The Presidents Tax Proposals have Significant Financial Planning implications
The president has made no secret about his desire to raise taxes on wealthier individuals. In fact, his tax proposals have been very specific. Here are a few of the more potentially impactful items on the presidents wish list, and how they could impact your financial planning. When or even if these changes become law is still unknown, but likely will be 2022 at the earliest. Impacts will not be limited to the wealthy, and some of the impacts on middle income earners will likely be positive.
Tax Rate Increase. The tax rate on those making over $400,000 will raise to 39.6% from the current 34%. As of now, taxes for those in the lower brackets, reduced in 2017 by President Trump, will remain at current levels.
Social Security tax expansion. Employees and their employers currently split the burden of paying a 12.4% social security tax on income up to $137,000. The president wants to also apply that tax to those with income over $400,000. This would be added on top of the higher 39.6% federal income tax. This actually would create a donut hole effect where Social Security tax is paid on the first $137,000, then none on income between 137k and 400k, then it is applied again on income over $400k. There would be big incentives for employers and employees to consider non-cash compensation like stock options in lieu of salary. Note that when combined with New Jersey state income taxes, high earners will be paying well over half of any income over $400,000 to the government in income taxes, the highest marginal tax rate in a generation.
Estate Tax Exemption Rolled back. Currently, only those with estates of over $11 million are subject to estate tax. President Biden proposes dropping that exemption level by 50% to $5.5 million. This means many more estates will be subject to taxation. Estate attorneys will once again be busy making sure that credit shelter trust provisions are up to date in people’s wills and estate plans, and gifting strategies will become more attractive. Anyone with net worth approaching $5 million needs to pay attention to this one.
Repeal Step Up in Basis at Death. We’ll have to see what this looks like. Currently if you own an asset at death, your estate is able to reset the “cost basis” to its value at the date of death. This means if you inherit a home worth $600,000 that your parent bought for $200,000 40 years ago, the cost basis will be reset to $600,000, allowing you to sell it with no capital gain tax. The idea used to be that you were paying estate tax, so it wasn’t fair to ALSO pay capital gains on the same asset. With the estate tax all but repealed given the high exemption level, many have suggested that this so called “step up in basis” wasn’t needed any more. This change would fundamentally change estate planning strategies. It will also be one aspect of Biden’s tax plan which does not impact only the rich, but will impact almost everyone inheriting an asset. It does not appear that this is intended to only apply to larger estates so I anticipate it will apply to everyone.
In fact this one may only end up applying to smaller estates which are exempt from estate tax. For those with estates subject to estate tax, eliminating the step up in basis would result in significant double taxation, something our leaders will need to figure out. It is also unclear how this would work in practice. Few people have good records on the cost basis of assets purchased years ago, so the executors job will become even more difficult. Record keeping will become very important, particularly regarding home improvements, etc. which increase cost basis but are not really important during your lifetime since sale of a primary residence isn’t taxed for most people. This one will keep financial planners, tax accountants, and attorneys busy for years if it goes through. Job security!
Changes to Deductibility of Retirement Account contributions. This is also a proposal with significant financial planning implications. The proposal would replace the current deductibility of 401k or IRA contributions with a flat 26% tax credit. This effectively means that for those below the 26% tax level, the government is actually helping you fund your retirement account. But for those over this tax bracket, it means you no longer get full deductibility – but you will still be fully taxed when you take the money out. The math of Roth vs. Traditional or taxable savings will be turned on its head for both lower earners AND higher earners.
Tax Credit Bounty for the Middle Class! If you have kids, pay for child care, Biden wants to raise the existing child tax credit and child care tax credit. He also wants to add a first time homebuyer tax credit of $15,000. Essentially the government (actually, all those people subject to the tax increases outlined above, lol) will pay for a big chunk of your downpayment!
These are big and substantive changes with significant financial planning implications. In fact, there are more (like limits on tax deductions for higher earners), but this is enough for one day!
It is not too soon to start planning for those who expect to be impacted by these changes. I can’t know what the final rules will look like, but it is pretty clear that taxes will be going up, probably next year, maybe 2023. We will be here to help our clients make sense of it all.