It’s looking like 2020 will be the last certain year of low tax rates.
We know that current rates are scheduled to expire after 2025. Now that we know there will be a Joe Biden presidency, the tax laws from 2021 through 2025 could change greatly. Although we have a general idea of Biden's tax proposals, we don't know what impacts the economy and a probable Republican Senate will have on those proposals. And, we don't know what, if any, provisions will pass in 2021. One thing we do know: Tax rates will not be going down.
In my last column, I looked at year-end 2020 tax-planning strategies. In several areas, including capital gains and estate planning, expectations for higher taxes ahead potentially mean acting now.
In this column I’ll go deeper into the possible tax landscape under a Biden Administration.
Part of the challenge in assessing the future path for of tax rates is that Biden's tax proposals have been lacking in many details. He has stated that taxes will not increase for anyone with income under $400,000. As with other references to "income" in his list of tax changes, there is no clarification as to whether the $400,000 applies to both married and single filers; nor is there clarification of whether "income" means gross income, adjusted gross income, or taxable income. Other parts are also nebulous. However, there's enough information to be able to compare current laws to Biden's vision. Biden's major tax provisions include changes in individual income taxes, estate and gift taxes, corporate taxes, and Social Security taxes. Most of the proposals result in higher taxes.
Individual Income Taxes The Tax Cut & Jobs Act, or TCJA, lowered tax rates (especially for high-income taxpayers) while cutting deductions (like state and property taxes) and increasing the standard deduction amount. Biden's proposals change the top individual rate from 37% to 39.6%. Since this tax increase provision contains no details, commentators disagree on whether the higher tax applies at the prior highest bracket or on all taxable income above $400,000. Capital gains tax would jump to 39.6% to the extent income (presumably taxable income) exceeds $1 million.
Itemized deductions would be reduced $3 for each $1 of income in excess of $400,000. (My guess is that income, in this instance, refers to adjusted gross income.) Additionally, the tax benefit from itemized deductions will be capped at 28%. In other words, itemized deductions cannot offset taxes above the 28% rate. It also appears that Biden would seek to remove the current $10,000 limit on state and property taxes.
Other individual tax proposals include the elimination of the Qualified Business Income deduction when income exceeds $400,000; increased credit amounts for dependents and children as well as child care; and a new credit for elder care. Biden proposes an advance credit of up to $15,000 for new homebuyers that can be used toward the down payment, as well as a credit for renters to bring the cost of rent down to 30% of income. Finally, retirement contributions, such as 401(k)s, would result in a credit (estimated at 26%) rather than a reduction to wage income. The impact of this would be to "equalize" these tax benefits no matter the taxpayer's income. Note: By eliminating the deduction, retirement contributions will no longer reduce adjusted gross income and thus, certain phase-outs would be accelerated.
Estate and Gift Taxes Biden intends to decrease the current estate and gift exemption from its current $11.18 million per person to pre-TCJA levels. Since it is unclear which "pre-TCJA" levels would be selected, the new limit has been estimated at a low of $3.5 million to as high as $6 million. Thus, although we don't know the exact amount proposed, it seems that new estate exemptions will likely be no more than half of current amounts.
Two surprising elements in the intended changes are the elimination of basis step-up at death and the treatment of death as a "realization event." This means that appreciated assets will be treated as sold upon death of the owner. Both of these concepts are major deviations from current law. As such, I personally do not believe they will be enacted.
Corporate Taxes The current corporate tax rate of 21% would be increased to the pre-TCJA rate of 28%. Much will depend here on the results of the Georgia Senate run-off elections. The biggest impact here could be ripples in the stock market.
Social Security Social Security taxes are currently imposed on wages or self-employment earnings of up to $137,700. The tax rate is a total of 12.4%. In the case of wages, this amount is split between the employer and employee. For earnings over $137,700, no Social Security tax applies. The Biden tax plan would not change this structure until wages or self-employment earnings exceed $400,000. For earnings above $400,000, the full Social Security tax would apply. This proposal essentially creates a "donut hole" where no tax is payable for earnings between $137,700 and $400,000.
To Plan or Not to Plan To enact new tax laws, Biden will need the support of a majority in both the House and Senate. If the Georgia runoff election results in a Democratic majority in the Senate, many of Biden's proposals will become law. However, if we continue to have a Republican-controlled Senate, it is likely that new tax laws will not be enacted prior to 2023 (after midterm elections), with the possible exception of the Social Security tax increase.
So how do we plan? In my opinion, we must assume that these new rules will apply in 2021 and later. To the extent any strategy would put the client in a worse-off position should new laws not be enacted, that strategy should not be recommended.
Morningstar Office clients can find more tax planning articles like this one, here.
Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and principal 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 views expressed in this article do not necessarily reflect the views of Morningstar.