The Latest Tax Hike Proposal and How To Plan
By John Owens, CFP®, EA, ECA, CPWA®
With Congress working at a breakneck pace to pass one of the most significant pieces of spending legislation in history - topping $3.5 trillion over the next 10-years, much of our focus now shifts from what they’re spending on to how we pay for it. And for many of our clients, that means tax hikes and other changes designed to nip the efficiency of certain planning strategies - and raise revenue.
While we don’t know exactly how the legislative sausage maker will grind up these provisions and turn them into law, we’ve at least been provided with a roadmap that helps us better understand the areas they’re targeting and what prudent planning moves we should consider before year-end.
First, let’s review some of what they’re changing:
Increasing the top ordinary income bracket: The top tax bracket is going up from 37% to 39.6%. This starts for Married Couples at $450,000 in income, Single folks at $400,000. It’s important to note that not only does this bump up the top bracket by 2.6%, but it also compresses the 35% bracket. Meaning that high earners will get into the top tax bracket quicker, and that bracket is higher.
Increasing the top capital gains bracket: Currently capital gains are taxed at either 0% (very low earners), 15%, or 20%. But the 20% bracket is illusory due to the 3.8% tax on Net Investment Income. So effective capital gains brackets are 0%, 15%, 18.8%, and 23.8%. This change would eliminate the 20% bracket and replace it with a 25% capital gains bracket, effectively making capital gains taxed at 0%, 15%, 18.8%, and 28.8%. The current draft of the legislation makes this change effective 9/13/21.
Less favorable tax treatment for S-Corporations: High earners will pay an additional 3.8% tax on income derived from S-Corps. When combined with the increased ordinary income tax rates, the top tax rate for S-Corp income will go from 37% to 43.4%.
Creating a surcharge tax on very high earners with income over $5M: Folks in the top 0.1% of income earners will see a 3% additional tax on their income over $5M. Combined with the top ordinary income bracket of 39.6%, and the 3.8% net investment income tax, this could effectively create a top federal tax bracket of 46.4%.
Lowering the Estate Tax Exemption: The current estate tax exemption would drop from $11.6M per person to about $5.8M. Taxable estates with assets over that level are taxed at 40%.
Eliminating the Backdoor and Mega Backdoor Roth: After 12/31/21, taxpayers would no longer be allowed to convert after-tax funds in IRAs or 401(k)’s to Roth, effectively closing the Backdoor strategy. It also prohibits Roth conversions for high income earners starting in 2031.
Crackdown on large retirement accounts: The legislation requires minimum distributions if you’re a high income individual with retirement account balances over $10M. This is a a shot at the Peter Thiels and Mitt Romneys of the world who have amassed fortunes in tax-deferred accounts.
With these changes in mind, there’s a variety of planning opportunities to consider both for 2021 and beyond. But since this is only proposed legislation, it’s important to not let the mere potential for changes cause you to totally up-end your plan. So let’s start with a review of the low-hanging fruit. Moves that make sense given the proposed legislation that doesn’t have significant downside if it changes or stalls.
2021 Planning Moves:
1. Get your 2021 Backdoor Roth done NOW. This legislation prohibits conversions of after-tax IRA funds after 12/31, so you not only need to make your contribution in the calendar year, you also have to convert this year or you’ll be SOL.
2. Convert after-tax 401(k) funds NOW. Ditto for after-tax 401(k) savings. If you let them sit beyond 12/31, you’ll be SOL.
3. Accelerate ordinary income into 2021: Couples earning more than $450,000, and individuals earning more than $400,000 should seriously consider accelerating any ordinary income into 2021. Practically speaking, this can include:
Exercising Non-Qualified Options sooner than planned.
Disqualifying Incentive Stock Options sooner than planned.
Roth IRA conversions.
4. Defer deductions and write-offs into 2022: High earners will see more bang for their buck with deductions and write-offs in the next tax year if this becomes law. Taking a deduction against income taxed at 39.6% more is more valuable than a deduction against income taxed at 37%.
Defer charitable gifts to 2022.
Defer property taxes and Q4 estimated payments to 2022.
Re-evaluate depreciation and Section 179 elections for business property
5. Be wary of geography and state/local taxes: Increases in federal tax rates can be negligible compared to the tax arbitrage between states. If you’re planning to move from a high tax state, like NY/NYC to an income tax-free state, like Texas or Florida, your overall tax bill should be driving the conversation, not just federal rates.
6. If you have assets >$25M, think about giving away $11.8M this year: I know, this is a bold one, but the strategy could save upwards of $2.3M in estate taxes. Folks with significant assets should consider irrevocable trusts or other gifting mechanisms that can fully use the $11.8M estate exemption before its halved for 2022.
7. Strategize around capital gain income: For folks making less than $400,000 (single) and $450,000 (married) that have unrealized gains, it makes sense to consider accelerating capital gains into 2021 up to those income levels to effectively fill up the 15% capital gain bracket.
Strategies for 2022 and beyond:
1. Re-evaluate ISO Exercise and Hold Strategies: With the capital gains rates creeping up to 28.8%, and a potential additional 3% tax if income is over $5M (31.8%), folks may want to reconsider whether or not they want to exercise and hold ISOs, as the spread between capital gains and ordinary income brackets has tightened.
2. Optimize the capital gains brackets: Since this provision, in theory, took effect 9/13, folks with incomes under $450,000 should consider maxing out the 15% capital gains bracket.
3. Develop a 10-year Roth Conversion Plan: With Roth conversions being eliminated for high earners starting in 2032, savers have a 10-year window to decide how they want to handle pre-tax retirement savings and build long-term tax diversification.
4. Consider charitable gifting: With rates creeping higher, charitable gifts may be more valuable in 2022 and beyond.
5. Re-Evaluate Estate Plans: Many more folks will be subject to estate taxes under this proposal than are currently. Documents and strategies should be reviewed to identify ways to reduce the impact of estate taxes. Each dollar not subject to federal estate taxes saves 40 cents in taxes.
6. Consider annual gifting: With a much lower estate tax threshold, using up the annual gifting exclusion of $15,000 is an even more tax-efficient way to get assets (and their subsequent growth) out of your estate.
7. Re-Evaluate Life Insurance Needs: Given the higher likelihood of paying estate taxes, life insurance may become more common for high income/asset individuals who may need liquidity to pay the tax.
While it remains to be seen whether all these provisions make it into a final piece of legislation, our team at Brooklyn FI will continue to monitor the potential changes and strategies available to our clients.