Proposed Tax Changes that Could Affect High-Income Earners
What the Biden Tax Plan May Mean for You
The first year of a new president’s administration usually brings quite a few changes. After first focusing on COVID-19 economic assistance, the Biden administration has begun to talk more about tax policy, introducing both the American Jobs Plan and the American Families Plan. President Biden’s tax proposals are starting points for congressional debate, and they lack details that will be required for final legislation. Still, they provide a window into the administration’s priorities and give us insight into proposed changes. Below, we will review proposals that could impact high-income earners, as well as discuss strategies that may be beneficial for high-net-worth individuals to pursue.
Proposal: Income Tax Increases for High Earners
If your income is in excess of $400,000, you are classified as a high-income earner. This means you are subject to higher tax rates, which could impact you if the top income tax bracket reverts back to 39.6%. This was the rate prior to the passage of the 2017 Tax Cuts and Jobs Act (TCJA), which reduced it to 37%. Outside of this proposal, the Biden administration hasn’t been clear about what could happen to other tax brackets.
The president’s plan also includes eliminating the preferential 20% long-term capital gains tax rate for those with incomes greater than one million. These taxpayers could see their gains taxed as ordinary income while remaining subject to the 3.8% Net Investment Income Tax currently in place. Taxpayers seeking to use a 1031 to defer capital gains taxes may also face limitations, including a potential reduced amount of gains that can be deferred.
There is a potential opportunity of note here:
High-income earners may choose to act prior to potential legislative changes in order to accelerate the receipt of income or realize long-term capital gains now. A possibility for recognizing additional income now would be to convert a portion of pre-tax retirement assets into Roth accounts. This is a strategy that can also benefit your heirs if you expect to remain in a high tax bracket while in retirement.
A final proposal to be aware of is that the Social Security portion of the FICA tax (6.2%) could apply to additional earnings. Currently, this tax is leveraged on the first $142,800 of income, but the new proposal would increase that cap to $400,000. Of course, this would mean additional taxes for high earners.
SEE ALSO: RMD Strategies to Reduce Taxes
Proposal: Capping Itemized Deductions
The Biden proposal also caps itemized deductions at a maximum rate of 28%. Currently, one dollar of deduction offsets one dollar of income, regardless of tax bracket. Of course, deductions provide the most benefit for higher earners because they offset income that would be taxed at their marginal rate. A cap of 28% on deductions means an important change for those in the 32%, 35%, and 37% tax brackets. In effect, it would mean these taxpayers offset less than one dollar of income per one dollar of deduction.
The administration’s proposal also includes a reintroduction of the Pease limitation, which was eliminated by the TCJA. This would have the effect of reducing certain deductions by 3% of Adjusted Gross Income for high-income earners.
A bright spot in the proposal comes for those living in states with high-income tax rates. The president wishes to remove the State and Local Tax (SALT) limitations, meaning all state and local taxes would be deductible. Under current law, only the first $10,000 of state income and property tax can be deducted. The total benefit, however, would still be capped at 28%.
Proposal: Limiting the Deduction for Retirement Plan Contributions
One of the key themes throughout the Biden administration’s proposal is an equalization of benefits received by low-to-middle income earners and high earners. For example, the president has proposed limiting the deductibility of qualified retirement plan contributions. At the moment, contributions are made with pre-tax dollars. This means they are deducted directly from gross income before taxes are applied, resulting in a larger benefit for those in higher tax brackets. The new proposal would introduce a flat credit, rather than a deduction. The details surrounding a flat credit remain unclear, though a 26% credit has been widely discussed. Such a change would mostly benefit taxpayers with a marginal rate of less than 26%.
There is a potential opportunity for high earners here:
If the benefit for pre-tax savings is reduced, those earning higher incomes could turn toward making Roth 401(k) contributions instead. Although there are no current tax savings for Roth contributions, future earnings generally avoid taxation when withdrawn after retirement.
Proposal: Reduced Estate Tax Exemption
Under current law, an individual may transfer up to $11.7 million in assets to a non-spouse and avoid paying transfer tax. The assets can be transferred as gifts made during life, inheritance upon death, or a combination of both. Since this exemption level is so high, most Americans are not subject to the federal estate tax. The details in the president’s proposal are unclear, but they could reduce the exemption to somewhere between $3.5 million and $6.5 million per individual. It also remains unclear whether the current federal estate tax rate of 40% would apply, or whether it would revert to the rate of 45% that applied during the Obama/Biden administration.
Another potential opportunity exists here:
Wealthy families and individuals may be able to avoid significant estate taxes by making large gifts of assets now before a change is in place. It is expected that there will not be a clawback for assets transferred prior to new legislation taking effect.
Proposal: Elimination of the Step-Up in Basis at Death
As of right now, assets that transfer to a beneficiary after the owner’s death receive a step-up in basis. What this means is that the basis is reset to the fair market value at the time death occurred. This ostensibly erases the gain for any assets that had a large, unrealized gain. It means the beneficiary is only taxed on gains incurred from the date of death until the date the asset was sold. Eliminating this step-up in basis means significantly more capital gains tax.
Two alternatives are being discussed and it remains unclear which may prevail: carry-over basis or assessing capital gains tax at death. Either option would fundamentally change estate planning for high-net-worth individuals and families.
For those who are charitably inclined, there is a potential opportunity here:
If the step-up in basis at death is eliminated, there would be significant benefit in using appreciated assets to make charitable donations, or in making a large gift to a Donor Advised Fund (DAF). This could allow a donor to enjoy a full charitable deduction and avoid the capital gains tax if appreciated assets were used to fund the DAF.
Is 2021 a Year of Opportunity?
So much remains to be seen with regard to President Biden’s proposed tax changes and the congressional debates that will ensue. While it’s possible that any changes could be made retroactive to January 1, 2021, most experts believe that would be unlikely. It is more likely that changes will take effect on a specified date in mid-2021 or January 1, 2022. If you’re a high-income earner and the above proposals could impact you, you probably have time to plan potential tax minimization strategies now. Be sure to utilize the expertise of your tax advisor, financial planner, and estate attorney as you review your options.
If you need assistance navigating potential changes, please reach out to us. At FC Wealth Solutions, we strive to help you find confidence in your financial future with a plan of action that helps you work toward your financial independence.