Key Takeaways
No one knows exactly what the new tax landscape will bring. But most rates will be going up—not down—for affluent, successful people.
Just know there are still plenty of ways to ensure you remain on track to meet your financial and retirement goals.
Be ready to pivot when the dust settle. Just don’t overreact to all the gloom and doom headlines. Read on for smart planning opportunities.
General Douglas MacArthur summed up all the failures of war and life in just two words: “Too late.” Too late in preparing, too late in grasping the enemy’s intentions, too late in securing allies, too late for leaders to be exchanging contact information, and too late in rushing to the aid of those in need.
I like to be optimistic. But when it comes to your financial plan, preparing for the worst-case scenario can help you gain more clarity about remove the fear of what may come down the road.
President Biden’s tax plan, while still in the works, is not likely to be kind to people with substantial investment portfolios, high incomes and other long-held assets. There is no reason to panic about the government taking all of your hard-earned wealth, but it’s worth getting up to speed on all the proposed changes (keyword “proposed”) and be opportunistic when tax-planning opportunities arise.
Here are 7 important areas to keep an eye on:
1. Income tax rate increases
One of the most discussed propositions is the increase in income tax rates, bringing individual tax rates to 39.6% for ordinary income. This new rate applies to married individuals who file jointly with taxable income over $450,000. It also applies to heads of household with taxable income over $425,000, to unmarried individuals with taxable income over $400,000, to married individuals filing separate returns with taxable income over $225,000, and to trusts and estates with taxable income over $12,500, as adjusted for inflation in future tax years.
2. Rate bracket adjustments
In addition to the tax rate increases, the rate brackets will also be adjusted. Those on the upper end of the 32% and 35% income tax rate brackets may see a tax rate increase as a result.
PLANNING TIP: Consider pulling in more income this year and deferring deductions for next year when tax rates will likely be higher. Consider Roth conversions when it makes sense to do so.
While the proposed changes to tax rates are numerous and far-reaching, they’re not unprecedented. It’s simply a reminder of how tax laws and rates can change dramatically and on relatively short notice. We are still in a period of some of the lowest tax rates since World War II. Some of you may remember the 1970s when the U.S. had top tax rates in the 70% to 90% range at the federal level. With so many headwinds facing the U.S. Treasury (Government debt, Social Security, Medicare), there is a strong chance tax rates will continue to rise.
3. Long-term capital gains and qualified dividends will be taxed at a higher rate (20%-25%).
Depending on what you were planning to do with your highly appreciated assets, it might be a good time to liquidate them before year end, while you can still take advantage of today’s lower long term capital gains rates. Just make sure the assets you are selling have been held for at least 12 months—you don’t want to pay at the higher short-term rates, which could be as high as the 37% ordinary income rate.
4. Changes to grantor trust taxation
People with assets establish trusts for many reasons. Typically trusts are designed as separate legal entities to protect the grantor’s (or originator’s) assets and the income generated from those assets so that the grantor’s beneficiaries may receive them.
A “grantor trust” is a trust that is disregarded for federal (and sometimes state) income tax purposes. That means the “grantor” (or creator) of the trust pays all income tax on behalf of the trust. Yet, the trust assets are not “included” in the grantor’s estate for federal estate tax purposes. That way the trust is not subject to federal estate tax on the grantor’s death.
Establishing a grantor trust allows your assets to appreciate income tax-free for your beneficiaries. It also permits you to engage in several estate planning transactions with the trust, such as sales and loans to the trust, without incurring federal income tax.
PLANNING TIP: If you have a desire to position some assets outside of your estate when passing, it might be time to explore these options before any legislation gets puts in place to limit its usefulness.
5. Lowering exemption amounts
Currently, an individual can transfer up to $11.7 million to an heir or charity without incurring a federal gift, estate or generation-skipping transfer (“GST”) tax. The latest proposals from the Biden tax plan would reduce each exemption amount to $6.02 million effective January 1, 2022 and some tax pundits think the exemption amount could go as low as $3 million.
At this level, far more people than the “ultra-wealthy” that policy makers have their sights trained on would be impacted. Again, as we go to press, none of these proposed changes, while concerning, have been signed into law.
PLANNING TIP: Now might be a good time to explore strategies to position assets outside of your estate. Always check with your estate planning attorney and/or financial advisor before making a transfer. The timing is critical, and the rules can be complex.
6. Eliminate step-up in basis (less likely to happen)
The Biden tax plan shapers have frequently discussed the possibility of eliminating the step-up in basis provision. This is what has long let families leave certain assets to their heirs without having to pay capital gains tax when the assets are transferred. That’s because on transfer, the assets are valued at current market prices, not what the deceased family member paid for them.
Biden has said the plan would close the loophole, “ending the practice of ‘stepping-up’ the basis for gains in excess of $1 million ($2.5 million per couple) and making sure the gains are taxed if the property is not donated to charity.”
While this is not the firm time legislators have called for eliminating basis step up, tax experts believe it is not likely to pass due to complexity and other compromises being needed to get the meatier portions of the Biden tax plan pushed through.
PLANNING TIP: Make sure your assets are properly aligned with your goals. Under current law, low-basis assets are useful for both philanthropic and future wealth transfer goals. If the proposed changes to basis rules are passed, consider prioritizing your charitable giving.
7. Eliminating 1031 Exchanges for Real Estate (less likely to pass)
Like-kind exchanges, (aka 1031 exchanges), have been in the tax code since 1921. After a real estate investor sells a property, instead of paying capital gains tax immediately, they can “exchange” the property for a similar one within 180 days to defer the recognition of gain. The justification surrounding the deferral of gain is that a taxpayer who enters into the exchange is merely changing their investment vehicle.
Lawmakers have proposed several times limiting the amount of deferral to $500,000 or $1 million if filing jointly.
While real estate investors were worried, the like-kind exchanges did not appear in the House Ways and Means Reconciliation Bill released on September 15, 2021. While this does not guarantee that it will not come up again in negotiations, it is a good sign that the limitation on like-kind exchanges good be off the table.
PLANNING TIP: Identify legacy assets your are willing to hold indefinitely or look to Opportunity Zones if your holding period is at least five years.
Conclusion
With a divided Congress, many of the proposed tax changes are not likely to go through—at least at their extreme level. No one knows how all the legislative horse-trading will shake out, but it pays to be prepared for the worst-case scenario.
As Ben Franklin said: “Failing to plan is planning to fail.”
If you or someone close to you has concerns about your tax, retirement or legacy planning, please don’t hesitate to contact me to schedule a Discovery Session.
Also, come join our private Facebook group to connect with others looking to gain control over their finances.
