What Proposed Tax Changes May Mean for You

Christine Benz: Hi, I'm Christine Benz from Morningstar. In September, the House Ways and Means Committee released a wide-ranging proposal for tax reform. Joining me to discuss some of the highlights for investors as well as what, if anything, you should do in response is Tim Steffen. He is director of tax planning at Baird.

Tim, thank you so much for being here.

Tim Steffen: Great to see you, Christine.

Benz: Great to see you, too. I want to discuss some of the highlights of this proposal. But before we do that, Tim, can you give us a sense of what you think about whether investors should act pre-emptively when they hear about tax changes? Should they start making changes or should you wait until there is more clarity?

Steffen: You want to be careful because we want to make sure we know exactly what's going to be in there. All we've got right now is a proposal, one of several we've had over the last year. This is a little bit more formal than others. So, we think we've got a pretty good sense of where this proposal might go, and it sure feels like something is going to happen later this year. There's some uncertainty out there. If you follow the political side of this, the Democrats have very small margins to work with to be able to get something like this to pass and they're struggling right now to get what they need. So, who knows what's ultimately going to happen. But it sure feels like something is going to be changing here.

I would say the estate provisions where we know there's going to be changes coming a few years down the road regardless of what happens this year, those are probably things you want to start really planning for maybe ready to take advantage of. Some of the other things that might be changing--we've got a little bit of time yet this year, let's kind of see how it plays out. The reality is most people don't have a lot of flexibility in moving their income or their deductions from one year to the next. There isn't a lot you can do in some of those. But some of the retirement plan things, there may be some opportunities to take advantage of strategies this year before they go away.

Benz: I'm wondering if you can summarize some of the highlights of this proposal. There's a lot in it, but it does seem like $400,000 if you're a single filer and $450,000 if you're married filing jointly. Those are the big thresholds for a lot of these changes. Can you summarize some of the changes that will be contained within this proposal?

Steffen: Sure. The latest proposal, if it goes through as has been talked about, the headline components are probably the increase in the top marginal tax rates. So, what would happen is for married couples, you'd see any income over $400,000 actually would be taxed at a higher rate. $450,000 is the big jump. That's where you're going from up to 39.6%. There's actually a window between $400,000 and $450,000 where there's still a tax increase. For singles, it starts at $200,000, but again, the big jump is really at $400,000 when you get up to that 39.6% rate. So, that's kind of the headline one. That would take effect next year.

The other bigger one that's got people's attention is an increase in the top capital gain rate. Today, that's 20%. The new rule would be 25%. But what's complicated about that one is that it would be retroactive. If this bill passed today, we already be under these new rules because the effective date on that was roughly Sept. 13. So, whether that stays that way or not remains to be seen, but those are the two big ones for individuals. There are some changes in the corporate tax side as well. We won't get into those necessarily. But on the individual side, those are the big ones. Again, a lot of things on the retirement plan side that are pretty interesting: forcing distributions out for those with super large accounts, limiting some of the contributions and rollover and conversion techniques, which we can get into. But I'd say the headline ones are those two on the tax bracket side.

Benz: Let's talk about some of those retirement-plan-related provisions. And what I want to home in on is the backdoor Roth IRA and the mega-backdoor Roth IRA. Can you talk about how the proposal addresses them, and why it's seeming like many people think this whole backdoor thing may be over for people who had been taking advantage of it?

Steffen: It sure seems like the party is coming to an end on the backdoor Roth. Just real quick on the backdoor Roth: It's been a technique that allows people who otherwise couldn't contribute to a Roth IRA because they exceed the income thresholds to still be able to get money into the account but doing it via the traditional IRA. So, you put the money in the traditional, you immediately convert it into the Roth. And if you got the right combination of circumstances, that can be very effective. It was always a little bit uncertain, certainly not what Congress intended when they created these rules that allow this to happen. But it's been one of those things, "All right, you've found a loophole, go ahead and do it, we're going to figure out a way to stop this one of these days." And it seems like now they've decided they're going to stop it.

