On September 13th, Democrats on the House Ways and Means Committee released their highly anticipated, and speculated, proposed tax changes. It’s unclear how they will ultimately shake out, as Democrats need almost every vote they have to advance the changes. Regardless, the proposed measures are quite different from what many anticipated.
It’s also not out of the question for additional provisions to make their way in, like an expanded deduction for state and local taxes (SALT). While the current version of the bill may not be in final form, many of its features are likely to become law, set to go into effect in the new year.
While the proposed changes are vast, we’ve narrowed the focus here to four main areas, which are most applicable to Uplevel clients.
Higher Ordinary Income Tax & Capital Gains Rate
The highest tax brackets are changing… again. In 2018, the top federal rate income tax rate was reduced to 37%. Rates are now potentially reverting back to former top rates of 39.6%, which would be ‘permanently’ reinstated beginning in 2022.
That’s not all. The highest tax brackets will also be substantially compressed – meaning you hit higher tax rates at much lower incomes. Those earning $400,000 to $450,000, depending on filing status,will see the largest average increase in tax liability of 4.6%, as today’s 35% bracket becomes 2022’s 39.6% bracket.
Those affected by the new rate will also see fewer deductions in the tax code today than previously, making their effective tax rate higher. It also appears that all ordinary income brackets are indexed for inflation, except the top brackets of $400,000 for single filers and $450,000 for married filing joint.
The top long term capital gains rate is also set to increase 5%, from today’s 20% to a new 25%, again impacting lower income thresholds of $400,000 for single filers and $450,000 for married filing joint. The cherry on top would still be the 3.8% Medicare surcharge that some filers are already accustomed to.
The proposed long term capital gains rate changes leaves little room for planning, as Congress isn’t waiting until the start of the new year. Rather, increased rates would be retroactive to September 14, 2021. If you sold appreciated securities prior to this date, the top rate would be 20%. A day later, you’ll pay an additional 5%. It’s also likely that year-end capital gains distributions from mutual funds and ETFs will be taxed under the new rates.
You may be thinking what we’re thinking – thank goodness we’re not tax planning software coders right now.
What strategies, if any, can you employ if these bumps apply to you? High earners may want to accelerate ordinary income in 2021, prior to the rates increasing. The folks that would most likely benefit the most from this strategy fall into the compressed brackets, where they would move from 35% to 39.6% in 2022, instead of 35% to 37% in 2021.
Additionally, high earners who are charitably inclined could consider postponing charitable donations to next year, when the associated tax deduction would be more beneficial.
Elimination of Backdoor Roths
A previously little-known strategy high income earners have used for years is likely on the chopping block, beginning in the new year.
Earners who exceed income limitations for contributing directly to a Roth IRA have an alternative route: open a traditional IRA, make a $6,000 contribution (if under age 50), and convert it to a Roth IRA shortly thereafter. In doing so, there is likely little tax on the conversion, and it allows the money to grow tax free in a Roth.
There’s more. In what’s often referred to as a “mega-backdoor” conversion, participants in 401(k) plans that allow after-tax contributions have been able to sock away as much as $58,000 a year into a 401(k) and then convert a good portion to a tax-free Roth account.
Not anymore. The legislation would prohibit conversions of after-tax dollars in retirement accounts, including IRAs and 401(k)s.
The upshot? If it’s been a part of your financial plan to date, then do it while you still can. A word of caution: it can get tricky, so it’s best to work with a planner or tax professional.
Estate Tax Exemption
Roughly four years ago, the estate and gift tax exemption was doubled and indexed for inflation, bumping this year’s exemption to $11.7 million. The proposed bill reduces the exemption back to about $6 million for 2022, again indexed for inflation. The top estate tax rate remains at 40%.
What hasn’t found its way into the bill yet is an elimination of the step-up in basis at death, benefiting people well below the 1 percent. Think of grandma or grandpa passing away, leaving you with a home they bought for $100,000 that’s now worth $1,000,000. Without a step-up in basis, you could be looking at hundreds of thousands of dollars subject to capital gains tax.
Estate planners have been busy helping affected clients use this year’s $11.7 million exemption to give money to heirs without fear it will be clawed back, as well as addressing additional proposals to clamp down on various types of grantor trusts.
Before rushing to make drastic changes to your estate plan or irrevocable gifts to family members before rules potentially change, it’s important to ask yourself if these moves align with your long term intentions or are worth the increased complexity and cost.
Extension of Child Tax Credit
Under proposed legislation, the current expanded Child Tax Credit is extended through 2025.
For many families, these prepayments could trigger additional tax owed come next spring. They are based on your most recent tax return, which for many is 2020. If your income has risen this year or you have other applicable changes, you may have to pay back some or all of the prepayments.
Uplevel Can Help
While much still remains unclear, chances are likely lower tax rates, in addition to some popular tax loopholes, are coming to an end. Uplevel can help you navigate the new rules and work with your tax and estate planning professionals to make adjustments to your plans.
We’ve already gotten to work, proactively contacting clients who are affected. We’re here to help.