The short answer is probably “No.” The longer answer is, “I don’t know” because tax hikes proposed by the president may or may not be enacted into law by Congress.
Last month, President Joe Biden unveiled The American Families Plan, which among other things, proposes to raise capital gains taxes on long-term capital gains—on the sale of assets held more than one year—for households earning more than $1 million in income. This won’t affect most people, at least directly. I don’t plan on diving into the economics behind the proposal. But if the plan becomes law, let’s look at ways we can use tax planning strategies to avoid or lessen the impact.
Thanks to a stronger economy, the successful rollout of the vaccines, very low interest rates, and more, stocks have rallied sharply over the last year. You have benefited, but the sale of an asset could create a tax liability, depending on your tax bracket and how long you’ve held the asset.
Today, the maximum long-term rate on capital gains is 20% plus the 3.8% net investment income (NNI) tax on certain income. But if you earn more than $1 million per year, listen up. Your rate may go much higher. Currently, ordinary income is taxed no higher than 37.0%. That could rise to 39.6% if the president’s plan is approved. If you earn over $1 million, you’ll may pay that 39.6% rate on the sale of assets held over one year plus the 3.8% NII tax.
It’s a substantial increase in taxes for the wealthiest Americans.
How might we lessen the impact, assuming we see a big increase in the capital gains rate?
- If a higher rate is not made retroactive, we can consider recognizing profits in tax year 2021, thus avoiding the new rate. Further, we step up the cost basis.
- Another way to sidestep the tax is to simply avoid large asset sales in taxable accounts, assuming there isn’t a compelling reason to do so. The only constant in tax law is change, and a future Congress and president could adjust the rates again.
However, there is an important caveat: the time-honored tradition of passing on assets to heirs without paying taxes could be in jeopardy, which most of you know as the stepped-up basis at death. In his proposal, the president wants to trigger taxes on unrealized gains passed to heirs. This would occur after a $1 million exemption.
- We can also strategically time the sale of assets, making sure we do not pass the $1 million limit on income. That would ensure the maximum federal rate paid would remain at 20% plus the 3.8% NII tax. It’s a far cry from 43.4%.
In a perfect world, we would not allow investment planning to be affected by tax planning. But tax laws and tax planning do affect investment planning.
Biden’s proposals are a long way from being enacted into law. They may be modified in Congress before any bill reaches his desk and is signed into law. Our team will be closely monitoring the situation. We can become more proactive when we have a better idea how everything will shake out.
As always, we encourage you to consult with your tax advisor before implementing any tax strategies.