Financial Planning Insights
8 minute read time
Director of Wealth Strategy, Joe Maier, explains various tax planning opportunities you might want to take advantage of before they are gone. Consider how proposed legislation could influence capital gain rates, social security taxes, and the estate and gift tax system. If you’re looking to maximize your results by minimizing tax exposure, it’s important to meet with your advisor to discuss what these proposed changes, if implemented, would mean for your plan.
As I have mentioned in several previous posts, your financial success is based upon having a thoughtful plan that hinges on your behaviors, tax minimization and investment performance. Given that one of your pillars of success is minimizing what you pay in taxes, planning in an election year generally takes on a little more urgency. And when the challenger is leading in the polls this late in the election season, it is wise to consider what that candidate’s tax plan could do to your planning, and, if possible, take advantage of opportunities available under the current law. With that in mind, let’s look at some planning opportunities you might want to take advantage of before they are gone.
Under Joe Biden’s proposals, for taxpayers with a certain level of taxable income, the long-term capital gains rate would increase from 20% to the higher ordinary income rate (as much as 37% currently; 39.6% proposed). 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, if your annual taxable income exceeds $1 million (the current threshold level for most of Joe Biden’s tax changes), you might want to consider selling capital assets before the end of the year. For those closely held business owners who are negotiating a sale of their businesses, while you might otherwise have held off the sale date until January 1, 2021 to defer the payment of income taxes for an additional year, you might want to accelerate the closing date to 2020. Finally, if you are close to that threshold level of income and have the opportunity from your employer to defer a material portion of your compensation income, you might want to defer sufficient income to drive your total taxable income below that threshold level.
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. Finally, if deferring income causes greater risk of future payment due to an employer that is financially insecure, it is better to receive lower after-tax income now than an empty promise to be paid in the future.
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 $138,000). 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, the solutions are similar to capital gains. For employees who have the ability to defer income, they could potentially defer enough to get below the threshold. But before taking that step, there are three considerations. One, as mentioned above, you should consider your employer’s financial viability. 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. Application of the ordinary income tax rate on capital gains only applies if ordinary income is already over $1 million, or to the portion of capital gains that go beyond the $1 million threshold. For example, if you have ordinary income of $950,000 and $100,000 of realized long-term capital gains the first $50,000 of realized long-term capital gains will be taxed at the current 20% (plus 3.8% Medicare surtax) rate and the second $50,000 of realized long-term capital gains will be taxed at the highest ordinary income tax rate of 39.6% (plus 3.8% Medicare surtax).
Currently, a taxpayer has the ability to transfer, either during life (a gift regulated by the gift tax) or at death (a bequest regulated by the estate tax) property valued at $11.58 million without the imposition of a transfer tax. Any property transferred by the taxpayer (over the course of his or her lifetime) in excess of this value is taxed at 40% of the value of the transferred property. The $11.58 million exemption is scheduled to be cut in half (leaving more taxable exposure) on December 31, 2025.
This is an area where there is the least clarity on what the Biden proposal entails. The democratic platform early in the 2019 primary season was to reduce the exemption to $3.5 million. Since then, the Biden proposal can be read to “push the 2025 reduction forward” to 2021; in other words, cutting the exemption in half. Either way, for taxpayers with eight figure net worth, there should be strong consideration to make gifts before the end of the year considering the potential reduction in the exemption. For clients considering this strategy, it is important to engage counsel soon to begin crafting the tools (trusts, documents of transfer, family owned investment entities) to execute these transfers in the next three months. Also, if clients are concerned that such gifts require a complete loss of control and influence, click here to read more about spousal trusts and estate planning.
Another reason to consider giving this year is the removal of the stepped-up basis under the Biden plan. Right now, lifetime giving of appreciated (or appreciating) property requires a trade-off between the transfer tax and income tax consequences of the gift. If the taxpayer continues to own the property, any appreciation in the property that exceeds the transfer tax exemption will be subject to a 40% estate tax. However, the recipients of the property will inherit the property with a fair market value income tax basis (known as a “stepped-up basis”); all of that appreciation avoids income tax. Conversely, if the taxpayer gives the property away, the appreciation is not subject to transfer tax. However, if the property is sold, that post-transfer appreciation is subject to income tax. The Biden proposal eliminates the stepped-up basis, leaving lifetime gifts with no income tax tradeoff for their transfer tax benefits.
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). First, the Biden tax plan, as it is constituted, seems unlikely to be drafted and passed in its current form unless not only Vice President Biden wins the election, but the democratic party also holds onto their majority in the House of Representatives and hold fifty seats in the Senate. Second, 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 legislation has passed in the first term. And given that any income tax legislation could be retroactive to the beginning of the tax year, the only safe move to avoid the impact of potential tax legislation is to take action in 2020.
With that in mind, in thinking about what to do between now and the end of the year to maximize your results by minimizing tax exposure, it is critically important to be aware of the presidential challenger’s tax proposals. It is important to meet with your adviser to discuss what those changes, if implemented, would mean to your plan. If those changes would have negative consequences, it is important to work with your adviser to determine what can be done to avoid those consequences and whether those solutions have countervailing risks that could have greater negative economic impact than the tax itself. At the end of the day, it is important to engage in planning led by your planning team: (1) understand your goals, (2) understand your plan’s assumptions, (3) understand the risks of tax change, (4) understand where those risks could impact your plan, (5) discuss scenarios to change the plan to avoid those risks, (6) evaluate the risks of making those changes and (7) make the changes that provide your plan the best chance of maximizing your happiness.
* Johnson Financial Group and its subsidiaries do not provide legal or tax advice. Please consult your attorney or tax advisor with respect to your personal situation.