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What Retirement Savers Need to Know About Capital Gains Tax Changes

Robert Powell reviews proposed changes to long-term capital gains tax and to estate and gift taxes.

President Joe Biden recently announced his individual tax proposals, which include a 39.6% long-term capital gains tax rate, the elimination of the stepped-up basis on death, and major changes to the estate tax, gift tax and generation-skipping tax provisions of the tax law.

Given those potential changes, what might you consider doing with your assets?

Plan for Higher Taxes

“I ask every client what they think their tax rate will be in the future and most respond with higher,” said Jon Gassman, the CEO of Gassman Financial Group. “At the same time, we know what the current rates are and what the proposal looks like from all the camps. In the short-term, our clients are looking for ways to lock in their rate today and not kick the tax can down the road with guesses.”

Given that, Gassman said now is a good time to convert from a traditional IRA to a Roth IRA. “Money inside the Roth grows tax-free, not tax deferred, and when distributions occur, they are tax free versus taxable,” he said.

And by converting now, you lock in the current tax rate.

At the moment, Gassman said annual Roth IRA conversions rather than a total account conversions make sense for retirees in lower brackets.

Gassman also noted that the SECURE act, which was signed into law in 2020, changes the way beneficiaries -- for the most part -- have to take their distributions.

“Prior to the SECURE Act, a beneficiary could take their required distributions over their life expectancy,” he said. “Under the SECURE Act all the money is to be distributed by the end of the 10th year. For some beneficiaries this would cause them to pay more taxes due to their distributions pushing them into a higher tax bracket.”

Ultimately, he said, if you pay the income tax today the heirs will pay less taxes later. “Plus, to the extent you pay the tax today this will also reduce your estate by the tax paid thereby reducing the taxable estate if your estate is over the proposed estate exemption amount,” said Gassman.

Income Acceleration

This tactic may not be appropriate for all taxpayers but it must be considered, said Gassman.

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Under Biden’s proposals, Gassman said an increase of the top tax rates on personal income (from 37% to 39.6%), capital gains (from 20% to 39.6%) seems like a no-brainer for high-income individuals to think about accelerating income.

Other Considerations

Selling appreciated securities now: “Locking in the current 20% capital gains rate or perhaps lower makes it palatable to biting the tax bullet,” Gassman said. “We have had a significant run up in the markets since last March." 

"The Dow Jones hit bottom around 19,000 and is now trading at 34,000," Gassman said. "Many investors have not rebalanced and are overweight in equities. Taking money off the table, paying the tax and then rebalancing makes sense for those that have had their asset allocations shift off course. At the same time, individuals holding significant concentrated positions may want to take some chips off the table. Concentration builds wealth but diversification protects the wealth."

"A 20% tax is far better than 39.6% tax. Pay the tax and repurchase the shares, giving you a new basis for determining sales later,” Gassman said.

Taxpayers for whom a large portion of their compensation is equity-based, such as non-qualified stock options, control when they exercise the options. “This type of option generates ordinary income, so locking in today versus tomorrow can save a couple of percentage points,” said Gassman.

Estate and Gift Tax Changes

Two potential laws also need to be planned for, said Gassman. In March, Sen. Bernie Sanders and the White House formally proposed a bill called For the 99.5% Act — so called because it aims to tax the wealthiest 0.5% of Americans — which proposes to change our current estate and gift tax system. The other proposed law is the Sensible Taxation and Equity Promotion Act of 2021, which “would close the stepped-up basis loophole by taxing unrealized capital gains when heirs inherit huge fortunes on which the original owner never paid income taxes.”

“Both of these proposed laws would significantly impact future estate planning as well as disrupt significantly existing estate plans,” said Gassman. He says the changes impact the amount of estate taxes that an individual may pass tax-free at death, as well as alter the effectiveness of common estate-planning techniques that are used today.

Here’s Gassman’s review of the proposed changes:

  • Estate exemption and rates: The For the 99.5% Act would decrease the estate exemption to $3.5 million, thereby reducing the exemption amount by more than $8 million. In addition, the Act increases estate tax rates, creating a series of graduated tax rates with a top rate of 65%. So, for example, if a person dies leaving an estate valued at $11 million, under today's tax regime the estate would pay no federal estate taxes. Under the proposed act the person's estate would pay approximately $4.7 million in federal estate taxes.
  • Lifetime gifts: Under the proposed law the lifetime gift exemption would be limited to $1 million. Currently the gift tax exemption is the same as the federal estate exemption amount, which allows an individual to gift their $11.7 million-dollar exemption on gifts made during life rather than waiting till death.
  • Annual gifts: The act would also place significant limitations on annual exclusion gifts. It proposes limiting each person's ability to make annual gifts to cumulative amounts equal to twice the annual exclusion ($15,000 per beneficiary) for certain types of gifts including gifts in trust.
  • Gain recognition on death: This is probably one of the most talked-about issues, the step-up in basis. Under the current tax regime, assets inherited from an estate receive a “step-up in basis” or a new basis equal to the fair market value at date of death. This essentially eliminates capital gains at death. The beneficiary only pays tax on gains accrued after death, not before. The current proposed law would eliminate the step-up in basis and cause the estate to recognize the gain on the property passing at death, as if the property had been sold, causing the gain to be subject to income tax at that time. What's also interesting about the law is that it would cause gain recognition on property transferred by a lifetime gift and it would require certain trust to pay capital gains tax on trust property on a periodic basis.

So, what is one to do as it relates to estate planning and their assets?

Review your circumstances, said Gassman. “Determine what amount of core capital one needs to maintain their lifestyle and manner of living they have grown accustomed to. From there determine how best to gift the balance to heirs and charity.”