Now that the election has passed, it’s important to review your financial plan to prepare for potential upcoming tax legislation. Learn how to divide your wealth into buckets based on your financial situation, understand the impact of the proposed long-term capital gains rates, and consider various factors before deferring your income. Most importantly, work with a trusted financial advisor who can help you assess and evolve your existing plans.
Now that the election has passed and Joe Biden is President and Democrats control both houses of Congress, it’s time to update our pre-election guidance on critical tax-planning topics. Here are three of the most important areas for watching—and potentially acting—in the year ahead.
Currently, the transfer tax exemption (the amount that can be transferred tax free) sits at $11.7 million. If a married couple works collectively to transfer their wealth to their children, they can transfer $23.4 million without any transfer taxes. That amount is indexed to increase every year.
On December 31, 2025, that exemption amount is scheduled, by law, to be cut in half. But with full control of government, it looks likely that Democrats will seek to reduce the exemption this year, to an amount somewhere between $3.5 and $5.85 million.
With all these factors in play, it is critical, as soon as possible, to prepare a financial plan. That plan should be focused on dividing your wealth into two “buckets.” Bucket one is your assets and income that you expect to spend during your lifetime. Let’s call that bucket your “independence bucket.” The second bucket is the remainder of your assets, those you will not spend during your lifetime. That is the legacy bucket. And the threshold question is “what is the value of that legacy bucket?”
- For married couples whose legacy bucket is less than $7 million (or single persons whose legacy bucket is less than $3.5 million): There is nothing in the current state of transfer tax policy to concern themselves with. They will not be subject to transfer taxes, even if the lowest currently discussed exemption of $3.5 million is adopted.
- For married couples whose legacy bucket exceeds $7 million but is less than $23.4 million: The main objective here would be to transfer assets in a way that removes them from the couple’s gross estates but gives the couple access to those assets if they need them for their wishes, hopes, dreams and desires. I recommend meeting with financial and legal advisors sooner than later to get plan revisions in motion. There are millions of other people watching the same dynamics, and that may slow down the process of getting legal documents drafted and filed.
- For married couples with a legacy bucket of more than $23.16 million: The goal is, as quickly as possible, to meet with your advisors and give away $23.4 million worth of legacy assets, without transfer tax consequences, as soon as possible. Simply put, the exemption has never been larger than it currently is, and it should be taken advantage of before it is lowered.
Rates Under Joe Biden’s proposals, for taxpayers whose taxable income exceeds $1 million, the long-term capital gains rate would increase from 20% to 39.6%. Long-term capital gains are triggered when you sell a capital asset that you have held for more than one year for a higher price than you paid for it.
So any such taxpayer might want to consider selling capital assets before the end of the year. The most obvious example of such a taxpayer and transaction (those over $1 million incurring a capital gain) are business owners who are selling their businesses. So for business owners contemplating the sale of their business, they should quickly assemble their advisory team to begin analyzing the positives and negatives of putting the business up for sale before the tax law changes.
All of this should be considered by remembering that tax minimization is merely one pillar of plan success. No action should be taken if the risk of economic loss is greater than the potential tax savings. For example, it would not benefit a business owner, who is not deep in the sales process, to inappropriately rush through the sales process; that type of “desperation” typically leads to giving the buyer tremendous leverage that reduces purchase price. Or for a business that has been impacted by the recent pandemic, selling the business when there is less uncertainty about future prospects is more strategically sound than trying to rush for tax savings.
Under the current employment tax system, employees and employers each pay a 6.2% social security tax on wages under a threshold amount (this year, approximately $142,800). Under the Biden tax plan, taxpayers and their employers would also pay that tax on wages above $400,000. So if you make more than $400,000 in wages, those in excess of $400,000 would be less valuable to you.
From a planning perspective, employees who have the ability to defer income could potentially defer enough to get below the threshold. But before taking that step, there are three considerations. One, you should consider your employer’s financial viability. Any funds you defer as an employee are subject to the claims of your employer’s creditors. Second, to avoid social security tax on deferred wages, not only must they not be withheld, they cannot be vested. Lack of vesting creates more economic risk of deferral. Finally, unlike capital gains where the entire gain is taxed at the ordinary income rate if your taxable income exceeds the threshold, with social security, you are only taxed on your wages above the threshold.
This analysis would be incomplete without some discussion about the process of the Biden tax plan becoming a law (as the music for the Schoolhouse Rock classic “I’m Just a Bill” plays in the background). Even with control of both houses of Congress, bills of this magnitude take a material amount of time to draft, discuss, and debate. Classically, major legislation tends to pass in the second year of the president’s first term, in this case 2022. But major legislation has passed in the first term. Now’s the time to take a close look at your existing plans with your advisor and how to evolve them. Contact your Johnson Financial Group Advisor or find one today.