Here's a deeper dive into some of the current tax areas where significant increases would affect individual taxpayers, and an overview of various strategies to mitigate potentially higher taxes.
The paths of least resistance
SALT Deduction: Reversing or modifying the provision of the 2017 Tax Cuts and Jobs Act (TCJA) that limited the federal income tax deduction for individuals’ state and local taxes (SALT) to a maximum of $10,000/year is proving to be one of the most controversial but probable provisions to make its way into final legislation.
Reversing this highly controversial item is particularly important to Democratic legislators from high-tax states that are facing waves of out-migration. However, given that this would benefit upper-income taxpayers most, the deduction may be limited to taxpayers with incomes under the top bracket, and/or capped at a lesser rate than the maximum tax bracket. The latest version of the Build Back Better Act raises the cap to $80,000 for all taxpayers, which is proving a major sticking point in Senate debates.
Surcharge on income for top earners: Under the reconciliation bill, households and trusts with incomes exceeding $10 million (joint and individual), or $5 million (married filing separately) and trusts with income exceeding $200,000 would pay a 5% annual income tax surcharge, while households with income in excess of $25 million (joint and individual), or $12.5 million (married filing separately) and trusts with income exceeding $500,000 would pay an additional 3% income surtax (8% tax overall).
Qualified Small Business Stock (QSBS) Limitation: This provision amends section 1202(a) to provide that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock will not apply to taxpayers with adjusted gross income equal to or exceeding $400,000. The baseline 50% exclusion in 1202(a)1 remains available for all taxpayers. The amendments made by this section apply to sales and exchanges after September 13, 2021, subject to a binding contract exception.
Limits on Very Large Retirement Accounts
- Recent publicity regarding some extremely large tax-deferred accounts, particularly Roth IRAs owned by very wealthy taxpayers, has supported the inclusion of a number of provisions aimed at restricting the future growth of these “mega-IRAs”, as well as immediately reducing the size of existing tax-deferred accounts owned by high-income taxpayers. These restrictions surfaced in the September proposal from the House and reappeared in its adopted version of the Build Back Better bill. Seeking to end strategies for doing “back door Roth IRAs”, the House’s Build Back Better bill prohibits employee after-tax contributions to qualified retirement plans and IRAs from subsequently being rolled over to a Roth IRA.
- In a further effort to curtail the use of Roth IRAs, top taxpayers1 would not be able to make Roth conversions from traditional IRAs and retirement plans beginning in 2032.
- Individuals with combined IRA (including Roth IRA) and defined contribution accounts totaling more than $10 million would face additional required minimum distributions of 50% of the amount the total exceeds $10 million, and they would not be able to make further contributions to Roth or traditional IRAs until the total was below this threshold, beginning after 2028.
Possible strategies to mitigate tax increases
So, what should taxpayers do? Now is the time to plan, but not panic. Remember the old but relevant advice not to let the proverbial “tax tail” wag the dog. History is littered with examples of hastily crafted documents and asset transfers done ahead of rumored tax changes only to be regretted later.
There has been some concern over the possibility that tax increases will be retroactive to the beginning of 2021. While retroactive tax changes can be done for a “legitimate purpose,” they are highly unpopular and quite rare. Currently, the only retroactive tax provision is the limitation on the Qualified Small Business Stock deduction. Given the short time between now and year end, changes enacted in 2021 are more likely to be effective in 2022. There is a stronger possibility that tax increases may be effective as of the date a bill is introduced in Congress. This has been done with prior increases in order to prevent taxpayers from gaming the system.
The plethora of alternatives can be overwhelming. Experienced counsel is critical for taxpayers in order to select and execute appropriate structures that are effective for tax savings while also working out well for their families. Below is a partial list of some of the planning strategies that may be useful in today’s environment:
1. To avoid the 5%/8% income tax surcharge, those in upper-income tax brackets may want to accelerate the realization of income into 2021. In particular, large taxable events such as the sale of a business made before December 31, 2021—rather than after—would avoid the surtax. Concurrently, you may consider funding charitable gifts with low basis stock to benefit from an immediate income tax deduction and avoid future tax on capital gains. Going forward, the use of tax-managed strategies for their investments has become increasingly important
Similarly, trustees of trusts where income could be greater than $200,000 are encouraged to consult tax counsel and work with their investment managers to explore ways to avoid or limit paying the surtax. These may include weighing the advantage of distributing income (possibly including capital gains, if permitted by statute and/or the trust document) to beneficiaries versus the benefits of retaining the income in the trusts for future growth and creditor protection outside the beneficiaries’ estates.
2. Utilize remaining gift and estate tax exemption of $11.7 million per person, or $23.4 million per couple, by making gifts outright or in trust to your heirs.
- This is a “use it or lose it” situation which—while currently not affected by the reconciliation bill—remains important given the sunset of the generous federal estate and gift tax exemption on December 31, 2025, as well as the focus of the current administration on lowering the exemption.
