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Prepping for Possible Tax Changes

From estate taxes to gift taxes and more--how potential revamps can affect us all.

Christine Benz: Hi, I'm Christine Benz from Morningstar. With prospective tax changes on the horizon, is now the right time to start gifting assets and pursuing other such strategies? Joining me to discuss that topic is tax- and retirement-planning expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back with your Christine. Thanks.

Benz: It's great to have you here. I'd like to start by talking about where we are with prospective changes to the tax code under the new administration. Can you outline some of the proposals under consideration and where they are in the pipeline?

Slott: Well, the big items, and again, the key word is proposals. But you have to know about that to plan because--let's look at the Secure Act that happened a few years ago. That gave us 11 days to plan. If you remember, that was enacted, I think, on Dec. 20. And you had 11 days to scurry around and plan because it was effective Jan. 1. So we don't even know where these proposals are going. First thing, if I was a betting man--not that I would go to Las Vegas--but if I was a betting man, one of the proposals said some of these changes may be retroactive back to April. I don't think that's going to happen. I would bet heavily against that because we're too far into the year. And it just has a sour taste to change the rules where people already made decisions to go retroactive. I don't think we'll see that. So anything we're talking about now, I think if it does happen, it's going to be effective Jan. 1. So it's a good time to have this discussion, be aware of the issues, because you do have time to plan if you want to make plans.

So some of the things they're talking about: Basically income tax, capital gains, and estate and gift tax are the big issues, where all the big money is. So the income tax, maybe they want to raise the rates on people that make $400,000 or more, but there's all kinds of permutations to that. We don't really know where that's going to go. And it may even affect people that are under $400,000, but they're over $400,000 for one year--somebody sells their house... There was just a story in, I think, The Wall Street Journal, recently called "the one-year millionaire." So one year, all of a sudden, it hits you. So that brings us to the capital gains rates, which is a preferred rate. You could pay 20%, 23.8%. They are thinking making that equal to ordinary rates, which can run over 40% if you add in that extra 3.8% tax on net investment income for higher earners. So if they made them the same, the only time that ever happened before was in the '80s. And I think it only lasted a couple of years. So that would take a lot of the planning off the table because where everybody tries to get capital gains, now it might be treated like ordinary income. I don't know if we'll see that.

Then probably the biggest change--and the one that will hurt a lot of people that weren't planning on it--is the elimination of something called step up in basis for capital gains, for long-term capital gains. Just to give you a quick example: If you bought your home for, say, $100,000 many years ago, and now it's worth $2 million, that gain would be relieved at death. Or a stock, you bought a stock for $100,000, now it's worth $5 million. Your beneficiaries pick it up at $5 million. All the income tax on that appreciation is eliminated at death. So not only do they want to eliminate that big benefit for the appreciation, but they want to tax it at death or some other transfer as if you sold it. I think that's a nightmare waiting to happen. Even though you didn't sell it, so where you're going to get the money to pay the tax just because it appreciated then at death. I think this is a loser provision. It would be a mess. Plus, they would have to couple it and fix the estate tax because then you'd have it included for income and estate tax. And by the way, that may sound awful, but what I just described is an IRA. An IRA is always subject to income tax and estate tax, which is why I love Roth IRAs, at least it eliminates the income tax, still included in the estate. So I think that may be a bridge too far. But if you're worried about that, maybe you want to sell some of your winners now for the stocks. Lock-in today's low capital gain rates. And here's a nice play: Use some of the proceeds from that to pay the tax on a Roth conversion. If you're worried about higher taxes in the future on your IRA, move more of that to the Roth. So use those proceeds to pay the tax on a Roth conversion. You may want to look at that.

Also on the estate tax side, estate and gift tax: We have a huge exemption now, over $11 million, $11.7 million. There is talk of lowering that. So you may want to take advantage of using some of that exemption now during lifetime, which it can still be used for the rest of 2021 through lifetime gifting. We don't know where that's going to go next year. So you may want to lock-in some of the things you know: the low tax rates, the low capital gain rates, and the large estate exemptions. Now, if you want to wait till the end of the year, because we don't know what's going to happen, a lot of this can wait till year-end. But bigger assets, like the sale of a business, you have to get the wheels going now. For example, if you want to sell a stock, the law comes in Dec. 20, let's say, all right, you push the button on selling. But you can't do that on selling a piece of land or a business. You may want to get the process going if you're truly worried about that, to the point where you can push the button right at year-end or not, if it seems like it may not be an issue. But these are things everybody has to think about because this is what's been proposed in a number of different bills in Congress, none of which may come to anything, but you never know.

Benz: Well, that was my question, Ed. I think investors, people wrestle with how pre-emptive to be in terms of making changes to their portfolios, selling things, gifting things if none of this is a done deal.

Slott: It's not a done deal. But I don't believe personally--my own opinion, again, not a betting man--my own opinion that anything drastic, like some of the things that I think are a little extreme, are not going to get passed because you have a 50-50 Senate. You would need every Democratic senator to buy in. If one of them is sick, for example, it's not going to pass. So it has to be something more moderate, more in the middle that everybody can get behind. I don't think you're going to see anything extreme, like some of the things I talked about, actually get through. But I think, if I had to bet again, they're going to do something because from the Democrats' point of view--and this is apolitical, I'm just saying--if they don't do it now, nothing's going to happen in 2022. It's an election year, and nothing's going to happen. So if they want to make the case that they did something, something's got to happen now. And to get that something to happen, they may have to give a little to get the 50 votes and go less extreme.

Benz: People who are watching might be thinking, "Well, you know, he's talking about estate tax, gifting assets. All of this stuff is mainly relevant, they might be thinking, to people with a lot of money." You mentioned the very high estate tax exclusion currently. Is there relevance for people who don't have quite as much in assets in terms of some of these pre-emptive strategies?

Slott: Yeah, it always falls on unintended people, like people who have a home, like I said before, that appreciated. Lots of people are in their homes for 30, 40 years. They have, look at the real estate market, incredible appreciation. These are these "one-year millionaires." If they ever sell their home, and they did it next year instead of this year, they could be losing half of what they would have had, maybe, if these proposals go through, than what they would have kept after taxes this year. So it's a big difference. So even people, say, of modest means that have a lot of money tied up in a home or a small business, they don't consider themselves wealthy, but at some point, if they want to sell out, they could be one of these one-year millionaires that gets trapped by these taxes, supposedly on the wealthy. And that's the problem with it. A lot of this falls on unintended taxpayers.

Ed, really helpful information. Thank you so much for being here.

Slott: Thanks, Christine.

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