By Robert Waskiewicz, Wescott Principal and Senior Financial Advisor, Wescott Tax Alpha Group
President Joe Biden’s American Families Plan sent a shock to many high-net-worth and ultra-high-net-worth individuals recently with the announcement of proposed changes to the current tax code.
Under the proposed new tax plan, high-net-worth and ultra-high-net-worth individual filers and married couples that fall within the highest tax bracket would see their marginal tax rate increase from 37% to 39.6% in the coming year(s) if passed. In its current state, the plan would also raise long-term capital gains taxes for those earning more than $1 million per year.
With the possibility of higher tax rates looming in the not-so-distant future, it’s only natural that many investors are now eager to make a plan of action to best protect their potential earnings, savings and investments. However, it’s important to remember that there is a high likelihood that this proposal will meaningfully change. The final form of the American Families Plan, if it does eventually pass into law, may look vastly different than it does today.
Because of this, our Wescott advisors are advocating for patience. We encourage our clients not to make any immediate modifications to their wealth management strategies to accommodate for changes that may or may not come down the road. As a fiduciary, it is simply not in the best interest of our clients to alter a long-term financial plan based on a proposal that is likely to change – or may even fail to pass entirely.
However, this proposal still requires close attention as it continues to take shape. There are three areas in particular we’ll be watching closely on behalf of our clients:
1. What protections will be built in? The main intention behind President Biden’s new plan is to only raise taxes for the highest earning individuals. To do so effectively, protections will have to be built in that exclude certain lower income earners from being taxed like a high earner due to one-time events. These one-time events can include anything from receiving an inheritance from a deceased family member to selling a piece of property. Gaining clarity on these protections will help financial and tax professionals decipher exactly which tax bracket will apply to their clients and create a plan to ensure filers aren’t taxed unnecessarily.
2. How will step-up in basis be handled? Removing the step-up in basis would essentially tax capital gains on inherited assets upon the death of the original owner. A change like this could force the inheritor to sell assets to pay the resulting capital gains tax– becoming especially problematic for illiquid assets that are difficult and time consuming to sell. The proposal addresses part of this issue by stating that those who inherit a small business or a farm will not be taxed on capital gains if they continue operating the business. But there are many details still outstanding when evaluating how this will work in actuality. Will there be additional exceptions with other illiquid assets? How will assets transferred to spouses or to trusts be handled? If capital gain rates are increased, would inherited assets be subject to this increase? How would the elimination of the step up in basis potentially impact the current estate tax exclusion? Would the Net Investment Income Tax apply? Until we have more detail on these factors and more, we cannot appropriately develop planning strategies.
3. How will capital gains be calculated? With capital gains taxes set to increase, many investors are eager to recognize a capital gain today before the rule change goes into effect. However, it remains unclear exactly what income will be included in the $1 million figure being used to separate those who will pay higher rates. When the Obama Administration created the Net Investment Income Tax in 2013, it introduced a new form of income calculated for the purposes of the Net Investment Income Tax. It modified the deductions, exceptions, and criteria for what specific income was to be included or excluded, and it’s possible we’ll see a new calculation introduced again with the proposed changes. Some of the prevalent questions include: Will we see something similar to determine if capital gains should be taxed at ordinary income rates? How will that calculation differ from the current capital gain calculation, if it does at all? It also remains to be seen what deductions taxpayers will be able to make or the impact donated securities will have on the final amount of taxable income. Until these specifics come to light, we suggest remaining patient and sticking to your current investment plan.
Without concrete answers and judicious explanations to the above questions, we’re advising our clients to stay the course for now. Until we get a full and complete picture of the pending changes, it is not in the best interests of our clients to make any radical adjustments to their financial plans. In the meantime, we’ll be monitoring this proposal closely to be ready if and when the time comes to take action on behalf of our clients, notifying them of modified recommendations.
In the meantime, discover more about our tax planning expertise in our Tax Strategy Guide and how our Wescott Tax Alpha Group can help you make the most out of your investments and earnings through various tax-smart strategies by contacting us today.