As financial planners, we understand that taxes and tax management can have a significant impact on an individual’s finances.
In fact, bad tax management can have negative consequences for the health and strength of a financial plan. So when we do a financial plan for a client, we look carefully at their tax situation and how it could be improved in order to strengthen their financial plan outcome.
As planners, it is important for us to have an understanding of the Biden administration tax proposals and how they could impact our clients.
Here are few of the proposed changes that we believe could have a more significant impact on individuals: 1) raises the top tax rate on incomes above $400,000 from 37% to 39.6%; 2) increases the tax rate on long-term capital gains and qualified dividends from 20% to 39.6% for individuals earning over $1,000,000; 3) eliminates the stepped up basis for inherited assets; 4) increases social security tax on individuals earning over $400,000; 5) caps itemized deductions at 28% for those earning in excess of $400,000; 6) reverts gift and estate tax exemption back to 2009 levels.
We believe it is highly unlikely that all of these proposed changes will sail through Congress in their current form. The Congressional balance now is very tight which makes passage of all these proposals problematic. But one thing we believe has pretty high likelihood and that is taxes will be going up over the next several years.
So how do we as planners, prepare our clients for these changes, especially when it is early and no one knows exactly how this will all play out? Or put another way, how can we help clients best manage their “tax risk?”
There are several avenues for us as financial planners to help clients with this dilemma.
First, we can use our planning skills to run scenario analyses of different tax strategies. For clients with estate planning implications, it could make sense to take some capital gains this year (assuming elimination of the basis step up is not retroactive) and also possibly accelerate some gifting under the current lifetime exclusion as a means of “hedging” potential reductions in the lifetime exclusion. For certain clients, it could also make sense to accelerate Roth conversions.
Although our understanding now is there may not be significant changes in tax brackets below 37%, bracket “creep” and potential for some adjustments in the tax brackets could be an issue and it may make sense in some cases to accelerate Roth conversions.
Also, for some individuals, it could make sense to increase holdings of municipal (tax free) bonds as means of reducing taxable income. The overriding notion here, of course, is the tax situation is highly fluid and could change substantially from current proposals.
We will have to see how the Congressional debate plays out and see what is actually passed in order to have a higher degree of certainty with any of this.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.