The winds of political change bring with them the potential for consequential revisions to the tax code. As anticipated, in late April President Joe Biden unveiled a number of significant proposed changes to the individual tax provisions. As with proposed revisions to the corporate code made several weeks earlier, these potential increases would fund an ambitious, multi-trillion dollar “Build Back Better” spending plan.
To be clear, the ultimate forms these proposals take and their political pathways remain uncertain. We do believe, however, it is likely some changes will be enacted.
A mantra at Northern Trust is, “It is better to plan than predict.” Below, we discuss four areas of individual tax policy, how proposals could shape the law, and corresponding strategies for consideration. Note that many of these strategies are beneficial across tax environments and are worth considering incorporating into wealth plans, come what may.
Individual Income Taxes
Proposed change: President Biden advocated raising the top individual ordinary income tax rate, from 37% to 39.6% for individuals making more than $400,000 per year. With current rates at historical lows, this relatively small increase would represent a return to 2013-2017 levels.
Strategies for consideration: If income tax rates are positioned to increase, we recommend identifying areas to accelerate near-term income in order to take advantage of low rates, and deferring expenses and losses. For example, those who have control over their compensation may decide to take a bonus this year rather than next, or plan to exercise in-the-money nonqualiﬁed stock options that are near expiration. This analysis requires detailed consideration of current and future tax brackets.
Additionally, reconsider whether you should make an election to defer compensation in 2021, delaying the income tax on deferred amounts until the date of distribution. We advise clients to remain mindful that (a) higher income tax rates in the near future make elections to defer a less attractive option if the funds will be needed for near-term goals; (b) their company’s plan is essentially an unsecured obligation; and (c) those who are considering relocating will need to plan for state-specific rules surrounding the taxation of distributions.
Finally, we recommend clients consider Roth conversions as part of an overall tax diversification strategy. For example, clients can coordinate taxable and tax-free withdrawals to minimize income taxes in retirement through ownership of traditional and Roth individual retirement accounts.
Long-Term Capital Gains and Qualified Dividends
Proposed change: The Biden tax plan includes nearly doubling the capital gains rate for those making more than $1 million, from a 20% maximum rate (plus 3.8% net investment income tax) to 39.6% (plus 3.8% net investment income tax). However, we think an increase in the 25-30% range is more likely, as investor “lock-in” (deferring asset sales indefinitely) is a risk that increases proportionally with the tax, resulting in a diminishing return on tax revenue generated at higher rates.
Strategies for consideration: Even an increase to 25% would be an impactful tax change for many. Yet we continue to advise clients that funding long-term goals, not taxes, should be the primary driver of decisions. Assessing the impact of capital gains requires careful analysis and projection of future income and tax brackets: For example, there may be years in the future when a client’s income falls below the proposed $1 million threshold, resulting in a lower rate.
Notably, if capital gains tax rates rise as proposed, our research suggests that returns will be meaningfully lower for taxable accounts.
Realize capital gains when necessary to fund goals and manage risk. Consider realizing capital gains (i.e., to “up-cost” the tax basis) at today’s low rates if needed to fund short-to-intermediate-term goals (which Northern Trust defines as 1-10 years). For longer-term goals, the “up-cost” benefit dissipates, and investors may choose to retain optionality in the event future tax reform lowers the capital gains tax rate.
Employ asset location strategies by placing tax-inefficient assets in tax-deferred or nontaxable accounts. Interest income, dividend income, and realized capital gains are not taxed in IRAs, so high yield and taxable bonds, real estate investment trusts (REITs), high-dividend strategies and any high turnover active strategies should be in tax-deferred accounts. We also recommend considering the use of installment sales to regulate annual income levels, keeping income under $1 million as much as possible, and donating highly appreciated securities to a charity or donor advised fund to avoid capital gains tax entirely.
Basis Step-Up at Death
Proposed change: Under current law, the cost basis of assets is “stepped-up” to fair market value as of date of death, resetting the tax basis to fair market value and reducing capital gains taxes owed. President Biden has proposed eliminating the step-up, and legislation to do so has also been introduced in the Senate. The STEP Act would tax unrealized capital gains on any transfer during lifetime or at death. At death, there would be an exclusion of $1 million and, during one’s lifetime, any gift to a person or trust other than to a spouse would allow for the first $100,000 of cumulative gain to be tax free.
Strategies for consideration: The long-term implications of enactment of legislation that modifies step-up in basis has the potential to significantly impact tax and estate planning.
Potential strategies to discuss with your advisers include flexible grantor trusts, which allow for maximum post-execution planning options (swapping assets, borrowing, loaning), as grantors would need flexible documents to cope with the possibility of changing tax laws. Irrevocable trusts permit strategic gifting to charity to avoid a deemed sale (and imposition of capital gains) in conjunction with careful tax-loss harvesting. Consider decanting trusts where permissible for adaptiveness, as trusts prepared five or 10 years ago may encounter tax issues their drafters did not fully anticipate.
Estate and Gift Tax Changes
Proposed changes: Although President Biden did not address gift and estate taxes as part of the American Families Plan, potential changes to these laws continue to be a top client concern. On the campaign trail, the president advocated returning estate and gift taxes to 2009 levels, indicating a proposed reduction from the current record-high exemption of $11.7 million to $3.5 million and higher estate taxes. Even if there are no changes to estate taxes, under current law, today’s record-high exemption will be cut in half by the end of 2025.
In addition, the ”For the 99.5% Act” introduced by Sen. Bernie Sanders would curtail several tax-reduction strategies—many of which were also targeted during the Obama administration. These include (a) requiring that grantor retained annuity trusts (GRATs) have both a minimum term and remainder interest; (b) limiting valuation discounts for transfers of “non-business assets,” such as family limited partnerships; and (c) limiting annual exclusion tax-free gifts that are often used to fund life-insurance trusts.
Strategies for consideration: The regulations for these proposals are already written and could be relatively easy to enact if looked at as “loophole closers.” Consider using today’s favorable GRAT and valuation rules to reduce the value of gift tax liability and make maximum use of the expiring exemption. Today’s GRAT rates remain historically low, so this is an ideal time to create a GRAT. Consider funding trusts now, particularly those that are expected to need cash to meet future expenses, such as life insurance premiums, in case annual exclusions are capped.
We also advise clients consider gifting to flexible trust structures if gifting aligns with the client’s goals. This allows you to take advantage of today’s larger exemption before much of it potentially disappears. We recommend a careful review of your estate plan, in close collaboration with your advisers, to understand the prospective legal and tax implications for your situation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Pam Lucina is the Chief Fiduciary Officer and Trust & Advisory Practice Leader for Northern Trust Wealth Management. Pam leads a national team of trust and estate professionals to help clients achieve their goals through the use of world class tools and techniques, with an eye toward the human element of wealth and family dynamics. She is a recognized leader and speaker within the trust and estate legal community and a Fellow of the American College of Trust and Estate Counsel (ACTEC).
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