“Uncertainty” and “change” were defining words for most aspects of life in 2020, and those words could also describe the tax landscape in 2021. During his 2020 presidential campaign, President-elect Biden proposed increasing taxes on high-income Americans and corporations, expanding tax credits, and implementing a host of other significant tax changes.
Even though Democrats will control both chambers of Congress, it is far from certain that Biden will have enough support on Capitol Hill to pass all aspects of his tax agenda. Furthermore, it is unclear when any changes would take effect. But it is never too early to start thinking about how these potential changes could affect you.
Major components of Biden’s tax proposal.
Based on Biden’s proposals, here are some of the most significant changes that the incoming president could pursue:
- Top ordinary income tax rate increase: The Tax Cuts and Jobs Act reduced the top marginal tax rate on ordinary income from 39.6% to 37.0% starting in 2018. Biden proposes returning this top rate to 39.6%. It is unclear what income level this top rate would apply to, but during the campaign Biden proposed generally increasing taxes on people who make more than $400,000.
- Capital gains tax rate increase: Under Biden’s proposal, the maximum capital gains rate of 20% would increase to 39.6% for those whose annual income exceeds $1 million. And because the 3.8% net investment income tax would still be assessed, the top capital gains rate would actually be 43.4%. If you are in this income bracket, this change could greatly affect your decisions on when to sell appreciated assets.
- Payroll tax expansion: Currently, you aren’t assessed Social Security tax on any income beyond the Social Security wage base, which is $142,800 in 2021. Biden’s plan would extend the payroll tax to workers’ income in excess of $400,000 a year, leaving a “doughnut hole” in which income between the current $142,800 wage cap and $400,000 amount wouldn’t be taxed. The Social Security tax is 12.4%; self-employed people pay that full amount and employees pay half that amount, 6.2%.
- Stepped-up basis at death: Currently, when you inherit an appreciated asset, your tax basis increases, or “steps up,” to its fair market value at the time you inherit the asset. As a result, you only owe taxes on any additional appreciation that occurs from that point on. Biden has proposed eliminating the stepped-up basis rule and instead having the previous owner’s basis “carry over” to you as the beneficiary. This could be a very significant change for families that own assets, such as homes or stocks, that have appreciated dramatically since they were first acquired.
- Estate and gift tax exemption decrease: Currently, the unified federal estate and gift tax lifetime exemption (the amount people can pass on at death free of taxes) is $11.58 million per individual ($23.16 million per married couple). This amount is now set to automatically “sunset” at the end of 2025 and return to $5 million per individual ($10 million per couple), adjusted for inflation. Biden’s tax plan would reduce this amount to $3.5 million ($7 million per couple) and limit the amount individuals can transfer in gifts to $1 million.
- Corporate tax increase: Biden’s plan would raise the corporate tax rate to 28%. This is above the current 21% rate that has been in place since 2018 but below the previous rate of 35%.
- Tax credit for retirement plan contributions: In place of the current deductibility for retirement plan contributions, Biden has proposed providing a tax credit for contributions to 401(k)s, traditional IRAs, and other types of qualified retirement vehicles. Biden’s proposal would provide an estimated 26% refundable tax credit for each $1 contributed. Because the credit would be refundable, you would receive the full credit even if it is more than what you owe in taxes. The downside, however, is that for some people in a tax bracket higher than 26%, the credit may be less valuable than the current deduction system.
- Child tax credit increase: Biden’s plan would increase the child tax credit, which phases out for higher-income taxpayers, to $3,000 per child (up from $2,000) for children ages 6 to 17 and $3,600 for children under six; the credit would also be fully refundable. Biden has also proposed expanding the child care and dependent care tax credits.
Other changes that Biden has proposed include capping the value of itemized deductions for high-income taxpayers, creating tax credits for first-time homeowners and renters, forgiving student loans and excluding that forgiveness from taxable income, and creating and/or expanding tax credits for clean energy.
Will changes be enacted—and when?
Predicting what will happen in Washington is difficult under any circumstances; doing so during a pandemic is even more challenging. While the Democrats will control the White House and both chambers of Congress, the Biden administration will likely face challenges in passing his ambitious tax agenda in its entirety.
Responding to the pandemic will likely occupy much of the Biden administration’s time and energy in the first part of his term. In addition, Democrats hold the Senate by the slimmest possible margin; given the apparent results in the Senate runoff races in Georgia, the Senate will now be split 50-50, with Vice President Harris essentially giving Democrats the tie-breaking vote. Democrats also saw their margin in the House of Representatives decrease in the November elections. As a result, Biden would likely need some degree of bipartisan support to pass some elements of his tax plan.
The timing of when any plans would take effect is uncertain as well. Democrats may wait until 2022 to pass any changes, or they could seek to make the changes retroactively apply to the full year of 2021.
What can you do?
Even with this uncertainty, you may still want to be proactive in your tax planning. Our tax specialists at Leelyn Smith can help you identify the most tax-efficient way to pursue your goals in light of potential tax law changes.
Possible strategies that could make sense, depending on your individual situation, include:
- Examining the gifting structure you have established for your family and beneficiaries, keeping in mind the potential decrease in lifetime gifting exemption. Of course, until there is a clear indication that this exemption will dramatically decrease, you won’t want to radically restructure your estate plans.
- Making charitable gifts of appreciated stock if the capital gains rate increases. You could make your gifts through a donor-advised fund, or, in many cases, larger and mid-sized charities are set up to receive stock donations directly. Speak with your financial advisor to evaluate and initiate this type of transaction.
- Reviewing your allocation of tax-preferred investment assets if you are in one of the top tax brackets. This could be a key move if the capital gains rate does increase for people with income in excess of $1 million.
Regardless of what is in store for our tax laws, there are some “all-season” moves to consider:
- Fully fund your IRA. You have until April 15, 2021, to fund your Roth or Traditional IRA for the 2020 tax year.
- Review your quarterly tax payments. If you pay taxes quarterly, review the amount you are paying in relation to your income. If your income has increased significantly, either through earned income or portfolio income, you may need to adjust your quarterly payments.
Talk with us about potential tax changes.
While no one can know exactly what tax changes will come out of Washington, our tax specialists are closely monitoring these developments. This allows us to be ready to help you prepare for, and respond to, any changes that can affect your ability to achieve your long-term financial goals.
We encourage you to schedule a time to talk with us early in 2021 to review your tax situation. We can help you prepare for filing your 2020 taxes in April while also developing a strategy for responding to whatever changes may come.
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