Dear Clients & Friends,
This weekend, we are discussing the newest proposed changes to the US tax code. This is a hot topic any time such changes are considered by Congress (although, in my opinion, it seems that the voting public understands less and less about actual proposed adjustments, as the news and social media predictably distort facts in favor of flavor). So, as we often do, it’s time for our MORWM team to give you straight up data regarding these proposals.
This weekend’s article is co-authored by Anna Snyder of Temple University. Anna has been working with our team as part of her summer/fall internship and will be graduating in December with a Bachelor’s in Business Administration. We are proud to have her help us address the critical topic at hand. In fact, she wrote most of it. I added some “Ramer” to it. Our dedicated readers will know what that means.
Last week, the House announced several new tax proposals. These changes to the Internal Revenue Code are intended to raise more than $2 trillion to help fund President Biden’s Build Back Better agenda, the $3.5 trillion infrastructure bill you may have heard about. Many of the proposed rules fall short of what President Biden had called for during his presidential election campaign. Some of the changes in this proposal are controversial, such as adjustments to the rules governing individual retirement accounts. Other provisions are more obviously positive, like a new $250 above-the-line deduction for union dues, and increased appropriations for the deeply underfunded Internal Revenue Service. Many of the proposed rules are aimed at closing loopholes for corporations, but some of them may affect your financial plan. We’ve highlighted some of the most salient proposed rule changes below.
One rule would reduce the estate tax exemption, which is the amount of money and assets you can transfer to your heirs before estate and gift taxes kick in. Since the Tax Cuts and Jobs Act of 2017, the exemption has been $11.7 million per individual. With proper estate planning, we can assume this number is $23.4 million per married couple. This new proposal would return the exemption to what it was in 2010 ($5 million per individual or $10 million per married couple). This amount would be retroactively adjusted for inflation (this works out to about $6.2 million per individual and $12.4 million per married couple) and would start on January 1st of next year if the proposal becomes law. It is worth noting that this would create an urgent need for our clients to review their estate plans.
As many of you know, it is possible to make transfers to your intended heirs during your life, up to the amount of the exemption, without incurring transfer taxes. It is a common gifting strategy intended to reduce one’s estate to below the limit where taxes would be assessed. However, if one wishes to use the current exemption of $11.7 million, the transfer must be made before the new rule takes effect on January 1st of next year. Obviously, we are keeping tabs on these proposals, but the outcome remains unpredictable, especially if Congress approaches winter break without a resolution.
Though this estate tax change would affect many of our clients, according to the Tax Policy Center, the Federal estate tax applies to just one tenth of one percent of households. In 2020, there were about 4,100 estate tax returns filed, and only about 1,900 were determined to owe tax, for an approximate total revenue of $16 billion. Of course, the potential reduction in the exemption will increase those numbers, but it will still only affect a small percentage of households. We often touch on the “grander perspective” because, while we all must attend to our own best interests, our family of clientele is unique in that we try to consider the community at large as well. Nevertheless, many of our clients will be affected if this proposal becomes law.
Another change that would affect our clients is an increase in the highest capital gains tax rate from 20% to 25%, which is a substantial difference. However, as Matt loves to remind our clients, “If you’re paying taxes, it’s because you’re earning money.” This higher rate would apply to married couples earning $450,000 or more and individuals earning $400,000 or more. It is also worth comparing this new rate to top capital gains rates in European OECD countries. Denmark comes in at the highest with 41%, France and Finland each take 34%, Ireland 33%, and Germany 26.4%. Two of these countries happen to be among the top 10 of 156 countries surveyed for the World Happiness Report. And despite a common misconception, Finland, for example, though having substantial social welfare programs, has a capitalist economy. (Click links above for more information)
You may also have heard of the proposed changes to corporate tax rates. From 1993 until the Trump administration, the corporate tax rate was 35%; during President Trump’s tenure, Congress cut the rate to 21%. The new proposal would institute a flat rate of 26.5% for corporations earning more than $10 million; corporations earning less than that will use new marginal tax rates. This is a big win for small businesses, who will pay less tax overall. On the first $400,000 of a smaller business’s income, they will pay 18%. On $400,000 to $5 million of earnings, businesses would pay 21%, and from $5 million to $10 million they would pay 26.5%. All in all, this is a compromise between the more conservative and more progressive elements of the Democratic party.
Now we arrive at the part you’ve all been waiting for – the new personal income tax rates. Only the top marginal bracket will be affected by the changes, and the change returns the tax rate to where it was in 2017. The income threshold for that bracket will be reduced as follows (indexed for inflation):
Single filers: from $523,600 to $400,000
Married filing jointly: from $628,300 to $450,000
Head of Household: from $523,600 to $425,000
This means that it will take less ordinary income to qualify for the top marginal tax rate than before. As mentioned above, that top rate will return to 39.6%. For the last 3 years it has been 37%. For reference, the top marginal tax rate has been at or above 39% for the majority of the last 90 years.
For married filers who earn more than $5 million annually, a portion of their earnings will now be subject to an extra 3% tax on top. If you and your spouse earn five million and one dollars next year, you would owe an extra 3 cents in taxes.
The final relevant proposals are changes to rules governing retirement accounts owned by top income earners. People who fall in the top marginal tax bracket will be disallowed from exercising a “backdoor” Roth conversion. To be fair, a strategy referred to as “backdoor” probably shouldn’t exist in the first place. Otherwise, the name would be unwarranted.
There may also be new rules for retirement account aggregate balances for the top income bracket. This refers to the total combined value of an account owner’s IRAs, Roth IRAs, and defined contribution plans (such as a 401(k) or 403(b)). If the final aggregate balance of all these accounts at the end of a tax year exceeds $10 million, then in the next year the account owner must take a Required Minimum Distribution (RMD) equal to 50% of the excess amount. For example, if your 401(k) is worth $7 million, your IRA is worth $2 million, and your Roth IRA is worth $2 million, for a total of $11 million, then you would be forced to withdraw $500,000, which is half of the extra $1 million. If the proper RMD amount is withdrawn, then the taxpayer may choose which account(s) to withdraw from.
If the aggregate account balance exceeds $20 million, it gets even more complicated. The account owner must take distribution of the lesser of
The amount needed to bring the total balance down to $10 million, OR
The full balance of all Roth accounts.
If, after satisfying these conditions, the accounts are still over $10 million, then the above 50% rule will apply.
As you mull over these tax proposals, I encourage you to remember that taxes are the dues we pay to live in America. They are an integral part of citizenship. Taxes pay for public services like fire departments, wastewater treatment plants, and early childhood education, as well as maintenance of roads, bridges, and other critical infrastructure. You may have heard fearmongering in the news about how these new taxes will destroy the economy. I will remind you that those media figures who rant and rave against taxes are likely earning income that is well in excess of what the majority of people live on. Their own self-interest become apparent in said screeds. While no one likes paying taxes, and we strive to help our clients be as tax efficient as possible, our country is operating with an enormous budget deficit that must be fixed. In addition, many of these proposed revenue-generating measures will be used to fund things that our clients value. We will continue watching these rule changes and keep you updated if and when the tax landscape shifts.
Matthew Ramer, AIF®
Principal, Financial Advisor
MOR Wealth Management, LLC
1801 Market Street, Suite 2435
Philadelphia, PA 19103
P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 |
601 21st Street, Suite 300
Vero Beach, FL 32960
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