October Insights - Will Tax Law Changes Increase Your Taxes?
Will you be paying more in taxes next year? Let’s ask the question in another way. Since politicians have taken aim at high earners: Are taxes going to rise for the wealthiest taxpayers? Clients usually ask, “How will this affect me?” Or, “Will I be ensnared by Congress’ definition of wealthy?” If proposed changes in the tax code that passed a House committee are enacted into law, those that are wealthy, as defined by lawmakers, will likely see their taxes rise.
The major provisions include:
- Raising the top federal tax rate from 37% to 39.6%,
- Levying a 3% surtax on income higher than $5 million for single and joint filers,
- Raising the tax on dividends and the long-term capital gains tax rate for assets held over one year to 25% (up from 20%) for individuals earning more than $400,000 and for couples that earn over $450,000,
- Placing new limits on those who have large retirement account balances, and
- Putting new limits on QBI deduction for pass-through firms.
These proposals are a long way from becoming law but are winding their way through Congress. The Senate may have its own set of proposals, which would require both legislative bodies to forge a compromise before a tax bill lands on the President’s desk. Moreover, a sharply divided Senate seems likely to pare $3.5 trillion in proposed spending, assuming legislators in the House compromise on new outlays. If new spending is reduced, smaller tax hikes could follow.
While a wait-and-see approach may serve some folks well, we understand that planning for any changes reduces the odds of an unwanted surprise. We are providing general guidelines. We understand that your situation is unique, and we would be happy to entertain any questions and tailor our recommendations to your needs. As always, feel free to consult with your tax advisor regarding any tax-related questions.
The proposed increase in the top tax rate and the surcharge on income over $5 million. A couple filing jointly that has $600,000 of taxable will see their top rate rise from 35% to 39.6% next year, if proposed changes are enacted (4.6 percentage points, or a $6,900 increase in taxes on $150,000 of income).
However, there are ways to minimize the tax sting next year. Consider shifting 2022 income into tax year 2021, which would be subject to today’s lower rate. And look for ways to defer expenses and deductions that you might normally incur in 2021 and push them into 2022. Maximize contributions to tax-deferred savings and retirement accounts. If you itemize deductions, charitable contributions will reduce your taxable income. In addition, municipal bonds, which are exempt from federal income tax, will become more attractive if a higher marginal tax rate is enacted.
The proposed 3% surtax on individuals earning over $5 million would effectively raise the top tax rate to 42.6%. This would hit very few taxpayers—but be aware that the sale of a business or large asset could push you above the threshold. Please note that the surcharge is separate from today’s 3.8% tax on net investment income.
A higher rate on dividends and long-term capital gains tax rate is being considered. As proposed, if a capital gain is realized on or after September 14, 2021, individuals earning more than $400,000 and couples earning over $450,000 will pay a top rate of 25%. The same would hold true with dividends.
With very narrow exceptions, it would be too late to incur a long-term capital gain at 2021’s lower rate. You may consider deferring gains, as an unrealized capital gain would not be subject to taxes. Or, rates may decline again in the future. As we commented up top, much depends on your individual circumstances.
There will be new RMD requirements for individuals who have high income and large retirement accounts, regardless of age. If you exceed $400,000 and $450,000 in income for single and joint filers, respectively, AND retirement accounts total over $10 million, you will be subject to RMDs beginning in 2022. You will also be prohibited from making IRA contributions.
However, the restriction on contributions does not apply to employer-sponsored plans such as 401ks, SEP IRAs, or SIMPLE IRAs. If your income is above the $400,000 and $450,000 limits and retirement accounts exceed $20 million (including a Roth IRA), you would be required to distribute funds from your Roth IRA.
New limits on QBI deduction. If you are self-employed, the House proposal limits the deduction to $500,000 for joint returns and $400,000 for individual returns. Once you have exceeded the cap, additional amounts will be disregarded.
Left on the cutting room floor
Lawmakers in the House have not proposed taxing unrealized capital gains at death, as had initially been proposed by the President. Also, the step-up in basis for inherited assets is NOT in the current House proposal. But one proposal being floated is to reduce the estate and gift tax exemption to $5 million. Tax reform in 2017 raised the limit to $11.7 million of individuals and $23.4 million for couples.
These are some of the major provisions. They may or may not be enacted into law. We understand that taxes play a role in overall returns, but so do many variables. Your financial plan should ultimately drive investment decisions, not tax laws. Don’t let the tail wag the dog. In other words, be careful not to let taxes solely dictate your investment decisions.
Sources and further reading
https://www.wsj.com/articles/capital-gains-and-capital-pains-in-the-house-tax-proposal-11633080602 Capital Gains and Capital Pains in the House Tax Proposal
https://www.schwab.com/resource-center/insights/content/will-taxes-rise-wealthy-what-you-should-know Will Taxes Rise for the Wealthy?
https://www.wsj.com/articles/democrats-want-to-raise-taxes-heres-your-to-do-list-11631871008 Democrats Want to Raise Taxes. Here’s Your To-Do List
https://www.cnbc.com/2021/09/13/house-democrats-plan-drops-repeal-of-a-tax-provision-for-inheritances.html House Democrats’ Plan Drops Repeal of a Tax Provision for Inheritances