What you need to know about the recent tax proposal and potential planning opportunities
In the past week, you may have seen that the House Ways and Means Committee released a draft of significant tax legislation. While the bill will not be debated in Congress and finalized in the weeks to come, I want to summarize eleven key proposed changes so that you can start taking action before the legislation is signed and specific planning windows are closed.
- Single filers with income below $400,000 and Married Filing Joint Filers with income below $450,000 will probably not see the significant impact right away.
The top ordinary income tax rate would return to 39.6%. In addition, the current 37% top rate doesn’t kick in for joint filers until they have over $628,300 of taxable income. But the bill would impose the top ordinary rate of 39.6% on joint filers at $450,000 taxable income in 2022. This bill would dramatically re-increase the marriage penalty. While present today, the TCJA really reduced the impact. This bill does the complete opposite. Two high-income earners could soon save a LOT of money being “single”!
As a result, the taxpayers who will be most impacted by the new rates are those in the $400,000–$500,000 income range, who will see themselves move from the current 35% bracket to the new 39.6% bracket – as higher earners who were already in the 37% bracket will see ‘only’ a 2.6% increase to 39.6%.
It may make sense to accelerate income into 2021. Those with the highest income could benefit the most under the proposed plan from accelerating their income into 2021.
- The Strategy of making non-deductible IRA contributions and then converting them to a Roth IRA - or the “backdoor Roth”- seems to end starting in 2022. The same goes for the “mega backdoor Roth” strategy inside of 401(k) plans.
This would create a need to take a close look at the convert-or-not decision if you have after-tax dollars in your IRA because this proposal is likely to become law, and the choice to convert may soon become now or never.
- Elimination of Roth conversion for people over the income thresholds, but not until 2031.
Why would this effective date be delayed so long? Keeping Roth conversions for high earners alive for ten years to bring in more tax dollars and reduce the bill's net cost.
You can continue to work with your advisor to decide the right amount to convert from your IRA to Roth IRA by looking closely at the marginal tax rate in the next ten years.
- Taxpayers with income over those thresholds should expect higher capital gains rates.
For people over the $400K/$450K income thresholds, capital gains increase from 20% to 25%, not the 39.6% in the “Biden Plan”. Unlike the proposed change to ordinary income tax rates that won’t take effect until 2022, the proposed top long-term capital gains rate change would be effective immediately, affecting long-term capital gains incurred on or after September 14, 2021.
If you have significant unrealized capital gains, you would not be able to sell such assets before the end of 2021 to avoid the higher rate.
- The gift and estate tax exemption amounts would effectively be cut in half starting in 2022. That would still be over $5 million per person.
This change would create an urgent situation for taxpayers with estate larger at death than the reduced estate tax exemption. Using as much of the current exemption amount to gift assets before the end of 2021 will save significant estate taxes in the future. Ultra-high-net worth clients have likely known this would happen. For the high-net-worth clients, the decision of whether to gift assets now (and if so, how much) will be more complicated and difficult.
The bill also cracks down on Intentionally Defective Grantor Trusts (IDGTs) by including those trusts’ assets in their grantor’s estates. In addition, any sale between an individual and their own grantor trust will be treated as the equivalent of a third-party sale, and any transfer out of a grantor trust will be considered a taxable gift. Family Limited Partnership discounts would no longer be eligible for valuation discounts (though any remaining bona fide business assets would still be eligible for a minority and marketability discounts).
Clients should focus on creating SLATs (Spousal Lifetime Access Trusts), undertaking sales to grantor trusts (using valuation discount), and using their gift (i.e. unified credit) and GST tax exemptions before they lose them. It’s time to schedule a meeting with your estate attorney and financial advisor soon to get them done timely.
- Application of the 3.8% Net Investment Income Tax (NIIT) to S-Corp distributions for taxpayers with income higher than $400,000 (individual) or $500,000 (married filing jointly).
The 3.8% NIIT is currently applied to only investment income, not the pass-through income from S-Corp. This bill will increase taxes for the high-income business owners and reduce the major benefit of structuring a S-Corp.
- 3% surtax on very, very high-income people.
3% additional tax on MAGI (Modified Adjusted Gross Income) over $5 million. This surtax is also going to apply to trusts with income of over $100,000. For clients who have left IRAs to a trust for the benefit of minor children, this income threshold may be reached faster than you expect given the 10-year requirement to deplete an inherited IRA.
- Bigger RMDs for high income people and huge retirement accounts.
This proposal would create new RMDs (Required Minimum Distributions) for single filers making $400,000 or more, joint filers making at least $450,000, and retirement accounts worth more than $10 million, regardless of age.
Tech mogul Peter Thiel used $1,700 in his new Roth IRA to buy startup shares of a firm he co-founded that become PayPal. That account became worth more than $5 billion.
This proposal would take effect in 2022. The RMD amount would be equal to 50% of retirement account dollars in excess of $10 million and less than $20 million but 100% of the total amount over $20 million.
- Limitations for investments inside IRAs.
IRA account owners would no longer be permitted to place or have funds in vehicles that are permissible only for accredited investors such as private placements and hedged funds. Funds that are currently invested in this manner must be removed from the offending vehicles by December 31, 2023. Failure to do so will cause the full balance of the account to be deemed distributed to the taxpayer under IRC 4975 and subject to penalties that can be equal to the amount of the prohibited investment.
Those who have one of these disallowed investments would either need to sell (if that is even possible) or take a tax reportable distribution that will most likely also be subject to penalties. These investments are often illiquid and may have very limited options to sell the position.
- Step-up in basis was not included in this bill.
This bill did not remove the step-up in basis at death. Current laws allow the non-retirement assets to use the market value on the date of death as basis instead of the original cost basis. Beneficiaries can save taxes and avoid the hassle of tracking down the original cost basis of each asset.
- The expanded child tax credit would be extended.
The current rules providing an annual Child Tax Credit with advance monthly payments would be extended into 2022. Starting in 2023, the Child Tax Credit would transition into a monthly child tax credit of $250 a month per child ($3,000 a year) for children 6 and older and $300 a month per child ($3,600 a year) for each child under 6.
It’s worth remembering that this bill is not yet in its final form – there may still be weeks of negotiation before it is passed. That said, you should be aware of these key changes and be ready to work with your advisor to act quickly, as many of the major proposals in the legislation are set to go into effect on January 1, 2022, and some will take effect as soon as the legislation is enacted… which may leave just weeks or even days to act if Congress proceeds.
Tax planning and estate planning can be complicated, so it may be wise to consult an estate attorney, tax CPA, and financial professionals to help you as you build your strategy. At Echo Wealth Management, our professionals can offer a depth of knowledge and breadth of experience in helping you create generational wealth. If you believe our wealth management services may be a good fit for your needs, please contact us today.