Despite being in one of the lowest tax environments in history, I think it is safe to say that most Americans want to reduce their tax liability where they can and pay only what they owe.
President Biden proposed sweeping tax law changes to tax rates and codes in April 2021 through the American Families Plan (“AFP”), which would raise taxes for wealthy individuals and generally those with incomes over $400,000.
While these changes are only proposals right now, it is important to take a look at the potential repercussions of some of the main changes he has outlined.
A great way a financial advisor can add value is to provide tax planning as part of holistic financial planning. To help ensure you are prepared for any of Biden’s impending tax law changes, I want to examine and explain a few of the primary proposals, along with some possible actions you can take to reduce taxes.
President Biden’s Proposed Tax Law Changes
Higher Marginal Tax Rate
Under the provisions in the AFP, the top marginal tax rate would increase from 37% to 39.6%, a reversal to the top rate before the tax law changes under the previous administration. Additionally, the tax brackets would revert back to the previous levels. For example, prior to 2018, a couple filing taxes jointly would reach the top tax rate bracket with $470,000 in income. Currently in 2021, the top bracket is reached at $622,050.
It is worth remembering that tax rates for the top bracket have been much lower in the last ~35 or so years than before; in 1986, the top tax rate was 50% with rates prior to that going up as high as 94%! Additionally, the top bracket has historically been at a much lower level than currently, even under the proposed AFP.
Increased Capital Gains Taxes
First, what are capital gains taxes? Capital gains are incurred when you sell a security for more than you bought it. The difference between what you bought it for and what you sold it for is taxed at a lower capital gains tax rate than ordinary income as long as you held the security for 1 year and 1 day. If you sell the stock before holding it for one year, the gains are taxed at ordinary income rates, like your wages.
For example, assume you bought 100 shares of Gamestop (GME) on January 2, 2019 for $13 each. You were lucky and held onto it through early 2021, and you sold it for $350 on January 27, 2021. Your capital gains income is $35,000 – $1,300 or $33,700. The gains would currently be subject to a 20% tax if a high wage earner, or $6,740.
The AFP proposes to charge the top income tax rate (39.6%) on capital gains for those earning more than $1 million. Under the previous scenario, the tax bill for capital gains would be $13,345, almost double. Add to that the Net Investment Income surtax (3.8%), and the rate gets higher.
This change would not affect those with lower income levels and would also not impact anything in a retirement or other tax-deferred account.
One situation where this change could potentially have an outsized impact is at the sale of a family business. Many small business owners grow their business over their lifetimes with the goal of selling the business to retire.
The business may be worth several million dollars by the time retirement comes around, which would generate a double whammy – the sale of the business would push the owner above the $1 million threshold which then subjects them to the higher tax rate, reducing the proceeds of the sale (and funds for retirement) significantly. There are some exemptions for those family-owned-and-operated businesses.
Loss of the “Step-Up” in Cost Basis
Cost basis is the value of the asset for tax purposes, and it is made up of what you paid for the asset plus adjustments for dividends, among others. Currently, if you inherit an asset from someone who has passed away, the cost basis is “stepped up” to the price on the date of death, removing the built-in capital gains tax liability for the one who inherits the asset.
Let’s say your grandmother bought the previously mentioned Gamestop shares and left them to you in her will. If she passed away on January 27th with an average price of $314.50 and you were (unrealistically) able to receive the shares and sell them the next day for $315.00, you would have a much lower tax liability of $50.
The loss of the step-up in cost basis stands to have a major impact on generational wealth transfers of family property, business interests, and securities holdings, among others. If this piece of the AFP passes, I know my job will get harder as I help track down grandmother’s cost basis from a stock she purchased in 1960 as well as finding creative financial planning solutions to reduce the tax liability owed at death.
Restrictions on 1031 Exchanges
Currently, real estate investors are able to defer capital gains taxes by swapping one investment property for another that is considered a “like-kind” property in the eyes of the IRS. There is no limit under current law on how many times or how frequently you can do 1031 exchanges, and there are several rules and guidelines that must be followed to qualify.
Since the announcement of the AFP in April, the proposal has softened a bit, but the AFP includes a proposal that would limit gain deferral at $1 million per year for a married couple ($500,000 for an individual).
Useful Financial Planning Considerations
Intentional Charitable Giving Strategies
A thoughtful and intentional charitable giving strategy done in concert with your retirement and estate planning can help minimize tax impact. Donor advised funds can be a good avenue to accomplish long term goals as well, although there has also been legislation proposed to place limits on the length of payout from a donor advised fund.
Detailed Estate Planning
My friends and colleagues who are estate planning attorneys tell me that they have been quite busy since President Biden was elected with clients anticipating estate and tax law changes. Here are a few things that can potentially be used.
- Be specific about which assets to gift, and if you have charitable intentions, give appreciated property to charity.
- Asset location is important.
- A GRAT (grantor-retained annuity trust) can “freeze” the size of one’s estate and help transfer appreciation out of the estate.
- A SLAT (spousal lifetime access trust) can benefit a spouse while offering tax flexibility
Acceleration of a Business Sale
Business owners with the intent to sell in the near term may want to start due diligence to be prepared to accelerate the sale before the end of the year if the laws pass as proposed. A business owner could potentially complete the sale before the capital gains laws change, saving money on the tax liability.
Other Tax Mitigation Strategies
- Consider tax efficient investments like ETFs and tax efficient mutual funds. Actively-managed mutual funds are often tax inefficient.
- Consider a Roth conversion to accelerate income now and preserve tax-deferred growth
- Make annual gifts to family or friends of up to $15,000 per individual, tax free, to reduce your estate.
- Advisors can minimize trading, especially if they are not actively investing and trying to time the market. High turnover typically leads to higher taxes.
Empower Yourself Through Awareness
The proposed changes under the AFP can have quite a bit of impact if enacted, so this is neither the time to panic or become complacent with your finances. It is important to remain aware of what changes actually go in place and how they will impact your financial situation.
While none of us can predict the future, it helps to have an understanding of the potential risks that lie ahead so you can be adequately prepared. Be sure to consult your tax or financial advisor prior to making any big changes to your financial plan.
If you have questions about your current tax plan or overall financial strategy and would like to discuss how Abeona Wealth can help, please don’t hesitate to get in touch. We can help you evaluate your financial situation and decide which financial, investment or tax strategy might work best for you.