UPDATE: The House Ways and Means Committee released its $3.5 trillion tax proposal on Sept. 13, 2021. See how the tax plan has changed since the proposal below and what we believe are key considerations for our clientele.
President Joe Biden has proposed substantial tax changes — affecting personal and corporate returns. The changes are, in part, to pay for his infrastructure plan and for education and family programs.
Changes to his proposals are likely, as he has said he wants to negotiate for bipartisan support. But you may want to take steps now to adjust for the expected 2022 tax landscape. So, let’s explore the possible tax and market implications of some of the major proposed changes. Of course, we recommend that you review your situation with your CPA and financial advisor before taking any action.
Income tax rates
As expected, President Biden’s proposal increases the top individual federal income tax rate to 39.6%. This would be a return to the 2013-2017 rate, after four years at 37%.
The proposal also would expand the number of people in the top bracket. For married couples’ joint returns, the top bracket starts at $509,300 in 2022 — down from $628,300 currently. For future tax years, the $509,300 threshold would be adjusted by the consumer price index.
Potential planning opportunities include:
- Increasing contributions to tax-deferred work retirement plans. (Caveat: The Biden administration is proposing changes to the tax benefits of work plans, so we’ll need to see how that shakes out).
- Charitable giving and other tax deduction planning.
- Shifting income to tax-free positions through municipal bonds, 529 college plans, Roth IRA’s, etc.
President Biden has also proposed an additional 12.4% Social Security payroll tax (split evenly between employers and employees) for those making over $400,000. This may be unlikely to pass because it would require 60 votes in the Senate rather than the 51 the budget process requires.
Capital gains rates
President Biden’s plan has major implications for anyone selling valuable property, business, or large block of appreciated stock.
His plan would eliminate preferential rates for long-term capital gains for people with more than $1 million in income — including income from the sale of a long-term asset. The capital gains would instead be taxed at the taxpayer’s ordinary income tax rate, almost doubling this group’s tax on capital gains.
This capital gains change could take affect retroactively, but it is more likely that January 2022 will be the effective date. So, if you sell in 2021, gains likely will be taxed at the current 23.8% capital gains rate (highest federal rate with surtax). If you sell in 2022, the gain likely will be taxed at the new top income tax bracket of 39.6% plus the 3.8% surtax.
If you are contemplating a big sale, you may want to complete it by year-end. Of course, consult your CPA and financial advisor about what may be best for you.
For transactions in the future, selling on the installment basis could reduce the gain recognized in a given year. Or you might include charitable strategies in your sales planning. This strategy may help avoid capital gains taxes, while generating an income tax deduction and potentially even reducing estate taxes.
Some people who earn more than $1 million today may earn much less after retirement. They might consider waiting to sell capital gains property until they reach their lower income years. This would be a typical scenario for a corporate manager or high-income service professional.
Lastly, a higher capital gains tax may make contributions to company work plans more valuable, including non-qualified deferred compensation plans.
Capital gains on real estate
Another proposed capital gains change affects how high value real estate transactions are taxed.
Currently, real estate investors can defer paying taxes on real estate gains by rolling profits into their next property. President Biden wants to eliminate this option for transactions where the gains exceed $500,000.
While a 2020 survey from the National Association of Realtors found that only 12% of sales used this type of deferment, it is a common strategy for high-value properties where professional agents help make the transaction seamless.
The same strategies mentioned above might help reduce the impact of this change.
Capital gains on inherited assets
President Biden’s tax changes also would eliminate the “stepped-up basis” on inherited assets for gains over $1 million for a single individual and $2.5M for a couple. This could affect many heirs, not just the wealthy.
Currently, when the owner of a large asset dies, the basis (think of this as the purchase price) is stepped up to the asset’s value at the time of death. A higher basis lowers the increase in value — which is subject to taxes — for the heir.
For example, say you purchased property for $50,000 decades ago and it is now worth $2,050,000. Upon your death, you bequeath the property to your four children. Under current law, each child receives their one-quarter share ($512,500) with no income tax.
Under the administration’s proposal, instead, income tax of $500,000+/- may be due and at the time of death. Some of the asset may need to be sold, possibly in a fire sale, to pay the tax. Even if the asset sells for full value, the taxes reduce each heir’s inheritance to $387,500 vs. $512,500. In some cases, there may be additional taxes due in the form of death or estate taxes.
If this change is approved by Congress, it will shift many estate planning discussions. Depending on the end results of law changes, strategies may include:
- Incrementally selling high value assets during life, staggering into lower tax years.
- Gifting assets to children during life to avoid the big tax at death. The tax would be paid at the child’s rate.
- Charitable giving strategies employed during life or at death may avoid the capital gains tax, avoid estate tax, and, in some cases, provide additional income tax deductions.
- Purchase of life insurance, especially in a trust, can make cash available at death to pay estate or income taxes. (Laurel Wealth Planning does not sell insurance but does consult on coverage and value-added strategies.)
Effect on the stock market
Analysts have estimated that President Biden’s proposed higher corporate taxes would reduce S&P 500 earnings by 3.5% to 7%. This sounds like a major headwind, but the last four times the corporate tax rate increased, stock market growth continued.
The economy was growing during each of those tax hikes, much like it is now. In our view, this means the growth in the economy and stock market masked the cost of the additional tax. In other words, without the additional tax, the stock market and economy may have grown more.
Some commentators believe the capital gains changes also could hurt the stock market. Major stock indexes lost about 1% when those changes were announced. Others commentators, however, believe it will have no effect because about 75% of U.S. stocks are not subject to capital gains tax, plus the change only affects people with over $1 million in income, which is 0.3% of tax filers.
And, even for those 0.3% of tax filers, as we’ve discussed here, there are strategies available to help mitigate the impact of this tax increase. Because of this, we think the change will have only a modest impact on the economy and stock market growth.
An evolving situation
As President Biden’s tax changes progress toward law, we will continue to adjust client portfolios accordingly and communicate what the changes mean for you.
If you have concerns about capital gains taxes, estate planning, or other tax-related matters, please ask your wealth manager. We are always happy to answer questions and walk through possible scenarios in coordination with your CPA.
Laura is a Senior Wealth Manager and the Founder of LWP. She has a master’s degree in tax and is an excellent listener. While she is a sophisticated financial planner with experience in complex issues, her priority is ensuring a financial plan works for people.