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Are Tax Changes Coming in 2021?

And what can investors do to prepare?

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Are taxes likely to go up in 2021 and beyond? Joining me to discuss that topic and to share some potential strategies to consider is tax and retirement planning expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great. Thanks, Christine. Great to be back.

Benz: Ed, let's talk about the factors that could influence higher taxes in the future. We've had a lot of spending, obviously, to try to stave off an even worse recession due to this pandemic. What other factors have contributed to taxes potentially going higher in the future?

Slott: Well, it's one word, four-letter word, math, M-A-T-H. I mean, the math is there. You know, I always like to say there's only three kinds of people in this world--those who understand math and those who don't--three kinds. All right. So, while you're thinking about that, it's all in the numbers. Look at the deficits and the debt. We're in the worst financial situation as far as our national debt and deficit numbers since the end of World War II. You saw those numbers that came out on the Sept. 30 fiscal year, our fiscal year as a nation, and it was the worst situation since the end of World War II in 1946, and that's when rates got jacked up. And just so you know, baby boomers like me and many people watching us now--those were the years, people like me were born between 1946 and 1964, the baby boomer years--do you know the top federal tax rate for every one of those years exceeded 90, 9-0 percent, except the last year, 1964, when The Beatles came to America and everybody was so happy they dropped the top federal rate down to only 77%.

Mark Twain said, history doesn't repeat itself. But it rhymes. Or there's another saying: Those who don't learn from history are bound to repeat it. I don't know if we'll get to those levels. But this is what happens when the bill comes due. At some point, the credit card bill comes due. Look at your own credit card. If you don't pay for a few months, look at how it explodes. That's what we have. And the accounts that are most in trouble are those retirement accounts, tax-deferred accounts, 401(k)s, 403(b)s, IRAs. They are on the chopping block. Why? Because that money has not yet been taxed. It's like a sitting duck for Congress, a big juicy steak. Every time they need money, they know they can raid those retirement accounts, kind of like they did with the SECURE Act where they illuminated the stretch IRA because they thought that would bring them some money. So, they always seem to go, obviously, where the money is. So, those accounts are most at risk of higher taxes, maybe even as soon as 2021.

Benz: That's a question: Say Congress does get together and decide to raise taxes on various items. I know capital gains have been under discussion. If they do that in 2021 at some point, would those be retroactive to the beginning of 2021? How does that typically work?

Slott: It would probably be retroactive. What they usually do so people can't game the system is, when a certain bill comes to the floor or passes a certain stage, they either have it retroactive to the date of enactment or the day they first started talking about it, or it could push it till next year or make it retroactive back to the beginning of '21. They can do anything. It depends on how late in the year anything gets done, and I don't really think a lot is going to get done. Doesn't matter. Remember, you have almost a 50-50 split in the House and the Senate. Big things I don't think are going to pass.

For example, one of the proposals was to eliminate the step-up in basis, which would affect a lot of people with appreciation in stocks, especially with the way the market has been roaring on. I think that's dead on arrival, my own opinion. I'm like Yogi Berra. You know, he had that saying, "I don't like to make predictions, especially about the future." I don't know about that. But my prediction is, that's dead on arrival. It's too much of a shock to the system to tax all of those gains. I don't think you'll see that. I think you'll see something that's more negotiable, trimming around the edges, maybe raising the capital gains rates or maybe that bringing the capital gains rates to the same as ordinary income rates.

You might remember, Christine, in the 80s--I think after the '86 Act under Reagan--there was a short time period where the capital gains rate was the same as the ordinary income tax rate. And we were fine with that. Maybe that's something that we could see happening.

Benz: A question is if people do think that taxes could be going higher in the future, how preemptive should they be in terms of making changes to their portfolio before there's actually settled law? Is that wise to do?

Slott: They could do a little. I wouldn't go in the extreme. I remember, I think it was 2012, when they were worried about the estate tax coming back and everybody was gifting everything. They said, "Gift all your money," to the wealthy people, "get it out because they're going to raise the rates" and all of these things. And all these people gifted all this money. And then, when it didn't happen--and in fact, the rates went down and the estate exemption went up--they wanted all their money back from their kids. And remember, if you're thinking about gifting, it only works one way. Once it's gone, it never comes back. So, I wouldn't go extreme. I mean, if you're thinking about--you have some positions and maybe you can lock in today's low capital gain rate and you know what it is--that's the benefit of these winding-down days of 2020. At least you know what the rates are. So, maybe moderation, like Shakespeare said, in all things is probably not a bad strategy.

Benz: I want to talk about some specific areas that you'll be watching where you think realistically there could be changes. You mentioned capital gains as one. Are there any other areas where you think realistically we may see changes that might affect people, especially with respect to their investments?

Slott: I think you might see something with Social Security because we all know that's going broke, too, maybe they will raise the age for the cap, if you know what I mean, maybe they will raise it. Or there was this one proposal, which I don't think it's going anywhere either, at 400,000, it comes back, and that seems a little complicated. But you could see higher rates for higher earners. That might make you think, "Well, maybe I'll get some income, maybe I have a business, take more income out this year," again, when you know what this year's rates are. But I wouldn't go overboard with anything because I don't think you're going to have dramatic changes because the legislature is just too divided.

Benz: Real quickly, Ed, if people do buy your argument that taxes writ large are likely to trend higher in the future, what are some strategies to consider? I know you're a big enthusiast of converting potentially traditional IRA assets to Roth. Any other strategies?

Slott: Right. That's probably number one.

Benz: Anything else?

Slott: I'll tell you why I love Roth IRAs so much--because I believe tax rates are going to go up at some point, and here's the great part about it. If I'm wrong--as a matter of fact, I had a guy, an advisor, tell me, he was on a program like this, a webinar, and he said, "Ed, I was at your big two-day program 10 years ago in Las Vegas, and you said the same thing then, tax rates are going to go way up. Well, it turned out, they didn't. You were wrong, and you told everybody to convert to a Roth IRA. What do you say now?" I say, well, if you had listened to me 10 years ago, all of those gains for the last 10 years in the market would have been tax-free in the Roth. See, the worst-case scenario with the Roth--let's say, I'm wrong about everything, you lock in a 0% rate. You can't beat a 0% tax rate. So, that's your worst-case scenario. Anytime you can lock in anything that low, it pays to do it.

Benz: Ed, it's always great to get your insights. Thank you for looking into your crystal ball a little bit for 2021. Thanks so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.