Congress is considering two major pieces of legislation, The American Jobs Plan and the American Families Plan. The Jobs Plan proposes $2.3 trillion funding of infrastructure, to be funded by increasing the corporate income tax. The Families Plan is larger at $3.5 trillion. It contains many tax changes for individuals and families. In this article we’ll highlight the tax changes in The American Families Plan, and the implications for your financial planning.
Targeted toward high income taxpayers
The American Families Plan targets taxpayers with incomes of $400,000 or higher (with some notable exceptions.) However, lower income taxpayers can find themselves in the bull’s eye if an extraordinary event pushes their income up into the $400,000+ range. As an example, let’s say your income is $100,000 and you sell a rental property for a $350,000 gain. Your taxable income may reach the $400,000 level for this year, and your taxes could be higher under the proposed changes. While this is a one-time event, it can have a big impact if part of your wealth is lost to the higher taxes.
Tax bracket changes
The bill would increase the top ordinary income tax bracket from 37% to 39.6%. However, the top bracket kicks in at a lower income level than the current 37% tax bracket. As an example, if you are a single taxpayer and your taxable income is $420,000, you will currently be in the 35% tax bracket. Under the proposed changes, you will pass right over the 37% bracket and into the new 39.6% bracket.
Planning opportunities: If your income is above the $400,000- $450,000 range, consider accelerating any income that you can into 2021. This may allow you to pay less tax on the income.
Capital gain tax changes
A new top long-term capital gains rate of 25% will replace the current 20% rate. The higher rate will take effect at $400,000 for single filers, $450,000 for married filing jointly. This is a lower income level than the 20% rate takes effect now.
Not only will the new higher rate take effect at a lower income level, but it is slated to take effect immediately. Unlike the proposed change to ordinary income tax rates, the 25% capital gains rate would apply to long-term capital gains incurred on or after September 14, 2021.
There is a narrow exception to this retroactive date: an existing contract to sell an asset will be exempt from the 25% tax rate if it is a written binding contract that was entered into before September 13th, and if the sale closes before year-end.
Planning opportunities: Retroactive changes like this make it very hard to plan around. If the effective date is pushed back to January 1st, 2021, there will be a small window of time to take capital gains by year-end. This may present a limited opportunity to pay less taxes on those gains.
Roth IRA restrictions
The American Families Plan would prohibit Roth conversions of after-tax dollars, beginning in 2022. This includes money held in IRAs and employer-sponsored retirement plans, such as 401(k)s). The changes would negate popular strategies such as the “Backdoor Roth IRA,” and the even more powerful “Mega-Backdoor Roth IRA,” which rely on rolling after-tax contributions into a Roth IRA, where future appreciation is tax-free.
Planning opportunities: If you have any after-tax contributions in a retirement plan, now may be the last chance to roll it into a Roth IRA.
Restrictions for Mega-sized Retirement Accounts
The proposal would create new RMD requirements for individuals with high incomes and very large retirement accounts (more than $10 million), regardless of their age. The high-income threshold would be Adjusted Taxable Income of $400,000 for single filers, $450,000 for joint filers. The “Mega-Sized” threshold would be applied by adding up all pre-tax retirement plan and IRA assets in the taxpayer’s name. The RMD would be 50% of total retirement account dollars in excess of $10 million.
Another provision would similarly place a RMD requirement on Roth IRA assets in excess of $20 million.
Planning opportunities: If your retirement accounts add up to these “mega-size” amounts, consider a partial distribution this year. Note: If you are under age 59 1/2, a penalty would apply to a distribution this year, while under the proposal, the penalty would be waived for the RMD distribution.
Estate and gift tax exemption reductions
Four years ago, the Tax Cuts and Jobs Act doubled the unified estate and gift tax exemption from (an inflation-adjusted) $5 million to $10 million. That change was temporary, however. It was due to “sunset” automatically in 2026. The proposed bill speeds up that timeframe to 2022. If passed, the proposal would reduce the exemption amount to about $6 million in 2022.
Planning opportunities: For taxpayers with estates larger (or projected to be larger) at death than the lower exemption amount, it may make sense to use up the current exemption amount by gifting assets before the end of the year. The gifts can be outright gifts to family or charities, contributions to charitable vehicles such as Donor Advised Funds, accelerated funding of 529 Plan accounts, or funding of certain irrevocable trusts.
Expanded Child Tax Credit
Here is a provision that affects families with income under $400,000. The Child Tax Credit will be increased to $3,000 and extended until 2025. This is a refundable tax credit, meaning you get cash back if the credit is more than your tax bill, and under the proposed changes the cash back will be paid monthly in advance. This means families with dependent children and low enough income will in effect receive direct support payments from the IRS. To the extent the Child Tax Credit is overpaid in monthly advances, it generally only must be repaid in cases of fraud, intentional disregard of the rules, or deliberate understatements of income.
There is a unique flexibility provision aimed at helping those with volatile income qualify for the credit. Under this provision, qualification for the Child Tax Credit will be based on the lowest income from either the then-current tax year or the preceding two tax years.
Planning for the Upcoming Changes
The American Families Act is inching through Congress and may go through changes before it becomes law. We may not know the result until very close to the end of the year. This gives families very little time to react.
If your income is very high or if your estate is above $6 million, it may make sense to make a year-end move. However, it’s seldom wise to make big moves without careful consideration. Tax planning moves are always about more than just taxes- they can affect your finances and your quality of life. It’s critical to review them together with your advisors, considering your overall financial plan. Contact us to learn more about how we can help you make decisions with Clarity, Confidence and Direction.