By Brian Littlejohn, CFP
The Tax Cut and Jobs Act (TCJA) of 2017 provided meaningful tax benefits for the wealthiest Americans, who tend to generate more income from appreciated assets and pass on larger inheritances than lower earners. Many TCJA provisions are set to expire at the end of 2025. However, wealthy individuals and families may see their taxes increase as early as 2022 as Democrats attempt to raise money for a $3.5 trillion spending plan.
Revisions to the tax code remain in flux. Nevertheless, affluent Americans may want to prepare for the changes President Biden and certain members of Congress are proposing—specifically, a higher capital gains tax rate and lower estate tax exclusion.
Here’s how proposed tax changes may impact wealthy Americans:
Capital Gains Tax
On September 13, House Democrats proposed raising the top federal tax rate on long-term capital gains and qualified dividends from 20% to 25%. An existing surtax of 3.8% on net investment income means the top federal rate would be 28.8%.
Beginning in 2022, single taxpayers with income exceeding $400,000 ($425,000 for head of household and $450,000 for married couples filing jointly) would be impacted by the proposed increase. Currently, the income threshold to incur the top rate is $1 million.
As a reminder, long-term capital gains are generally incurred when an investor sells an appreciated asset after holding it for at least one year. If the proposed legislation goes through, the higher tax rate would apply to all long-term capital gains realized after September 13, 2021.
Marginal Income Tax
Beginning in 2022, House Democrats’ proposed tax legislation would also create a 3% surtax on modified adjusted gross income exceeding $5 million. Furthermore, the proposal raises the top marginal income tax rate, currently 37%, to 39.6%.
The proposal would fast-track expiration of the TCJA’s estate tax exemption, which is currently scheduled to sunset at the end of 2025. This would lower the current exemption of $11.7 million to $5 million for individual taxpayers. In addition, House Democrats propose limiting several existing estate-planning techniques—for example, some uses of grantor trusts and asset transfers with discounted values.
An important difference in President Biden’s proposed tax plan is that it would impose the capital gains tax on appreciated assets upon the owner’s death, with certain exemptions. Currently, owners can leave appreciated stock and other property to their beneficiaries without triggering the capital gains tax.
Additionally, existing tax law allows for a step-up in cost basis when assets are transferred at death. In other words, the beneficiary’s potential tax liability may be reduced if they sell the appreciated asset, since the original cost basis no longer applies. It’s important to note the House plan maintains the status quo for appreciated assets transferred at death.
Qualified Retirement Accounts
The proposed legislation would also change the way some wealthy Americans use individual retirement accounts and 401(k) plans. For example, high earners with qualified retirement accounts exceeding $10 million would no longer be able to contribute to those accounts.
Moreover, these individuals would be required to take significantly higher distributions once their account balance reaches $10 million. These provisions would apply to individuals with taxable income above $400,000 and married couples earning more than $450,000.
Preparing for Potential Changes to the Tax Code
These proposed changes would target the wealthiest Americans, undoing several provisions in the tax code that historically have benefited high-net-worth taxpayers. Those who earn most of their income through investments may see a sharp spike in their tax bill if the capital gains tax increases. In addition, some beneficiaries may see a larger portion of their inheritance go to Uncle Sam.
Of course, no one knows yet what the final legislation will look like. However, now may be an appropriate time to review your financial and estate plans with a trusted advisor and look for opportunities to minimize or offset taxes going forward.
About the Author: Brian Littlejohn, CFP®, CFA®
Brian Littlejohn, CFP®, CFA® is the founder of Sherwood Wealth Management, a boutique wealth management firm located in Glenwood Springs, Colorado. As a fiduciary financial advisor, Brian helps his clients navigate the complexities of sudden wealth.
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