (or “sausage making”) process run its course. Rest assured, we are monitoring the potential tax changes and will continue to do so until passage. We will proactively reach out if we see adverse changes or beneficial opportunities to your circumstances due to the changes that are ultimately passed into law.
For now, we have summarized some of the key provisions that affect individuals and families, and provide some potential implications to consider if they are actually passed into law:
Top income tax rate: increases from 37% to 39.6%. Applies to individuals with taxable income over $400,000, or married individuals filing jointly (MFJ) over $450,000. In addition, a 3% surtax would be levied on taxpayers with adjusted gross income (AGI) above $5 million.
- Implication: for families on the income borderline, maximizing all pre-tax savings opportunities (401(k), IRA, HSA, FSA, etc.) and tax deduction opportunities within the calendar year may be warranted (including larger charitable giving, depending on if the so called “SALT” (state and local taxes) $10,000 limitation for itemized deductions is lifted). Otherwise, these families may be facing a 3-5% tax increase on some of their income (given the proposed 39.6% rate begins in the middle of the current 35% bracket).
Top capital gains rate: increases from 20% to 25%. Applies to taxpayers with taxable income over $400,000; a quirk in the proposal – the 20% top rate would apply to gains recognized before introduction of the legislation (September 13, 2021), and 25% for gains recognized thereafter.
- Implication: the top capital gains rate of high earners would now be 28.8% (including the net investment income surtax, discussed below). The good news for high earners is there does not appear to be appetite in Congress for retroactive taxing of gains already recognized this calendar year. But, given the rate hike would be effective from the bill’s introduction, and not passage, it means, as drafted, there is no opportunity to squeeze in more recognition of gains at the 20% rate before the change would become law. Also, this increase is significantly lower than President Biden’s initial goal to increase capital gains rates to match ordinary income rates (which would have made the top rate 39.6% + 3.8% surtax).
- Second implication: this implication is more of an addition by subtraction, and good news for those who have been planning to defer and avoid recognition of unrealized gains in non-qualified accounts until death – nothing in the tax proposals, as of yet, seeks to eliminate the so called “step-up in basis” at death. (Currently, at death, unrealized gains of non-qualified assets (for instance, taxable investment accounts, real estate, family business, etc.) are wiped out by resetting the tax basis for beneficiaries of these assets to fair market value at the decedent’s death.) President Biden had an indicated goal of eliminating the step-up, however, it appears the logistics of enforcing plus the potential hardships for certain small businesses and farms has swayed enough in Congress to drop the proposal.
Net investment income surtax: this is the 3.8% tax introduced by the Affordable Care Act (ACA) and currently applies to investment income (for instance, interest and dividends) for individuals with adjusted gross income (AGI) over $200,000, or MFJ over $250,000. The new proposal expands the 3.8% tax to cover net income derived in the ordinary course of a trade or business for individuals with taxable income over $400,000, or MFJ over $500,000.
- Implication: the 3.8% surtax would be expanded to include additional types of income, including potentially earnings from passthrough businesses, meaning another additional tax for certain high earners to watch out for. This further increases the importance of maximizing pre-tax savings and tax deduction opportunities.
Roth Conversions: eliminates Roth conversions for IRAs and employer-sponsored plans (e.g., 401(k)s) of individuals with taxable income over $400,000, or MFJ of $450,000.
- Implication: prior to 2010, income limits on Roth conversions were the law (previously $100,000 AGI). The current tax proposals bring back income limits, albeit at higher levels. Given Roth conversions above $400,000 of income would be fairly expensive with the proposed rate increases (closer to a 50% tax rate on converted assets, including state income taxes), this really was likely targeted at the very small segment of the population that may have been willing to pay high taxes in hopes of supercharging Roth accounts through aggressive investing, including with privately traded securities (i.e., Peter Thiel’s $5 billion Roth IRA through founders’ shares in PayPal).
Gift/Estate Tax Exemption: accelerates the sunsetting of the increased gift/estate tax exemption from former President Trump’s tax bill (currently $11.7 million per person, and $23.4 million for couples) from 2026 to 2022.
- Implication: this would halve the exemption for decedents dying between 2022 and 2025. For families with accumulated wealth on the borderline of the lower exemption (e.g., net worth of $5 million for an individual and $10 million for a couple) it may be worth considering inter vivos (during life) gifts to claim the higher credit amount during 2021, among other estate strategies, in consultation with their estate attorney. At a minimum, it may be time for such families to pick up the phone and dial their estate attorney as if this provision passes, the attorneys could be fairly busy during the last months of 2021.
The above is by no means a comprehensive summary of all of the potential tax proposals running through Congress at the moment, but the one’s we feel are most relevant and applicable to our clients. The general theme of the proposals is targeting increases at income levels above $400,000 and estates of multiple millions of dollars. For now, we will continue to monitor the sausage making.
Please feel free to reach out if you have any questions or would like to discuss further.
Alan Eskandari, JD, CFP®
Harvest Asset Group, LLC