“Everyone wants to know if they should be doing something, because there is just so much uncertainty about what might happen and when,” says David Peterson, head of wealth planning at Fidelity. “But making kneejerk moves is never wise, especially since many of these proposals may never get enacted. You need to think about them in terms of your long-range plan. Being prepared mostly means being educated about your options.”
Basing tax planning on what might come could be premature, because campaign proposals are rarely adopted in their exact form and often lack the specifics to perform pinpoint planning.
One possibility is that Congress simply allows the provisions of the Tax Cuts & Jobs Act to expire at the end of 2025. Or Congress could make major changes to tax laws that could impact financial planning for upper-income earners, investors, and anyone who is leaving assets to heirs. Those earning more than $400,000, especially those earning more than $1 million, and those with estates over $3.5 million, are perhaps more likely to be affected. But tax proposals could impact anyone—from a young executive to a retired couple living mostly off their retirement savings, to anyone leaving their home to their kids.
State taxes play into this too, given mounting pressure on state budgets in the wake of the COVID-19 pandemic. Some states, including California and New Jersey, are already moving to raise state taxes. Others may follow, and many are seeking federal aid to fill budget deficits.
The best kind of long-range financial planning helps you today, possibly helps you out much more in the future, and leaves you in a better position than if you hadn't planned at all.
To that end, here are some ways to look at the possibilities—no matter what Congress does.
Possible changes: During the campaign, Joe Biden proposed increasing the top federal marginal income tax rate from 37% back to what it was before 2018, 39.6%. Also, the income thresholds for the top brackets could get adjusted downward. While certain deductions may be reinstated, deductions in general could also end up limited at high income levels, potentially reducing the benefit of very large charitable deductions. Bottom line: There could be significant impacts for those currently in the upper tax brackets, if not by earlier legislative action, then when the 2018 changes expire at the end of 2025.
Actions to consider: Until rates for future years actually do change, there’s likely no need to do anything differently other than investigate your future options. If you’re concerned that rates could rise in future years, you may want to think about strategies to reduce taxable income in the future in order to stay below the upper threshold, or consider moves that accelerate taxable income from the future into this year. Converting from a traditional IRA to a Roth IRA, assuming that fits in with your overall plan, may be an option, since that both accelerates future income into this year and reduces future taxable income.* On the other hand, it’s possible (albeit unlikely given historical patterns) that a change in tax rates could be retroactive to the beginning of 2021, in which case part of the benefit of such a conversion would be lost. So again, it may make sense to just weigh your options for now.
In addition, remember that the tax code is progressive, and any tax increases for those earning more than $400,000 might only apply to the portion of your income that is over the cap. You might want to run the numbers with a tax professional to see the impact on you personally.
If you are over the age of 72, your options for reducing income will not include skipping your required minimum distributions (RMDs) in 2021, unless Congress authorizes another pause like it did in 2020. But it’s important to note that you have until the end of 2021 to decide how to take them—taking a single distribution at some point in the year or spacing out your distributions. Don't forget, though, because if RMDs are not waived again for 2021 and you do not take the right amount, you can be hit with big penalties and fees.
“The timing of your RMD from a traditional IRA doesn’t matter from a tax perspective, as long as it happens before the end of the year, with one exception—for your first RMD, in the year you turn 72, you have until April 1 of the following year. Just be aware that if you wait, you’ll end up with no RMDs in your first year and 2 in your second. That could have knock-on effects (e.g., getting pushed into a higher tax bracket), so give it some thought and consult with your tax advisor,” says Matthew Kenigsberg, vice president of investment and tax solutions at Fidelity.
Another move to consider this year involves charitable giving. One way of making the most of the tax deduction for charitable contributions is to “bunch” several years of planned contributions into a single year to take fuller advantage of itemizing. That tends to be an advantageous strategy for many people whose itemized deductions are below or only slightly higher than the standard deduction, but given the possibility of tax changes, the timing can be tricky.
“You might assume that if tax rates go up next year, you would benefit more from a large charitable donation then, but that does not necessarily hold if at the same time deductions are capped and phaseouts are reintroduced. Actually, you could do much worse,” says Kenigsberg. But again, at this point it’s hard to know whether any changes would go into effect in 2022 or be retroactive to the beginning of this year, so it could be smart to watch and wait.
