Given the unprecedented amount of government spending that has occurred over the past twelve months (more than $5 trillion in stimulus and counting), the question of how to pay for all this has naturally been on the minds of many Americans. Politicians in Washington are beginning to debate changes to tax policy in an effort to pay for this massive spending. It might be helpful to review the most notable elements of President Biden’s tax plan as presented on the campaign trail to get a sense of what could be coming. At the time of writing, several of these elements are in the beginning phases of being introduced as legislation.
President Biden promised not to raise taxes on people making less than $400,000 a year (although recently Press Secretary Psaki said this meant “families”). On its surface this sounds like most taxpayers would be spared from any increases in federal taxes. But that may not be what actually happens.
I have categorized the potential tax changes into three groups:
- Aspects that affect most taxpayers
- Aspects that affect certain families
- Aspects that affect high earners
Notable Aspects for Most Americans
Approximately 57% of American households paid federal income taxes in 2019 according to the website statistica.com. The vast majority of these taxpayers are not expected to see their federal income tax increase under the President’s proposal. However, there are two aspects that stand out to me that could result in actually paying more taxes, despite no change to income tax rates.
Tax Deductible Contributions to Retirement Accounts Disappear
First, the President’s proposal calls for the elimination of tax-deductible contributions to retirement accounts. Under our current system, workers can defer a portion of their wages into a retirement plan or IRA on a pre-tax basis and deduct the contribution from their gross income when filing their tax return. This has been a hallmark of our retirement system since the 1970s and about 43% of workers take advantage of it.
The President’s proposal would replace the tax-deductibility of retirement contributions with a tax credit. The proposal would eliminate deductible contributions and replace them with a 26% refundable tax credit for each $1 contributed. Contribution limits would not be impacted, and Roth contributions would be unaffected.
Theoretically, such a change would benefit taxpayers in the lower tax brackets more so than others. Those in the 10% and 12% tax brackets would benefit from this change, while taxpayers in the 22% and higher brackets will see their tax bill increase after contributing the same amount to their retirement account as before.
This is a complicated aspect of the President’s proposed tax plan with several moving parts. We will be following this possibility closely and if it looks like it will come to fruition, we will spend more time discussing the ins and outs, and how to plan appropriately. It could lead to a significant shift in the way Americans save for retirement.
Step-Up in Cost Basis is Eliminated
Second, the President’s proposal eliminates the step-up in cost basis used in calculating capital gains tax on the sale of inherited assets. This provision is not limited to the wealthy. Every American who is on the receiving end of an inheritance – no matter how large or modest – will encounter higher taxes if and when they sell those assets.
Traditionally, when a person passes away and leaves an asset, say a house, car, or jewelry to their children, those assets have a market value – what they are worth at that time. Those assets also have another value – their cost basis, which is the amount the person paid or invested when the asset was originally purchased. At the time of inheritance, the cost basis increases to match the market value. If and when the inheritor sells the asset, they only pay capital gains tax on the difference between the market value and new cost basis.
Under this proposal, the step-up provision would be eliminated. Instead of receiving the new, higher cost basis upon inheritance, the original cost basis would carry over and expose you to a hefty tax bill.
Here’s an example we often see. Parents pass away and leave their paid-for house to their daughter. They purchased the home a couple decades ago and now the house is worth $300,000, twice what they paid for it. Under the current tax regime, the daughter could sell the house upon inheritance and not owe any tax on the $300,000. However, under the proposal the daughter would owe capital gains tax on $150,000 which could mean $22,500 if she is in the 22% tax bracket.
If this proposal comes to pass, families will need to develop plans to address the embedded taxes of inherited assets. We will have more to say about this should it become a reality. This is currently being consider in the Senate’s Budget Committee.
Notable Aspects for Certain Families
In our recent article on three ways you can maximize your stimulus check I explained how the Child Tax Credit was expanded to $3,000 for children age 17 or younger, and $3,600 for children under 6. The President’s tax proposal would make this permanent.
In addition, the proposal would make permanent the expansion of the Child and Dependent Care Tax Credit from a maximum of $3,000 in qualified expenses to $8,000 (capped at $16,000 for multiple dependents). It would also increase the maximum reimbursement rate from 35% to 50%.
Making the Child Tax Credit and the Child and Dependent Care Tax Credit permanent could result in lower federal income taxes for many taxpayers, but only those that make less than $75,000 for single filers or $150,000 for married couples filing jointly.
Aspects for Americans Making More Than $400,000
Fewer than 2% of taxpayers make more than $400,000 of income each year, but they pay more than 40% of all federal income tax. President Biden’s tax plan proposes to increase their share of the nation’s tax bill. There are numerous proposals for this group of taxpayers. Here is a list of the most notable:
- Increases the top individual income tax rate for income above $400,000 to 39.6%. This is a reversion to the marginal tax bracket in effect before the Trump-era tax cuts.
- Imposes a 12.4% payroll tax on income earned above $400,000. This would create a “donut-hole” in the current payroll tax where wages between $137,700 and $400,000 are not taxed.
- Phases out the qualified business income deduction for filers with taxable income above $400,000. This will impact small business owners and reduce their ability to deduct certain business expenses.
- Restores Pease limitations on itemized deductions and caps the tax benefit of itemized deductions to 28%. Taxpayers making more than $400,000 would face limited itemized deductions.
- Taxes long-term capital gains and qualified dividends at ordinary income tax rates of 39.6% on income above $1 million.
Estate Taxes Affecting More Families
Finally, one more aspect of President Biden’s tax proposal that could affect some families relates to increasing the Estate Tax and broadening its reach to affect more families.
Under current law, individuals can exempt the first $11.7 million dollars of their estate. Married couples can double that to $23.4 million. This means less than 1% of estates experience an estate tax. Estate taxes are only applied to the value of the estate above these exemption levels and the highest rate of tax is 40%.
The Biden proposal seeks to reduce the exemption amount to $3.5 million for individuals and $7 million for married couples. At the same time, the highest tax rate would increase to 45%.
While this proposal will not affect most Americans, it will impact families that operate successful small businesses and diligent savers who invested well over the course of their careers. A cost-effective way of mitigating the estate tax will be to purchase life insurance and have the family use the benefits to pay the tax bill when the time comes.
We are only in the beginning stages of changing tax policy and whether any of the proposals the President made on the campaign trail comes to pass remains to be seen. Changing tax policy is an inherently complex process and history shows it can lead to many surprises in the ninth inning. We will be following this closely due to the many financial planning implications and we will share our thoughts with you when the time is right.
In the meantime, if you have any questions please let us know.