Proposed Tax Changes and Strategies for High Earners

President Biden’s tax proposal is just that – a proposal. The potential changes we outline below are based on several sources, including President Biden’s Tax Plan outlined during the 2020 campaign, the Democratic Party’s platform and the former Obama/Biden Administration policies. These proposals are a starting point for Congressional debate, and while they lack the details necessary for the final legislation, they provide a window into the priorities of the new administration. Below, we will review some of the proposed changes, along with some strategies that might be beneficial for high net worth clients to pursue.  

Income in excess of $400,000 may classify you as a high-income earner and subject you to higher tax rates. The top income tax bracket could revert to 39.6%, which was the rate before the 2017 Tax Cuts and Jobs Act. It is unclear how the other brackets would be adjusted, but top earners could see an increase from 37% to 39.6%.  

The plan also includes the elimination of the preferential 20% long-term capital gains tax rate for those with incomes exceeding $1M. Gains for these taxpayers could be taxed as ordinary income and remain subject to the 3.8% Net Investment Income Tax that is currently in place. Taxpayers seeking the ability to defer capital gains taxes through the use of a 1031 exchange may also face additional limitations, including a potential reduction in the amount of gain that is deferrable.  

• Potential Opportunity – High income earners may benefit from accelerating the receipt of income or realizing long-term capital gains prior to a potential legislative change. One potential for recognizing income could be converting a portion of pre-tax retirement assets to Roth assets. If you expect to remain in a high tax bracket during retirement, this strategy could benefit you and your heirs.  

Finally, the Social Security portion (6.2%) of the FICA tax may apply to additional earnings. Under current law, the tax is only leveraged on the first $142,800 of income. Under the new proposal, the cap could be increased to $400K, increasing the taxes paid by high earners.  This would impact take-home pay for those earning about this level. In addition, there could be legislation that would apply both the Medicare and Social Security taxes to Partnership and S-corporation income.  

Under the proposal, itemized deductions could be capped at a maximum rate of 28%. Under current law, $1 of deduction offsets $1 of income, regardless of your tax bracket. Deductions are most beneficial for those in the higher brackets since they can offset income that would be taxed at their marginal rate. Enacting a cap of 28% on deductions means those taxpayers in the 32%, 35% and 37% tax brackets will offset less than $1 of income with each $1 of deduction.  This would reduce certain deductions by 3% of Adjusted Gross Income (AGI) for high-income taxpayers.  

The proposal also includes the reintroduction of the Pease limitations, which were eliminated by the 2017 Tax Cuts and Jobs Act. For high income taxpayers, this would reduce certain deductions by 3% of Adjusted Gross Income (AGI).  

For those living in states with high income tax rates, such as Oregon and California, one bright spot in the proposal is the removal of the State and Local Tax (SALT) limitations. This would allow all state and local taxes to be deductible. Under current law, only the first $10,000 of state income and property tax is deductible. However, the total benefit would still be capped at 28%.  

Throughout the proposal, a key theme is an equalization of benefits received by low-to-middle income earners and high-income earners. An example of this is the proposed limitation on the deductibility of qualified retirement plan contributions. Currently, contributions are made with pre-tax dollars. They are deducted directly from gross income before income taxes are applied. This results in the largest benefit for those in the higher tax brackets. Under the new proposal, the deduction would be replaced with a flat credit. Details are unclear, but a 26% credit is widely discussed. This would largely benefit workers with a marginal rate of less than 26%. For example, assume a single taxpayer making $190,000 makes a 10% contribution to a qualified plan. Since the taxpayer is in the 35% tax bracket, the $19,000 contribution saves $6,650 in taxes. The proposed 26% credit would only result in tax savings of $4,940 (26% of $19,000). Now suppose a single taxpayer making $40,000 makes a 10% contribution to a qualified plan. Since this taxpayer is in the 12% tax bracket, the $4,000 contribution saves $480 in taxes. Under the proposed plan, this same $4,000 contribution would result in tax savings of $1,040.

• Potential Opportunity – With a reduction in benefit for pre-tax savings, high income earners may turn toward Roth 401(k) contributions. There are no current tax savings for the Roth contribution, but all future earnings generally avoid taxation when withdrawn in retirement. 

Currently, every individual can transfer $11.7M in assets to a non-spouse and avoid paying transfer tax. These assets can transfer as gifts made during life, as inheritance left at death, or a combination of both. The high exemption level results in very few Americans being subject to Federal estate tax. Under the new proposal, this exemption may fall as low as $3.5M per person. The details aren’t clear, but a range of $3.5M to $6.5M per person is expected. For estates valued at more than the exemption level, it is also unclear whether the current 40% Federal estate tax rate would apply or whether it would revert to the 45% rate that applied under the Obama/Biden administration.  

• Potential Opportunity – It is widely expected that there will not be any clawback for assets transferred prior to the passage of new legislation. Therefore, wealthy individuals and families may avoid significant estate taxes by making large asset gifts now. It is important to have a sound financial plan prior to making large gifts to ensure you aren’t jeopardizing your ability to achieve future spending goals.  

Assets that transfer to a beneficiary after an individual’s death currently receive a step-up in basis. This means the basis is reset to the fair market value on the date of death. For assets that had a large unrealized gain, the gain is essentially erased. The beneficiary would only be taxed on any gain incurred from the date of death until the time the asset was sold. The elimination of the basis step-up would result in significant additional capital gains tax. The two alternatives being discussed are either carry-over basis or assessing capital gains tax at death. Under the first option, the basis the decedent had in an asset would carry-over and become the basis the beneficiary has in that asset. No capital gains tax would be due at the time of transfer, but the entire gain would be realized when the beneficiary eventually sells the asset. Under the second option, all unrealized capital gains would be taxed at death. This would result in immediate capital gains tax liability. The basis would then be set to the fair market value for the beneficiary.  

Either of the above options would significantly change estate planning for high net worth individuals and families. However, family wealth transfer planning may provide opportunities to gift low-basis assets to family members in a lower tax bracket. Capital gains tax will still apply but potentially at a lower rate.  

• Potential Opportunity – For those who are charitably inclined, there would be a large benefit to using appreciated assets for charitable donations. Making a large donation to a Donor Advised Fund (DAF) in 2021 may also be beneficial. This may allow the donor to secure a full charitable deduction and avoid the capital gains tax if appreciated assets are used to fund the DAF. Meeting with an estate attorney to review your wealth transfer plan is highly recommended.  

2021 – a year of opportunity? While legislative changes could be retroactive to 1/1/2021, many experts believe that is unlikely. The other options are selecting an effective date mid-year or making the changes applicable in 2022. This may result in time to plan and discuss potential tax minimization strategies now. Aspects of the proposal may be also be changed or eliminated during congressional debate. Any strategy you are considering should be discussed with your tax advisor, financial planner and estate attorney. Your Aldrich advisor is here to help you navigate these opportunities.