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Biden's Capital Gains Tax Plan Could Mean Big Changes for Wealthy Investors

Most people don't need to worry, but pay attention if you think your income could ever top $1 million.

It's not law yet and it might not ever be, but there could be some big changes for capital gains taxes as early as 2022. If you think your income could ever top $1 million, you might want to pay attention. Even having a one-time large transaction--such as selling a business--could put you over the edge.

And if you are lucky enough to be making in the high six figures or above on a consistent basis, there could be big changes in store for tax planning around your investments.

Currently, long-term capital gains on assets held over one year are taxed at a maximum Federal rate of 20% plus a 3.8% Medicare surtax. President Joe Biden's reported proposals would raise the top rate almost double to 43.4% in order to help pay for education and childcare proposals. The way this would work is that for those with income of over $1 million, long-term capital gains would be taxed at ordinary income tax rates. And under Biden's plan, the highest tax bracket would be 39.6% (up from 37.0%), and the Medicare surtax of 3.8% would still apply.

For Most People, No Need to Worry

Biden has repeatedly said that taxes would not be raised on those earning less than $400,000 a year. But there are a lot of gray areas yet to be defined. We don't know what changes will happen to itemized deductions, phase-outs, and other tax law changes. If you typically have income levels in the high six figures and own appreciated assets, you should worry--but not too much. There is a long road between a proposal and a law.

It appears that we can feel fairly confident there won't be increases affecting 2021 taxes. So, there is time to plan for any potential changes. In addition, you don't want to jump to make moves that might put you in a worse situation should tax laws not change. The key to planning is to be nimble.

If You're in the Cross Hairs

For those with consistent income above $1 million, this could mean that long-term capital gains will always be taxed at the highest possible rate. That, in turn, could warrant some significant changes to how you allocate investments between taxable and tax-deferred accounts. Thus, the typical strategy of holding appreciating assets--such as growth stocks, precious metals, or raw land--in taxable accounts might prove to be disadvantageous. Also, with long-term rates equal to short-term rates, delaying sales until assets are held at least one year will become a thing of the past. That's a big deal as it removes the current penalty for short-term investing.

More broadly, because capital gains taxes could jump significantly for those with an income of over $1 million, planning now could save a lot of money. There are essentially three ways to avoid the potential capital tax increase:

  • Keep income below $1 million.
  • Recognize gains in 2021 before the tax rate increases.
  • Continue "normal" tax planning: defer gains, harvest tax losses.

Keeping income below $1 million would avoid higher capital gains taxes. Since the earliest the law would likely change tax rates is for your 2022 taxes (the ones you file in April 2023), you would not need to implement these strategies this year. Thus, if you think you might approach $1 million in 2022, you might want to accelerate income to 2021 in order to lower your 2022 income.

How does this work? You can defer income in future years, implement a retirement plan, recognize losses, buy and expense business assets, accelerate business expenses, and so on. We don't know if the $1 million income limit refers to adjusted gross income or taxable income. If it ends up being taxable income, then accelerating itemized deductions would also be helpful: prepaying mortgage interest or increasing charitable deductions. And again, we're likely not looking at anything that would affect your 2021 tax bill.

For large capital gains, it might make sense to recognize the income in 2021 rather than take a chance on 2022. For example, if your expected income before capital gains is $600,000, a large capital gain in 2022 could push into the higher rate. So, for example, if you plan to sell stock that will produce $1 million in long-term capital gains and you have the flexibility to close the transaction in either 2021 or 2022, you might want to close in 2021. In this example, the tax savings could be well over $100,000.

An installment sale situation could expose you to an even greater tax liability. Let's say that you earn $600,000 per year without capital gains and are selling your business for $4 million, receiving $1 million per year beginning in 2021. Should Biden's new capital gains provisions take effect in 2022, your total tax would be increased by over $300,000. In this case, it might be worth it to elect out of installment sale treatment in 2021. In other words, it would be better to bite the bullet and pay all the tax up front then to spread a much higher tax amount over the future three years.

Clearly, nobody wants to spend virtually all of the first year's proceeds on taxes when the increase might not even happen next year. So, for a sale occurring in 2021, since this election must be made on the 2021 tax return, extending the tax return can postpone the decision until Oct. 15, 2022. At that point, there presumably would be more known about whether or not the capital gains increase would be implemented.

And continuing to defer capital gains recognition and harvesting tax losses can become a high priority should capital gains rates increase in the future.

What Else Should I Worry About?

It has always been a key strategy to defer capital gains as long as possible. After all, at death, there is a step-up in basis, and no tax would ever be paid on the appreciation.  There are some proposals that would eliminate the step-up at death. And there's talk of lowering the estate tax exemption from $11.98 million per person to $3.5 million and lowering the gift tax exemption to $1 million.

These provisions will likely not impact most Americans. But for those with a net worth of more than $3.5 million, gifting in 2021 might be important. Also, obtaining life insurance to cover the potential tax (through a life insurance trust) should also be considered.

What Should I Do?

Right now, the best thing to do is nothing. Since tax increases in 2022 are not certain, you shouldn't take any drastic steps now. What you can do is make sure you have a good tax person, financial advisor, and estate attorney, and be ready to get their advice when and if the new tax laws are finalized.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and founder of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar or of Rowling & Associates LLC.