Year-end tax planning often comes with a bit of art sprinkled in with the science. Thanks in part to the January Senate runoffs in Georgia, this year presents even more challenges. It is not unusual to see material tax legislation in years in which the presidential party changes. We are likely to see that continue in 2021. How impactful those changes will be hinges on the two Senate races in Georgia. Democrats need to win both seats to effectively win the Senate and thus control Congress and the presidency.
Much of what has been said and written about President-elect Biden’s tax plan highlights the impact on high earners – those making $400,000 or more. We will focus on those provisions of his plan.
- Ordinary Tax Brackets – The top ordinary tax bracket reverts to 39.6% from the current rate of 37% and applies to those making over $400,000.
- Capital Gains and Qualified Dividends – For those with income above $1 million, long-term capital gains and qualified dividends would be taxed at 39.6%. Combined with the 3.8% Net Investment Income Tax, the total capital gains tax would be over 43%, nearly double the current rate of 23.8% for high-income taxpayers.
- Step-up Basis – Also of note regarding future capital gains taxes, Biden has proposed eliminating the step-up in cost basis that allows for basis to be adjusted to fair market value at the time of death. Under current basis step-up rules, heirs can effectively sell inherited assets tax-free.
- Social Security Tax – A 12.4% Social Security payroll tax would be imposed on earned income over $400,000. Like the current Social Security tax, this would be split between employees and employers. The new tax would create a “donut hole” in which earned income between $142,800 (2021 wage base) and $400,000 is not taxed.
- Itemized Deductions – Biden has two proposals impacting itemized deductions:
- His plan reinstates the Pease limitation for those making over $400,000. This is a reduction of total itemized deductions by 3% for every dollar of income over $400,000.
- The Biden plan also caps the benefit of itemized deductions at 28%. This provision has the potential to impact more taxpayers, but Biden has pledged to prevent the limitation on those making less than $400,000
- Qualified Business Income (QBI) Deduction – The QBI deduction would phase out for taxpayers with taxable income above $400,000. Currently, certain businesses can claim a deduction of 20% of qualified business income.
- Corporate Tax – One of the major provisions of the 2017 Tax Cuts and Jobs Act was a reduction in the corporate tax rate from 35% to 21%. Biden’s plan would split the difference and raise the corporate rate to 28%. He has also proposed a corporate alternative minimum tax that would impose a 15% tax on book profit should ordinary corporate taxes not reach that level.
The greatest impact of President-elect Biden’s plan falls on the top 1% of taxpayers. According to the Tax Foundation, the top 1% will see a reduction of after-tax income in excess of 11% in 2021. So what can you do now to lower your tax bill?
Conventional wisdom in times like these, with expected higher tax rates on the way, is to accelerate income and defer deductions. Unfortunately, it’s not that simple. For example, with the proposed limitations on itemized deductions, you might be better off taking deductions in 2020. Another consideration for those making over $400,000 is a Roth Conversion. Converting funds from a traditional IRA to a Roth IRA is an easy way to accelerate income that also comes with the benefit of future tax-free growth. Finally, while some tax reform is likely next year, the ability to pass all the provisions listed above comes down to control of both chambers of Congress. And that will not be decided until January.
Tax planning is never a “one-size-fits-all” approach, so contact your tax professional to better understand what actions you can take before the end of the year.
Chris Sutherland is a Principal and Wealth Advisor in Trust Company’s Charlotte office, where he works directly with clients to provide integrated wealth management solutions.