This article was written by J. Patrick Collins Jr., CFP®, EA and published on October 7, 2020.
As we enter the last month of the general election, we thought it would be important to review Joe Biden’s tax proposal and the impact it would have on many of our clients. Not only that, we hypothesize on some of the strategies we would look to implement to minimize the tax burden associated with his proposal. Several broad strokes have been made public, but we wouldn’t fully understand the impact of Biden’s proposal until we saw the actual legislation. While there are many parts to his tax proposal that have been laid out, this blog will focus on some of the most impactful areas to individuals.
- Raising the marginal tax rates on high earners
- Biden’s plan is to raise the highest marginal tax rate to 39.6% from 37%. In situations where marginal rates are increasing in the future, high income individuals should consider accelerating income into the year before the tax law becomes active. For example, those with high IRA balances that will be in high tax brackets throughout retirement may want to consider converting all or some of their IRA balance to a Roth IRA. Once the tax law is in place, traditional strategies like deferring income into future years when marginal rates are lower (often retirement years), will make the most sense. Deferred compensation plans, retirement contributions and other tax-advantaged savings could become more valuable.
- Reinstituting the payroll tax on the top 1% of earners
- This proposal would have a large impact on wage earners with very little strategies to lessen the blow. Currently, all taxpayers must pay social security tax on wages up to $137,700. The tax is currently 12.4% and is split evenly between employee and employer (6.2% each). Biden’s tax proposal maintains this threshold but takes it a step further. In addition to this tax, individuals and companies would start having to pay this tax on any amounts OVER $400,000. So, for an individual earning $1 million in wages, they would be looking at an additional $37,200 per year in taxes owed for their share of the social security tax (companies would be paying the same amount!). One strategy that every business owner would need to consider would be structuring wages and profits appropriately. Instead of all the businesses income being considered wages to the owner, if the owner can reclassify wages as profits from ownership, social security taxes would not be owed on those amounts. This is an area that every business owner should consult their accountant on, since the reasonableness of wages is an area of scrutiny from the IRS.
- Increasing capital gains tax on filers earning over $1 million
- Biden’s tax proposal would change capital gains for high income individuals to their ordinary tax rate of 39.6% (along with most likely adding the 3.8% Obamacare tax on top of that), potentially taxing capital gains at rates higher than ordinary income. On top of that, most states already tax capital gains at the same rate as ordinary income, meaning that it may be possible to lose over 50% of your gains to tax if you are a high income individual in a high tax state! One strategy that may want to be considered is selling appreciated securities before a proposal like this turns into law. Second, asset location strategies will need to be revisited. Traditionally it makes sense to own equities in taxable accounts, while owning bonds in an IRA, but with potentially higher capital gains rates, high income filers may need to re-think this approach of where an asset should be held.
- Limiting itemized deductions to 28%
- For high income filers, limiting itemized deductions to 28% effectively lessens the benefits of things like charitable contributions, mortgage interest, or state taxes. Reducing the value of these itemized deductions may have an impact on high-end homes (higher effective costs for mortgages) and charitable organizations (will the wealthy give as much to charity if they don’t get the tax benefits?). With all the elements of Biden’s tax plan, I would expect to see certain lobbying groups try to fight this part of the proposal most vigorously.
- Eliminate the stepped-up basis at death
- Currently, when someone passes away and a beneficiary inherits an asset, the beneficiary’s new cost basis is the value of that asset on the date of death. For individuals who inherit low basis assets, this can save them significant dollars, since they can sell these assets and pay no capital gains taxes. This proposal would potentially impact everyone who inherits money as beneficiaries would receive the decedent’s basis in the property, thereby paying much higher capital gains when the property is sold. One of the key considerations is the requirement to maintain accurate records of cost basis, which may be nearly impossible once a decedent passes.
- Reducing the estate and gift tax exemption
- Even without any new legislation, the estate tax exemption amount is scheduled to sunset on January 1, 2026 from $11,580,000 currently to $5,000,000. With a Democratic sweep this election, this exemption may decrease much sooner. Individuals with very large estates (over $20 million) may want to consider using some or all of their estate and gift exemption in 2020 if they fear this exemption will drop. There are countless strategies on how to utilize this exemption, but those with very large estates should be speaking with their financial, tax and estate advisors about this real possibility.
An analysis by the American Enterprise Institute found that while the bottom 99% of tax payers would see negligible tax increases, the top 1% would bear nearly all the brunt of the tax increases, seeing their after-tax incomes drop nearly 18%, or to put it another way, realize an average tax increase of $118,194. Most analysts believe this tax proposal (in the entirety) is extremely unlikely. First, Democrats would almost certainly have to retain the House of Representatives as well as retake the Senate and the Presidency to have a chance at passing it. Polls are showing that this is not out of the question. Even in that scenario, it is not hard to see either Biden softening his tax proposals or centrist Democrats, realizing we are amid significant downturn in the economy, not wanting to make any extreme moves which could jeopardize the recovery.
Whatever proposals and laws come from Washington, we will continue to focus on maximizing your after-tax wealth through the various tools and strategies that are available to us at the time. If you have any questions about your current tax plan or what some of these proposals could mean for you, please don’t hesitate to reach out to us.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.