Income Tax Planning under the American Families Plan: Part 1

By John Owens, CFP, EA, ECA

For the second time in my relatively short career, the government has proposed sweeping tax changes that promise to rewrite the entire tax code and change the way I (and Brooklyn FI) give advice to our clients. While most folks might see this as an annoyance or hurdle, I take it as an interesting challenge and a shiny new way to ensure we guide our clients towards their ultimate goal of financial independence as quickly and as tax-efficiently as possible. There’s a lot to unpack here and none of this is final but over a series of two blog posts I’ll break down what’s in the plan and how it might impact our financial planning strategies. 

Last week the Biden Administration announced the American Families Plan, a $1.8 trillion spending plan composed of several domestic priorities for the administration. With a price tag that large, three questions come to mind:

1.       What is in the plan?

2.       How do we pay for it?

3.       What planning opportunities does this create?

What is in the American Families Plan?

In summary, the plan’s $1.8 trillion price tag is made up of about $1 trillion in additional government spending and about $800 billion in tax cuts. Key areas of the plan include child care, education, paid family and medical leave, nutrition, unemployment insurance reform, and an array of tax cuts and tax increases.

Key highlights:

Childcare – the plan provides $225B for childcare, including subsidies for families and a $15 minimum wage for childcare staff working with young children.

Education – the plan provides universal pre-Kindergarten for all 3- and 4- year olds, targets to provide two free years of community college, an expansion of need-based Pell grants, tuition subsidies, and support for special education teachers.

Family leave – the plan creates a path toward paid family and medical leave in the US, giving workers upto $4,000/mo in benefits, and additional benefits including bereavement.

Unemployment – aims to improve the US unemployment system to adjust the amount of benefits and length of claims.

Tax Cut Provisions:

Child tax credit – extends the one-time enhanced child tax credit of $3,000 per child under 18 until 2025, while also extending the additional $600 for children under 6.

Health Insurance – enhances the Affordable Care Act subsidies passed under the American Rescue Plan to make them permanent.

Earned Income Tax Credit – makes the Rescue plan’s changes to the EITC permanent.

Child and Dependent Care - makes the Rescue plan’s changes to this tax credit permanent, allowing a $4,000 tax credit for families with one child and an $8,000 tax credit to families with two or more, subject to phase outs.

 How do we pay for this?

I’m glad you asked, the administration is counting on several tax increases and increased tax enforcement (aka audits) in the coming years to help raise revenue to fund this plan.

1.       Regular tax increases: One direct way they plan to pay for this is through tax increases, specifically on high earners. The plan aims to increase the top tax bracket in the US from 37% to 39.6%, the same level it was before the Tax Cuts and Jobs Act in 2017. This bracket will kick in around $500,000 in income for married couples, $400,000 for single folks.

2.       Capital gains tax increases: they also aim to increase the capital gains tax rate to 39.6% for those earning more than $1M. This would be a huge shift in US tax policy. This one warrants at least three other separate blog posts, at least two webinars and a complete shifting of how we give financial planning advice. Stay tuned for individualized planning strategies around this one. 

3.       Taxes at Death: they are looking to largely eliminate the step-up in basis at death that’s afforded to capital gains assets. For example, if you purchased XYZ stock at $10 a share and it’s now worth $1,000 a share and you pass away, your heirs aren’t currently subject to income tax on the $990 in appreciation. 

4.       Enforcement: the plan includes funds to allow the IRS to modernize and improve enforcement and collections to raise additional revenue.

Planning Opportunities

There are several areas of planning that can come into play with this legislation. Two key areas are Income Tax Planning and Estate Planning, so we’ll tackle each separately. This week’s post will cover Income Tax Planning implications, while next week we’ll cover Estate Planning impacts. Note that they’re quite intertwined!

Income Tax Planning

While there are income tax implications for households of all sizes, we’re going to primarily focus on impact on high earners as it pertains to the tax increases discussed in the plan. That said, lower and middle income families should plan as well, as the credits pertaining to young children, childcare costs, and health insurance are subject to phase outs.  

Income Taxes:

With the top ordinary income and capital gains tax bracket potentially moving to 39.6%, there are some key planning opportunities to consider. Here’s a list of a few that come to mind:

1.       Accelerating income into 2021: If you’re in the top tax bracket regardless, moving more of your income into 2021 to pay tax at 37% on income you’d otherwise pay tax on at 39.6% in future tax years. How can we do this? Exercise NQOs sooner than we anticipated or disqualify ISOs that you weren’t planning to hold for a qualifying disposition.

2.       Decelerate Deductions: Write-offs and deductions may be more valuable in future tax years for high earners. Taxpayers can elect to depreciate business assets rather than expense them as to have larger deductions later on. Other write-offs like charitable gifts may be more valuable when they decrease your future income taxed at higher tax rates.  