The caveats: Your retirement income strategy and your charitable giving are highly personal decisions that depend on a lot of different factors. You do not want to make financial moves just because you think a tax change is coming, but instead you should do so because it helps you toward your overall goals. Before making a decision, always consult with a tax advisor.
Capital gains taxes:
Possible changes: Capital gains rates could go up in the future—Biden has proposed raising the top tax rate on long-term capital gains and qualified dividends from the current top rate of 20% to higher ordinary income tax rates for those earning more than $1 million a year. The top ordinary income rate is 37% currently and could increase to 39.6% (exclusive of the Medicare surcharge) under Biden.
Possible actions: If you are considering realizing some gains held in taxable accounts and you are concerned by the potential for higher rates in the future, you may want to think about doing it this year to capture today’s long-term capital gains rates. That's particularly true if you are considering or in the process of diversifying out of a concentrated investment position, and think your income will be over $1 million in the future, perhaps due to the sale of stock, a business, or other earnings. Once again though, there’s no guarantee the new rates would not include capital gains realized this year, so it may be sensible to watch and wait for now.
For both taxable investments and stock options, you want to think about your overall timetable, understand your tax rates, know where your taxable income falls in the tax bracket, and how the increased income fits into your overall tax picture now and if rates rise.
For the sale of a business that can’t be completed this year, you may want to consider the value of an installment sale versus an outright sale to spread out the gain and mitigate the potential tax impact of rising rates.
You may also want to look at charitable options, because donating appreciated stock now could provide a useful tax deduction if laws change. When you gift appreciated stock to a qualified charity or donor-advised fund, you pay no capital gains taxes and can deduct the contribution if you itemize, with some limits.
The caveats: You may be tempted to realize gains on highly appreciated stock you want to hold for the long term, and then buy it back later at a higher cost basis. This strategy could work for some. But for others, paying taxes early on some gains could end up reducing after-tax returns over the long term.
“Don’t let the tax tail wag the investment dog,” says David Peterson. “You should be buying and selling based on your view of the long-term value of the assets, not based on the tax consequences.”
Possible changes: The changes proposed in the estate area could be huge and could have more of an impact than all the other areas on some families. At the top of the list is the current federal estate tax exemption amount of $11.7 million for an individual (double for a married couple), which under current law is set to revert in 2026 back to prior amounts, adjusted for inflation. Congress could further reduce this for individuals. This would change the planning calculus for many families.
Further, Biden has proposed repealing the step-up in basis at death, which could mean that these assets would be subject to capital gains taxes based on their original purchase price, not the price at death. It’s also possible that changes could require those taxes to be paid at death versus when your heirs sell the property, but it is unclear whether a tax credit against any estate tax due would be allowed. That would affect anyone who plans to pass on appreciated assets, from a family home to a stock portfolio.
Actions to consider: Review your needs and goals. Estate planning for years has leaned toward setting up a plan for your assets to pass to heirs after your death, but if the taxation changes, the focus could shift to spreading out gifting of an estate over a longer span of time while you are still alive, either outright or with the help of a variety of trusts. “Market conditions could also affect your strategic plans,” says Peterson.
For 2021, you can give up to $15,000 ($30,000 for married couples) a year to anyone without affecting your lifetime gifting limit of $11.7 million for individuals ($23.4 million for a married couples), which can add up. You can also pay for a loved one’s tuition or health care costs directly, without impacting your lifetime gifting limit. And there are different trust options to consider. Many, however, will be irrevocable, meaning they are difficult or impossible to change once established. You may want to set up the trust structure you desire now and then take the step to fund the trust later.
The urgency here is that estate planning takes time—you must think through what you want, which is difficult for many people. You then need to engage financial and legal professionals, who get very busy at times of uncertainty. No matter what happens with potential tax law changes, reviewing your estate planning needs is one of those tasks that’s best to do sooner rather than later.
The caveats: Once you give money away or fund an irrevocable trust, you can’t control it, so be sure that it’s what you desire. You want to stress test your plan to make sure you have the assets and income you need for your own retirement. You also may want to talk with your heirs about your intentions and consider approaching this as an opportunity to share your goals and wishes.
With all financial planning, it’s important to make sure to think and plan for the long term. It can help to consult with a financial planner and a tax professional for support in assessing your own future needs and setting the right course, even if taxes do rise.
Article above from: Fidelity's What To Do About Tax Uncertainty