- Note that the IRS confirmed that there is no clawback of any previously used exemption if the exemption is later reduced before you pass away.
- These gifts can have the additional benefit of shifting embedded capital gains to taxpayers who are tax exempt or in lower tax brackets (e.g., charitable gifting of an appreciated asset, substitution of assets in an entity, or gifting to family members or descendants in lower tax brackets),
- Careful consideration has to be afforded on whether to gift assets outright or to trusts, as trusts provide greater protection from creditors and tend to preserve wealth within the family.
3. Consider funding various trusts and other structures that benefit from relatively low interest rates and the current historically-high gift and estate tax exemption.
- Examples of such trusts include Spousal Lifetime Access Trusts (SLATs), Grantor Retained Annuity Trusts (GRATs), Intentionally Defective Grantor Trusts (IDGTs) and Charitable Lead Trusts (CLTs).
- These trusts are often set up as “grantor trusts” so that the grantor pays the income taxes on the trusts, allowing the trust assets to grow without the burden of federal or state income taxes.
The “grantor trust” status also allows the grantor to swap appreciated assets out of the trust in exchange for personally owned high basis assets, thus providing for a step-up in basis on the assets with embedded gains, which will be in the grantor’s gross estate and thus will benefit from a step-up in basis at death. Although the elimination of the strategy was included in some prior proposals, it has not been included in the latest version of the Build Back Better Act, so these traditional estate planning techniques remain available at present.
4. Manage your tax-deferred retirement accounts now and later on.
- Given the focus on very large balances and the proposed legislation to reduce these for those with income greater than $400,000 single/$450,000 joint, plan for the possibility that you may have to take unanticipated distributions if your total balances exceed $10 million. You may also want to reconsider making contributions that would cause those accounts to exceed, or grow to exceed $10 million.
- If current or anticipated income is at or above $400,000 single/$450,000 joint, and you intended to convert from a traditional IRA or defined contribution account to a Roth at some point in the future, consider doing so sooner rather than later, before this may no longer be an option for you. This may be particularly important for those who have accumulated significant after-tax balances in their traditional tax-deferred accounts, as these are typically the most tax efficient rollover to a Roth and are in the cross hairs of proposed legislation to be prohibited as soon as next year. However, converting pre-tax contributions in a traditional IRA, or tax-deferred retirement account to a Roth IRA, is a taxable event that generates ordinary income for the owner. Implement a strategy to convert in tranches to limit your income over time or offset a larger income spike from a one-time conversion with a charitable deduction for a gift to an operating non-profit, Donor Advised Fund or private foundation.
5. Interest rates are still historically low but trending up. Before possible further increases, there are a number of planning options involving the use of credit.
- Intrafamily loans can shift future growth to family members in lower tax brackets. Low-interest loans can allow for the transfer of wealth to the borrower without using the lending family member’s gift and estate tax exemption.
- Borrowing against an investment portfolio can avoid the realization of capital gains while rates are high. This can be used for current cash needs or to make the aforementioned intrafamily loans.
- Similarly, families that have outstanding promissory notes (whether standalone or as a part of sale transaction) should consider refinancing those to take advantage of the lower rates without gift tax implications.
6. Take advantage of valuation discounts when gifting minority interests and illiquid assets before these are reduced or even eliminated.
In terms of investment portfolios, it’s important for clients not to make any changes to their long-term investment strategy just because of proposed tax policy changes – as what ultimately gets passed can look very different to today’s bill. While we continue to monitor any forthcoming tax policy changes, economic growth, inflation, interest rate moves and earnings have a far greater impact on markets than taxes.
We are positioning investment portfolios for slowing but above trend growth, tapering of stimulus and modestly higher inflation. i. Strong consumer demand, bolstered by high savings rates, will likely underpin the U.S. economy. And while the Fed is expected to hike rates in 2022 to dampen inflation concerns, borrowing conditions should remain attractive for consumers and corporates.
We remind clients that equity markets can do quite well under slightly higher interest rates, and that’s also true for higher tax rates, as we saw under the Obama administration.
For the more tax-sensitive investors, we recommend they take advantage of tax-managed equity strategies, which work to both minimize net gains and actively harvest losses to help maximize after-tax returns. The combination of staying aligned with investment plans and incorporating tax-efficient strategies can help protect and grow client wealth as we shift into a new year.
The proposed changes to many areas in the U.S. tax regime are far reaching and may significantly affect the wallets of upper-income taxpayers. The question pertaining to if/when they may be enacted and become effective adds a further dimension to investing and planning around them. Investment decisions based solely on proposed policy changes can prove costly, so it is best to adhere to long-term investment strategies aligned to one's goals. Clients who are interested in pursuing planning strategies are encouraged to seek advice from their wealth managers and tax professionals to ensure their choices are consistent with their goals and family situations.