Once again, it seems likely that significant changes in the tax code will be passed by Congress. The amount of deficit spending used to stimulate the economy and minimize the financial impact of the pandemic and the cost to fund Biden’s infrastructure plan is in the trillions of dollars. Accounting gimmicks, delays in implementation and reductions in favorable tax credits will make only a small dent in financing this ambitious plan and tax increases are inevitable.
While it is too early to act on tax proposals that will likely change before passage and not be effective until 2022, it does make sense to strategize for the remainder of 2021 while keeping tabs on developments in Washington.
The Democrats have focused on greatly increasing income taxes for those individuals they designate as high income. They have proposed raising the maximum individual tax bracket from 37% to 39.6% as well as expanding the income subject to the 3.8% surcharge. They also want to add an additional 3% surtax on individual taxpayers with an Adjusted Gross Income of more than $5 million. On the other hand, the Democrats would like to raise the $10,000 cap on the deduction for state and property taxes which would be very beneficial to high income earners who reside primarily in blue states. Perhaps the most debated proposal has been the increase in the maximum long term capital gains tax from 20% to 25%. Due to concessions made to placate Senators Joe Manchin and Kyrsten Sinema, most of these proposals have been shelved. The one area of agreement appears to be a 15% tax for all corporations with at least $100 million of book income. While the back and forth horse-trading is likely to continue, the rapidly expanding and expensive government programs need to be funded and an increase in taxes is inevitable.
In order to offset possible increases, taxpayers may wish to sell assets with long term capital gains in 2021 and apply available long term capital losses to offset these gains. Frothy stock markets valuations may represent an additional reason to pay taxes in 2021 rather than in the future.
Assuming higher future tax rates, there may also not be a better time to convert traditional IRAs to a Roth IRA. There are other factors to consider such as the age of the investor, projected retirement age, health, etc. Of course, projected future income is an important consideration since a significant reduction in income may represent a reason not to execute a Roth conversion.
The current standard deduction of $12,550 for an individual and $25,100 for married filing jointly eliminates the need to itemize deductions for most taxpayers. One way to exceed the standard deduction and benefit from itemization is to bunch charitable contributions from several years to one year. This objective can be achieved by contributing to a donor advised fund. By donating appreciated assets such as mutual funds, securities and real estate held for more than one year into a donor advised fund, the taxpayers can deduct the fair market value of the donation while also avoiding the capital gains tax. The securities are then liquidated by the plan sponsor and invested in a mutual fund type portfolio. The donor controls the timing, amount and charity they wish to receive the funds.
Many taxpayers who would like to donate to a charity don’t have the after tax assets to make a meaningful contribution. For those taxpayers who hold considerable assets in retirement accounts and are age 70½ or older, annual distributions up to a maximum of $100,000 may be donated directly to a charity with no income tax ramification. These Qualified Charitable Distributions (QCD) are not tax deductible but provide a significant benefit for taxpayers who are both charitable and have no need for the income from the retirement plan. Please note that the QCD must be made directly from the retirement account to the charity bypassing the taxpayers in order to qualify.
For those taxpayers not on Medicare and utilizing a high deductible medical plan, contributions to a Health Savings Account (HSA) can provide triple tax free benefits in the form of current tax deductions, tax deferred accumulation and tax free distributions. Current contribution limits are $3,600 for an individual and $7,200 for a married couple. Since these limits are relatively small, many taxpayers dismiss the current tax benefits but years of steady contributions plus investment gains can result in a sizable account and provide a flexible and tax preferred planning tool.
Finally, full advantage should be taken for retirement plan contributions. The maximum salary reduction contribution in a 401(k) plan is $19,500 but increased to $26,000 for taxpayers over age 50. If a participant in a plan has not maximized their elective contributions, they should aggressively fund the shortage by the end of the year to take full advantage of the tax benefit. Of course, if these salary deduction contributions are made to a Roth 401(k) no current tax benefit is realized.
While there will likely be many more iterations to tax proposals before they become law, we should understand that tax laws will most certainly change with the likelihood that many individuals will be subject to higher taxes.
Clifford L. Caplan, CFP®, AIF®