While we have yet to see a written, formal, proposal, the Biden campaign floated a number of proposals for changing our existing tax system: both income as well as estate and gift. Tax proposals that are perhaps most significant for individual taxpayers are those that would do the following:
- Increase the highest marginal income tax rate to 39.6% on income over $400,000.00;
- Increase the income tax rate on capital gains to 39.6% on all capital gains realized during a tax year in excess of $1 million;
- Limit the benefit from itemized deductions to 28% (impacts taxpayers whose marginal tax rate exceeds 28%);
- Bring back the Social Security tax once a taxpayer’s compensation exceeds $400,000 (i.e., creates a “donut hole” where an individual’s social security tax obligation goes away as under current law once a compensation level is hit – $142,800 for 2021 – then re-impose the tax when compensation exceeds $400,000);
- Reduce the estate and gift tax exemptions from $11.7 million per taxpayer (for 2021) to $3.5 milling for transfers at death, with a separate exemption of $1 million for gifts during lifetime (under existing rules, the exemption is “unified” so the existing $11.7 million can be used during lifetime and at death);
- Raise the top estate and gift tax rate to 45% from today’s 40% rate; and
- Perhaps worst of all from an estate and gift tax perspective, eliminate the rule that provides for a “stepped-up basis” for assets transferred at death and impose an income tax realization event at the time of any gratuitous transfer, whether during lifetime or at death.
Taken together, the income tax proposals create one of the most complex taxation regimes ever instituted and introduce the most sweeping overhaul to the estate and gift tax rules ever attempted.
That said, given the complexity of the tax proposals, as well as a full plate of other policy priorities vying for the new administration’s attention, most tax professionals believe that changes ultimately enacted are likely to apply to tax years beginning after December 31, 2021. So you may have time to plan, as best you can, for possible revisions to the Internal Revenue Code.
A quick caution, however: as we all know, time has a way of slipping away, and tax planning professionals are going to be hard pressed for time this year. Accordingly, make an appointment with your preferred tax professional as soon as possible so that you can discuss planning opportunities that may be available to you – it takes time to become comfortable with planning techniques, to choose those you want to implement, and then to actually implement them. The sooner you start the process, the more likely you can implement at least some techniques meant to alleviate the negative impact of any upcoming tax law changes.
With the introduction out of the way, the following is a (very) brief description of techniques and vehicles you are likely to hear about and situations in which they might be of use to you, with an emphasis on how they impact charitable giving and your charitable deduction.
Roth Conversion
Consider converting qualified plans to Roth IRAs. Determining the effectiveness of this technique is number crunching intensive. Since conversions trigger income in the year done, 2021 may be a great year to convert because of likely increases in marginal tax rates beginning 2022, with a corresponding increase in the cost of the conversion. Additionally, the increased charitable deduction allowed for the 2020 tax year originally provided for in the CARES Act continues for 2021 (it is possible to deduct up to 100 percent of your adjusted gross income). As a result, you can shield a larger Roth conversion from taxation by increasing your charitable giving during 2021.
Accelerate Gains
Sometimes referred to as “gain harvesting,” if you have assets with significant built-in gains (gains that would exceed $1 million of realized gain if the assets were sold), talk to your tax professional and determine if selling this year makes sense. Under the Biden tax proposal, any realized gain in excess of $1 million would be taxed at a 39.6% rate (ignoring the tax on investment income). It may make sense to harvest those gains this year. Even if the asset is one you like, such as a particular publicly traded stock, it may make sense to sell and then buy back the asset with a resulting higher tax basis. If you are charitable, you can shield gains recognized this year by increasing your charitable giving, perhaps to a donor-advised fund account.
Income Shifting
Consider moving income-generating assets to a different taxpayer. This may provide a separate income tax rate schedule to be applied to income generated by the asset. More importantly, though, for those that are charitable, limitations applicable to you as an individual taxpayer don’t apply to taxpayers that aren’t individuals. For example, if you implement a charitable income trust, the 60 percent of adjusted gross income charitable deduction limitation for cash gifts to public charities does not apply to the trust. In the case of charitable remainder trust, you receive a charitable deduction when you fund the trust and the trust itself pays no income taxes. Both of these charitable vehicles, along with the charitable lead trust, are examples of vehicles that allow you to shift income from you to a different taxpayer in a tax effective manner.
Defer Income
Once/assuming the worst of the Biden proposals become law, there will be an emphasis on techniques and vehicles that allow taxpayers to defer income. I predict you will hear more and more about charitable remainder trusts in the coming year and years, as this is one of the most effective income deferral devices available.
Closely Manage Capital Gains
If the 39.6% bracket on capital gains in excess of $1 million is enacted, much more attention should be paid to timing of capital gains and losses. Expect to see a variety of planning ideas centered on managing net capital gains.
Defer Deductions
To the extent you have control, it may make sense to defer some deductions. However, this is not a straight forward analysis. You need to take into account the proposed limitation on the benefit of itemized deductions (limited to a 28% benefit) and the re-introduction of the Pease Amendment that phases out itemized deductions. If, however, you have above-the-line deductions as a result of business operations, for example, deferring deductions for the business from this year to next may make sense.
It is not clear at this point if the new 28% deduction benefit limitation will apply to retirement plan contributions. If it does, then accelerating rather than deferring retirement funding to 2021 (within applicable limitations) from 2022 may make sense – but without modeling the numbers, it’s impossible to know.
Use it or Lose it
Much of the above discussion focused on income tax issues. The primary planning for 2021 consideration related to estate and gift taxes is what I call “use it or lose it.”
During 2021, each taxpayer can transfer, cumulatively, over lifetime and at death, $11.7 million. If Biden’s expected proposal is adopted, that amount drops to $3.5 million for transfers at death, and $1 million for lifetime gifts (the estate and gift tax system is no longer “unified,” as in the exclusion amounts are no longer the same for at death and lifetime gifts). As a consequence, to the extent you can afford to, this is the year to transfer assets out of your estate and to your loved ones if you project a taxable estate at the time of your death.
The vehicles best suited to help you make gratuitous transfers in a tax effective manner and assist with your charitable giving are charitable remainder trusts and charitable lead trusts. Both of these vehicles will be described and discussed in greater detail in my next post.
Over the next few weeks and months, anticipate additional posts that will delve deeper into the Biden administration’s tax proposals and the techniques and vehicles introduced in this post that may help ease the on-coming pain.
Finally, please keep in mind everything discussed in this post is for educational purposes only. We are not a law or accounting firm, and do not offer tax advice. The discussion offered is for illustrative purposes only. You must discuss your unique facts and circumstance with your preferred tax professional before taking any action.
