Given the size and number of tax changes proposed by the Biden administration, it’s no wonder advisors face challenges in helping clients prepare for the year ahead. The Georgia special election that is a few days away will be pivotal in determining if Biden’s administration is able to pass its proposed tax plan. Potential outcomes following the special election are as follows:
- If the Democrats win both seats, we will likely see a reduction or elimination of the Trump administration’s tax cuts made by the Tax Cuts and Jobs Act.
- If the Republicans win at least one Senate seat in the Georgia special election, many people expect to see Washington gridlock. This poses a difficult environment for the Democrats to drive tax rate changes, and we may see most provisions of the TCJA continue until they expire after 2025.
Regardless of what happens with the Georgia special election, strategies to minimize tax burdens are always relevant. As a starting point, here are five factors to consider in tax planning:
1. Know where you are and where you are going
Significant tax law changes are possible. To best prepare, it’s important for taxpayers to understand both the current tax law and the changes that may be on the horizon. One of the most important things a taxpayer can do throughout the year is assess their taxable income, so they know their tax bracket. With clients on the cusp, advisors can look for areas to reduce their taxable income to keep taxpayers in the lower bracket. This chart provides a comparison of the current environment and Biden’s proposed tax plan.
| Trump’s current TCJA plan | Biden’s proposed tax plan | |
| Marginal Tax Rate for $400,000 | 37% tax rate | Reinstate pre-TCJA rate of 39.6% |
Itemized Deductions | Limit certain itemized deductions while raising the standard deduction | Cap the tax benefit of itemized deductions at the 28% tax rate |
| Capital Gains and Dividend Income | Maximum capital gains rates of 20% For high earners, the additional 3.8% net investment income tax brings total effective rate to 23.8% | Removal of preferential treatment for taxpayers with $1 million + in taxable income With the net investment income tax, effective tax rate is 43.4% |
| Estate Tax | Maximum rate of 40% imposed after an exemption allowance; current exemption for 2020 is $11.58 million ($23.16 per married couple) A beneficiary is entitled to a step-up in basis of all inherited assets | Increase the top tax rate to 45% and reduce the exemption amount to pre-Obama levels of $3.5 million per taxpayer. Repeal of step-up in basis at death |
2. High earners, watch out for a jump in rates on capital gains and dividends
High earners need to be mindful of proposed changes to capital gains and dividend taxation. Under Biden’s proposed plan, favorable tax treatment of capital gains and dividends would be phased out for taxpayers with over $1 million in taxable income. For these taxpayers, their capital gains and dividends would be treated as ordinary income. Their tax rates would increase from a maximum of 23.8 percent to 43.4 percent (which includes the 3.8 percent net investment income tax). This large change encouraged ultra-high-net-worth investors to take early distributions and accelerate income in 2020. As the year progresses and we gain more clarity into 2021’s tax environment, we may see more UHNW individuals utilize long-term appreciated securities in their charitable giving to minimize their tax liability,
3. Tax-efficient investments are more important than ever
As clients move into higher tax brackets, the investment vehicles used to access market exposure becomes increasingly more important. When compared with mutual funds, single-stock portfolios offer many advantages for high-income earners. Investors can control their tax liability by managing the turnover within the portfolio. This allows investors to defer realization of any capital gains or take advantage of tax loss harvesting. While it’s always important for decisions to be economically sound, the ability to directly offset income through investment losses is invaluable to high earners.
4. Location, location, location
As with real estate, location is everything. For most investors, the location of a security within a portfolio may help reduce their tax liability. A security’s tax treatment will determine which account type is best. For example, equities tend to generate capital gains and dividend returns. These return streams have favorable tax treatment in taxable accounts, while they are treated as ordinary income in tax-deferred accounts. Although favorable treatment of capital gains and dividends may be phased out for taxpayers with over $1 million in taxable income, most taxpayers can still realize this tax minimization strategy.
5. Minimize taxable income.
President-elect Biden proposes to reinstate the pre-TCJA rate of 39.6 percent for taxable income above $400,000. While the payroll tax is mostly unavoidable, taxpayers can defer their income tax by maximizing their retirement plan contributions. This helps delay a portion of their tax liability and allows for more time to plan. Increasing retirement contributions will always be one of the best ways an investor can minimize their tax liability and prepare for retirement.
Understanding Biden’s proposed tax plan and its impact on taxpayers is important. It affects all life stages, from less take-home pay during working years, to reduced expendable income during retirement and decreased wealth transfer. It’s important for a taxpayer’s accountant and financial advisor to act as a team and bring clarity to this uncertainty.
Taxpayers need to exert caution. however, as these tax proposals are just …proposals. If tax law changes are enacted, they will most likely be modified from what was discussed on the campaign trail. Careful consideration with all appropriate parties is important to ensure a taxpayer’s actions best align with their long-term goals.