So, the two things that are in this proposal that would limit the ability to do this. One is the regular backdoor. What they're basically saying is you can no longer convert dollars into a Roth IRA that wouldn't have otherwise been taxable when you took them out of the traditional IRA. That basically says any money you put into an IRA on an aftertax basis can't be converted to a Roth IRA. That basically is the whole backdoor Roth conversion in a nutshell. The other one they've done is for the mega-backdoor Roth, which is, again, a technique that's been around a while, but it's got a newer term to it. That one affects more employer plans where people were putting in some cases tens of thousands of dollars into an aftertax 401(k) plan and then immediately converting that to a Roth 401(k), or in some cases, even taking it out and putting it into a Roth IRA. The proposal here would say you can't put aftertax money into a retirement plan anymore, into an employer plan, which would effectively kill the mega-backdoor. So, those two techniques would end after this calendar year.

This is one of those, as you're talking about, "What should people do in anticipation of this?" If you're one who's done the backdoor or the mega backdoor in the past, I would make sure you get it done before the end of this year. There is no guarantee you're going to be able to do it after the end of this year. So, get hopping on that one if you can.

Benz: It seems like if you have straggler aftertax amounts that haven't yet been converted for whatever reason, get that done as well?

Steffen: It sure seems like that's what you're going to want to do. Now, if you've got that blended with some pretax money when you do the conversion, it's pro rata. So, you're going to have to get that aftertax money out; you also have to take the pretax money out from your IRA. So, there's a tax cost to doing that conversion. The great thing about the backdoor is if you did it right, it was tax-free. If you've got aftertax dollars you want to get out of your traditional and into a Roth, this may be your last chance to do it.

Benz: I also want to talk about one thing that is not in this proposal that had been widely anticipated potentially to be in the proposal, which is some sort of cap on the unlimited step-up in capital gains that heirs can take advantage of when they inherit assets. Can you talk about that, Tim, whether this was surprising to you and what you think the implications of this might be from an estate-planning standpoint?

Steffen: It's long been assumed there was going to be some sort of change to estate tax system as part of this. Candidate Biden talked about it a year ago and as he's become President Biden, it's been high on his radar. And back in May when we got the most recent big proposal, there was one in there that said the basis adjustment at death was going to go away. What that means is, when you die, any asset in your name would get its basis stepped up or stepped down to its market value at the day of death. So, if you've got highly appreciated securities, a business, a home, all of those with a capital gain, it would go away. It doesn't impact retirement plans, annuities, those kinds of things. But those highly appreciated stocks you've been holding forever that you didn't want to sell because of the gain, death made that gain go away. Well, the thought was that that provision was going to go away and that was the proposal we've been working off of all summer. When the bill finally came out, or the first cut of the bill anyways came out, that wasn't there, it was gone. They instead went back to accelerating the reduction in the estate tax exemption, so effectively cutting the estate tax exemption in half from roughly $11.7 million now to what would probably be much closer to $6 million next year. That was how they were going to solve the issue of these large estates avoiding tax.

It was a little bit of surprise. We really thought the basis adjustment was going to be impacted. It's one of those where if it was ever going to go away, it felt like this is the year it was going to happen. Again, it still may come back, but the fact that it didn't make it into this bill tells me that they probably didn't have the votes to get it in there. So, they thought, "Why waste our political capital on this one? Let's try it with something else. This one was going to be a nonstarter." From an administrative standpoint, that's great news because trying to recapture all those old cost-basis numbers would have been a mess. Now, we can go back to not worrying about cost basis and just getting our basis adjustment at death if it stays this way, and we'll deal with the estate tax in a different way. So, again, not out of the woods yet, could always come back in the final bill, if there is a final bill. But as it stands right now, the basis adjustment at death is going to stick.

Benz: Tim, such a helpful overview as always. Thank you so much for being here to talk us through it.

Steffen: Thanks, Christine.

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