3.       Seek out capital gains to re-set cost basis: With the potential for capital gains rates to match ordinary income tax rates, it’s worth considering whether it makes sense to re-set your cost basis in investments now – paying tax on your unrealized appreciation at 15 or 20% now to avoid having some of that growth taxed at 39.6% in the future.

4.       Fill up the 20% capital gains bucket annually: If this becomes law and your income fluctuates, one planning consideration may be to fill up the 20% capital gains bracket – pushing your income up to $1M each year to take advantage of the nearly 50% discount on taxes that occurs before the 39.6% bracket kicks in.

5.       Reevaluate Long Term ISO Strategies: The common strategy of exercising and holding ISOs for a ‘qualifying disposition’ may make less sense for folks with incomes topping $1M. And unwinding ISO positions may require a more nuanced strategy if we’re aiming to avoid the top capital gains bracket. Simply said, some folks will likely benefit much more from disqualifying ISOs while others will necessitate a longer holding period to optimize capital gains taxes.

6.       Reevaluate 2021 ISO Strategies: If you exercised ISOs in 2021, we may want to consider disqualifying them before year-end if we see you being impacted by ordinary income and capital gains tax bracket increases that add additional risk to the strategy.

7.       Non-qualified Annuities: While this has consistently not made sense under the current tax code, non-qualified annuities could potentially become mainstream under these proposals. Annuities are tax sheltered, meaning you don’t pay tax on the appreciation on the assets you contribute. The downside is that that growth, when withdrawn, is taxed as ordinary income. When capital gains and dividends are taxed at favorable rates, this strategy didn’t make sense for most folks. But with capital gains rates potentially matching ordinary income brackets, a non-qualified annuity may make sense to shelter interest, dividends, and capital gains until you actually need to draw on the assets. Likewise, non-qualified annuities, unlike retirement accounts, aren’t subject to the provisions of the SECURE act and may be eligible for the beneficiary stretch – a feature that allows your heirs to withdraw funds over their life expectancy if you leave them the annuity.These will likely not make sense for most folks, but very high earners with significant assets may benefit from using them. 

8.       Renewed Focus on Deferred Comp / Mega Backdoor Roth / Backdoor Roth, etc Strategies: Filling up tax deferral buckets – like a deferred compensation plan, after-tax 401(k), Backdoor Roth, 457, 529, or HSA will be more valuable under the tax hikes. We’ll want to evaluate each mechanism for tax-deferred growth.

9.       Legacy Securities: I put this last on this list as it can impact estate planning and income tax planning. Conventional wisdom has been to consider holding substantially appreciated securities until death in certain cases for the ‘step up’ in basis. One provision of the Biden plan is to eliminate that step-up in basis and perhaps make death a taxable event generating capital gains. A better strategy may be to do some intergenerational tax planning to determine who would be best off paying that capital gains tax – i.e. which family member – parents or children, have the lower capital gains tax rate.

As you can tell, this is complicated and interconnected. We don’t even have the full context of the Biden plan just yet, only the broad strokes. So let me leave you with a bit of punditry of my own:

-          It is very unlikely the final version of the plan looks like this. While it’s reasonable to see capital gains and income taxes increase, I’d be very surprised if they actually taxed long-term gains at 39.6%.

-          Triggering income taxes on unrealized appreciation at death would be a major shift in the tax code. I’m not saying it’s unlikely, but it’s complicated. There are many assets out there that don’t have a readily available cost basis – think land or stock acquired decades ago? Art? A family business? I see this as a potential bargaining chip for a lowered estate tax threshold, perhaps.

-          A big provision of this plan is enforcement for the IRS. There are a lot of tax cheats out there, and studies show that each dollar spent on enforcement can bring in almost $7 in new revenue. Expect lots more letters from the IRS, Audits, and scrutiny if this gets passed.

In the meantime, the next steps for most folks are as follows:

1.       Review your financial plan, estate plan, and balance sheet. If you don’t have any one of those, it’s time to get one.

2.       Talk to your trusted advisors about how this proposal may impact you and what changes may need to be made to your plans to prepare.

3.       Start talking to your parents and/or children about how this impacts them. Nothing like higher taxes that can bring the whole family together.

4.       Assess your goals and update strategies as needed based on what happens in Washington. Look for moves that make sense under the current and proposed tax regime.

Tune back in next week for Part 2 where we dive into the estate planning implications of this legislation, and remember, at Brooklyn FI, we stand ready to help our clients navigate these changes. We’re following this legislation closely and constantly developing ways to help our clients in an ever changing environment.