What’s the one thing that is trickier than tax law?
That’s right. Tax law changes! Especially those that happen in the final quarter of the year, giving both tax preparers and tax planners sleepless nights pouring over the fine print and strategizing for their clients.
This year may prove to be no exception, as the “American Families Plan” tax proposal is moving through the legislative process. At the time of this writing, the proposal is not law yet. However, if it does become law, those who are affected by the changes may only have months, weeks, or even just days to act.
Our team at SYM Financial has been watching the progress of the proposal closely. Of course, we do not have the final tax law to study and analyze — because it doesn’t exist yet. What we do know comes from the “early exposure” draft, published for public review in September. There is no guarantee that the law in its final form will match the early draft exactly. Still, there is value in knowing what might be coming — and how it may affect you, whether positively or negatively.
Here is a summary of what’s in the draft of the new tax law:
Increase in top marginal tax rate
The tax system in the United States is progressive, which means that the tax burden increases with income. In other words, if you make $100,000, then the tax you pay on the first $10,000 of your regular income is not the same as the tax you pay on the last $10,000. The rate that applies to each layer (or bracket) of income is called the marginal tax rate.
Historically, the top marginal tax rate was 39.6% from 2013 to 2017, when it was lowered to 37% beginning in 2018. The tax proposal would bring the top marginal tax rate back up to 39.6%.
Not only would the top marginal rate go back up, but more people would fall into the top income bracket. That’s because the amount of income taxpayers can have before they find themselves in the top bracket would decrease at the same time as the top rate increases.
In 2021, a joint payer enters the top bracket when taxable income is higher than $628,300. Under the new proposal, joint payers would enter the bracket at $450,000. This change if it does go into effect, will kick in as of January 1, 2022.
As a side note, those who make $5M+ may also be subject to an additional 3% surcharge, which would effectively bring the top rate to 42.6%.
Bottom line: If the proposal is signed into law in its current state, then joint payers with taxable income over $450,000 (and single filers with taxable income over $400,000) would see a dramatic impact on their tax bill. One strategy to consider may be to accelerate some of the income in 2021, before the tax changes take place.
Increase in capital gains tax rate
Similar to ordinary income, capital gains follow a progressive rate structure. Right now, the top marginal capital gains tax rate currently stands at 20%.
The proposal would bring the top capital gains tax rate up to 25%, the highest it has been since mid-1997. At the same time, the capital gains threshold for the top rate would be lowered from the current $501,600 for joint filers to $450,000.
Importantly, if the proposal becomes law, this provision will become effective as of September 14, 2021. That means that taxpayers with large unrealized gains would not be able to liquidate those assets before December 31 in an effort to avoid the tax change.
Bottom line: If the proposal is signed into law in its current state, then there wouldn’t be much that taxpayers can do to navigate around the new higher rate. Aside from a few exceptions, taxpayers with large unrealized gains would need a plan for paying a higher tax rate upon sale.
Potential elimination of the “backdoor Roth” strategy
There are different types of savings accounts when it comes to tax treatment. Traditional retirement savings accounts (such as 401(k) accounts and IRAs) are tax-deferred, which means that taxpayers get to delay paying taxes on them until they begin withdrawals. Roth savings accounts are tax-free because those accounts are funded with after-tax money. There are income limitations imposed by the IRS that prohibit some investors from contributing to a Roth account. For those investors, a common strategy known as a “backdoor Roth” contribution offers a pathway to make a non-deductible contribution to an IRA and then convert it to a Roth IRA.
If the current proposal is passed into law, the backdoor Roth strategy would be eliminated. For those with income above the IRS imposed limits, new Roth contributions will be prohibited altogether after December 31, 2021.
Bottom line: If you have been waiting to complete your “backdoor Roth” contribution and conversion strategy for 2021 the optimal time to complete the strategy is now, before the opportunity is potentially lost at the end of the current year.
What about Roth Conversions?
Right now, individuals and families have an option to convert some of the funds in their “traditional” retirement savings accounts (such as 401(k)s and IRAs) into a Roth account. That allows them to pay taxes at their current rate — and shift the fund to generate a tax-free cash flow in the future. Roth Conversion strategies are beneficial for many individuals and families seeking to minimize total taxes during retirement. The proposed tax law targets this strategy, however, any changes to Roth conversion rules are delayed until 2032.
Bottom line: If you have been considering converting some of your retirement savings into a Roth account, you still have time to consider the benefits of this decision. Future Roth conversions may still occur until 2032 but your overall tax liability may differ based on new marginal tax rates likely to be in effect next year. Make sure to speak with your financial advisor, as Roth conversions require a lot of careful calculations and a thorough understanding of both federal and state tax law.
Reduction in the estate and gift tax exemption
Back in 2018, with the passing of the Tax Cuts and Jobs Act, the estate and gift tax exemption was doubled from $5 million to $10 million. This provision was expected to sunset in 2025.
The new proposal would bring the exemption amount back down to an inflation-adjusted $5M (which lands around $6M), effective 2022.
Bottom line: The proposal is not law yet, so we do not know the final shape of the future law. However, for those who expect their estate to be larger than the adjusted combined exemption amount, it may be wise to consider gifts before the end of the year to take advantage of the status quo.
Upcoming Tax Law Changes: What You Need to Know Today
To summarize, there are many things about the future law that we do not yet know. However, it is possible that the law will have a significant effect on the tax bills for some individuals and families. Some of the new rules may allow you no space to deflect the tax increase. Other rules may come with phase-in timelines or a cushion of space before they become effective — so that you can potentially course-correct.
If you are wondering how the future tax law may affect you and your family, reach out to your SYM advisory team. Our team is monitoring the new developments and is there to explain what we know and what your options are. If you are not working with a SYM Financial advisor yet, schedule a brief conversation with a member of our team today. We are here to help.