"Uncertainty is the only certainty there is." It is doubtful that John Allen Paulos was pondering taxation and financial planning when he made this claim, but the sentiment applies. We are in the midst of a presidential transition, often accompanied by change across many spectrums. Political campaigns are riddled with promises and assurances, yet what follows is always speculative at best. One certainty: tax changes are coming, and it is not a matter of if, but when!
The US government's fiscal year ended on September 30, with the Congressional Budget Office (CBO) projecting the US deficit to be roughly $3.13T, or 15.2% of GDP. With discussions of future stimulus circulating throughout Washington, deficit figures will likely continue to grow. So, how are these escalations curtailed? The government could stop spending at unsustainable levels or they could raise taxes. Using history as our guide, the latter option will likely prevail in some form.
Let’s look at what has been proposed and the potential impact on your financial plan.
Modifications to Individual Tax Rates
There has been discussion of moving the top tax rate from 37% back to 39.6% for taxpayers earning over $400,000. While only speculative, this could subsequently eliminate a portion of the 32% bracket and all of the 35% and 37% brackets for those married filing jointly.
Potential Strategy: Roth conversion. Moving assets from your traditional IRA to a Roth IRA would require you to pay taxes at today's rates. However, future distributions are tax-free. Remember, future distributions from your traditional IRA are subject to income tax. This strategy could be a benefit given increased taxes in the future.
Capital Gain & Dividend Income
For those earning over $1M, it has been proposed that capital gains and dividend income be taxed at ordinary tax rates, presumably 39.6%. When the net investment income tax (NIIT) of 3.8% is included, the applicable tax rate increases to 43.4%. Currently, the tax treatment for incomes exceeding $496,000 (Married Filing Jointly) is 23.8% (inclusive of NIIT). This will mean an additional 20% paid in tax.
Potential Strategy: A tactic to explore would be capital gain harvesting. This entails selling a position(s) in your portfolio that you have held for more than twelve months to recognize gains and pay taxes at today's rates. If you still covet the positions being sold, you can buy it back at no consequence. If the capital gain tax rate increases, you will benefit from this strategy.
Potential Strategy: If you are charitably inclined, consider donating appreciated stock. This will avoid capital gains taxes while creating a tax deduction.
Gifting & Estate Tax Exemption
Another potential change coming is the lifetime gifting and estate tax exemption. This is the amount that can be gifted or transferred to heirs free of transfer tax. As a result of the passage of the Tax Cuts and Jobs Act (TCJA), the current exemption sits at $11.58M per person. The Biden administration has hinted at lowering this amount to $3.5M. Even if nothing is passed, this exemption amount is set to revert to pre-TCJA levels of roughly $5M/person beginning in 2026. This means that amounts above these thresholds will be subject to estate tax rates, which can be as high as 40%.
Potential Strategy: One way to potentially circumvent these changes would be to look at increased gifting before year-end. Increased gifting will ensure you take advantage of the higher exclusion amounts, consequently reducing your overall gross estate, lessening the possibility of future estate taxes. Other strategies to consider would be trusts, such as Grantor Retained Annuity Trusts (GRATs) or Charitable Lead Annuity Trusts (CLATs). These are a bit more complex so fully understanding their ins-and-outs is imperative. The overall goal is to lower your gross estate without hamstringing your retirement.
Other Notable Proposals
Social Security Payroll Tax (OASDI): Currently, the 6.2% tax paid by employees is only applicable to wages up to $137,700. The proposed change would require this tax to be applied as well on any earnings over $400,000. For example, if your salary or wages for the year equal $500,000, you would pay 6.2% on your earnings up to $137,700 plus 6.2% on $100,000 (the amount over $400,000). Your social security payroll tax would be $8,537 on the first $137,700 plus $6,200 on the $100,000 for a total amount of $14,737.
Itemized deductions: This proposal is to cap the value of itemized deductions at 28% for those with incomes over $400,000. For taxpayers with marginal tax rates higher than 28%, the full tax benefit of their deductions will not be realized.
Corporate Income Tax: Another proposal is to increase the corporate income tax rate from 21% to 28%. If a corporation passes along this increase in tax to consumers via higher prices for products and services, individuals will be impacted by this change as well.
There is always fluidity with tax proposals. To become law, a tax proposal must be passed by Congress. Given the delicate economy and the current political environment, no proposal is guaranteed to become law. However, it is best to have a plan in place for whatever uncertainty may lie ahead. Review your options with your financial and tax advisors.
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We have helped our clients answer these questions and more. If you want a clear understanding of your financial future, and need help making changes to reach your goals, schedule a consultation and we can get started.
Please remember that past performance may not be indicative of future results. Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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