Given the size and number of tax changes proposed by the Biden administration, it's no wonder consultants face challenges when it comes to helping clients prepare for the year ahead. The Georgia special elections due in a few days' time will be critical to whether the Biden administration is able to pass the proposed tax plan. Possible results after the special elections are:
- If the Democrats win both seats, we will likely see a reduction or elimination of the Trump administration's tax cuts imposed by the Tax Cut and Jobs Act.
- If Republicans win at least one Senate seat in the Georgia special election, many people expect Washington to stand still. This presents a difficult environment for Democrats to drive tax rate changes, and we can see that most of the provisions of the TCJA will continue until they expire after 2025.
Regardless of what happens in the Georgia special election, strategies to minimize the tax burden are always relevant. As a starting point, there are five factors to consider when planning taxes:
1. Know where you are and where you are going
Significant changes in tax law are possible. To best prepare, it is important for taxpayers to understand both the current tax law and any changes that may be emerging. One of the most important things a taxpayer can do year round is assessing their taxable income so that they know their tax bracket. With clients on the cusp, advisors can look for areas where they can cut their taxable income to keep taxpayers low. This graph provides a comparison of the current environment and the tax plan proposed by Biden.
|Trump's current TCJA plan
|Biden's proposed tax plan
|Marginal tax rate of $ 400,000
|37% tax rate
|Put the pre-TCJA rate back in at 39.6%
|Limit certain individual deductions while increasing the standard deduction
|Limit the tax advantage of individual deductions to the tax rate of 28%
|Capital Gains and Dividend Income
Maximum capital recovery rate of 20%
For high earners, the additional net investment tax of 3.8% increases the effective total rate to 23.8%
Removal of preferential treatment for taxpayers with taxable income over $ 1 million
With the net capital gains tax, the effective tax rate is 43.4%
Maximum rate of 40% after an exemption allowance; The current 2020 exemption is $ 11.58 million ($ 23.16 per couple).
A beneficiary is entitled to an increase in all inherited assets
Raise the top tax rate to 45% and lower the exemption amount to pre-Obama levels of $ 3.5 million per taxpayer.
Cancellation of the increase in the base upon death
2. High earners, watch out for increases in interest rates on capital gains and dividends
High earners must consider the proposed changes in capital gains and dividend taxation. Under the plan proposed by Biden, favorable tax treatment of capital gains and dividends would expire for taxpayers with taxable income above $ 1 million. For these taxpayers, their capital gains and dividends would be treated as ordinary income. Their tax rates would rise from a maximum of 23.8 percent to 43.4 percent (including the net investment tax of 3.8 percent). This big change encouraged high net worth investors to make early distributions and accelerate earnings in 2020. As the year progresses and as we gain more clarity about the tax environment of 2021, more UHNW people may have long-term valued securities in their investments.
3. Tax efficient investments are more important than ever
With the transition of customers to higher tax brackets, investment instruments for access to market exposure are becoming increasingly important. Compared to mutual funds, single stock portfolios offer many advantages for high income individuals. Investors can control their tax liability by managing sales within the portfolio. This allows investors to postpone realizing capital gains or reaping the harvest of tax losses. While it is always important that decisions are made economically sound, the ability to directly offset income through investment losses is invaluable for high earners.
President Donald Trump (left) and President-elect Joe Biden
Morry Gash / Bloomberg
4. Place, place, place
As with real estate, location is everything. For most investors, the location of a security in a portfolio can help reduce their tax liability. The tax treatment of a security will determine which type of account is best. For example, stocks tend to generate capital gains and dividend yields. These return flows are treated favorably for tax purposes in taxable accounts, while they are treated as ordinary income in deferred tax accounts. While the favorable treatment of capital gains and dividends may be phased out for taxpayers with taxable income above $ 1 million, most taxpayers can still implement this tax minimization strategy.
5. Minimize the taxable income.
President-elect Biden proposes reintroducing the pre-TCJA tax rate of 39.6 percent for taxable income over $ 400,000. While wage tax is mostly unavoidable, taxpayers can defer their income tax by maximizing their pension contributions. This will help delay some of your tax bill and allow more time to plan. Increasing pension contributions is always one of the best ways an investor can minimize their tax liability and prepare for retirement.
It is important to understand the tax plan proposed by Biden and its implications for taxpayers. It affects all stages of life, from less take-away pay during the working years to lower consumable income in retirement and lower wealth transfers. It is important for a taxpayer's accountant and financial advisor to act as a team and bring clarity to this uncertainty.
Taxpayers need to be careful. However, since these tax proposals are just… proposals. When tax changes go into effect, they will most likely be changed from what was discussed on the campaign path. Careful scrutiny with all appropriate parties is important to ensure that a taxpayer's actions are best aligned with their long-term goals.