President Biden’s tax policy, known as the American Families Plan, is currently being negotiated in Congress, giving us an opportunity to study what a final version may look like and how it may impact our planning. The proposed legislation is intended to fund increased spending on the administration’s top priorities, including child care, education and health care. Tax increases on the highest-income earners would provide the funding for the bill’s measures.
Two of the more apparent changes in the proposed bill are changes to income tax and capital gains tax rates. The plan increases the top marginal tax rate to 39.6% and captures more taxpayers by lowering the top bracket to income of $450,000 for Married Filing Jointly (MFJ) taxpayers. Capital gains taxes may also see an increase to 25% from today’s current rate of 20%. Again, we would see taxpayers enter the top rate sooner, as it would start at $450,000 for MFJ filers, which is $51,600 lower than the current threshold. Curiously, the capital gains tax would go into effect immediately, preventing any real planning opportunities to realize capital gains by the end of 2021. It should be noted, however, that any capital gains incurred before September 2021 would still only be taxed at the highest rate of 20%, while gains incurred after September 2021 would be taxed at the higher 25% rate.
With higher taxes on the horizon, what can be done? Fortunately, there are still strategies available to mitigate some of the proposed increases in taxes. For charitably inclined taxpayers, deductions for charitable contributions may still be an effective method of generating tax deductions to offset tax liability. The higher standard deduction on the TCJA ($12,000 for individuals, $24,000 for MFJs) meant that many taxpayers stopped itemizing their deductible expenses, including charitable gifts. “Gift bunching” — combining several years’ worth of contributions, or using a donor-advised fund — has been an effective technique to provide taxpayers the ability to itemize their contributions if their total deductions are above the limits. For taxpayers planning to make more donations in 2021, they may even consider delaying their contributions to the beginning of 2022 if they will find themselves in a higher tax bracket under the American Families Plan.
Entrepreneurs may also be able to take advantage of potentially having two different types of tax strategies available between 2021 and 2022. Some business owners have the flexibility to shift both income and expenses based on how their company’s operations run. We are working closely with our business-owner clients this quarter to review how to take advantage of the tax legislation we know in 2021 versus what the legislation looks like in 2022 if the American Families Plan becomes law.
Non-business-owner taxpayers generally have less control over when income and wages are paid but still have many options to consider in addition to the charity strategy above. One method we often use, especially for our families with a long-term focus on being strong stewards of their wealth for future generations, is a Roth conversion. A conversion to a Roth IRA is taxed in the year it is completed, giving more control over when income is taxed. High-income earners may consider taking advantage of our current tax brackets to execute a Roth conversion.
As an example, taxpayers with income over $418,850 (for MFJ) are currently taxed at the 35% tax bracket and don’t hit the highest bracket until $628,301 of total income. However, the American Families Plan would increase the top tax bracket to 39.6% — and send taxpayers into it at total income of $450,001.
Every dollar above $450,000 (up to $628,300) under the Biden plan next year will be taxed an additional 4.6% next year. This provides an opportunity to save as much as $8,200 in additional taxes by realizing enough income to “fill up” the 35% tax bracket today. Taxable income above $628,300 will see a more modest 2.6% increase. Consider an investor with an income of $450,000 who owns a Traditional IRA or 401(k). She can convert up to $178,300 of that IRA to a Roth IRA in 2021. Her total taxable income would increase, and she would be taxed at a high rate of 35%, but she would pay less in taxes now than she would under the new tax law.
As we all know, a proposed tax law seldom looks like the final product. We will continue to track the American Families Plan, which could have significant implications around financial and tax planning opportunities. Stay tuned for more to come as we learn more. Please contact us with any questions, or if you would benefit from a review of your tax strategies, at firstname.lastname@example.org.
Debra Brennan Tagg and Sergio Garcia are CERTIFIED FINANCIAL PLANNER™ Professionals at BFS Advisory Group. They use their proprietary program, DBT360 Financial Plan, to help their clients prioritize their goals, leverage their resources, and address their risks. The planners at BFS Advisory Group teach the public and the financial services industry about the importance of values-based financial planning and investor education.