Last year was filled with unprecedented actions and unknowns. Following the presidential and congressional elections, it is appropriate to examine planning opportunities for a Joe Biden presidency with mixed congressional support.
President Biden has proposed a number of initiatives surrounding tax increases for high-income earning individuals as well as businesses. These tax increases aim to balance a budget deficit of more than $3 trillion in 2020. While there are many proposed policies to discuss, there are a few with very specific planning ideas that should be considered.
The first proposal to be examined is raising the top marginal tax bracket from 37% to 39.6%. This proposal impacts high-income earning individuals ($518,401 in taxable income for individuals filing single and $622,051 in taxable income for a married couple filing jointly), based on 2020 federal income tax brackets. A potential strategy to consider is accelerating income. This might include a Roth conversion, which allows you to transfer funds from a Traditional IRA to a Roth IRA while paying ordinary income taxes on the amount transferred. The Roth IRA grows income tax free, never to be taxed even upon withdrawal. A Roth conversion is a powerful planning option for high-earning households, as it allows you to fund a Roth IRA while also maximizing other retirement savings options.
Another proposal that Biden discussed on the campaign trail was taxing capital gains as ordinary income for taxpayers with taxable income over $1 million. This could effectively double the current top rate from 20% to a potential 39.6%. Planning solutions to this proposal include selling investment securities with an embedded gain before the potential tax increase and an increased focus on tax-loss harvesting after the potential tax increase. Accelerating capital gains would mean recognizing gains and paying capital gains taxes (20% for individuals filing single that have over $441,450 in taxable income and for married couples filing jointly that have $496,600 in taxable income), based on 2020 long-term capital gains tax rates. If you are a high-income earner, recognizing capital gains could lead to less capital gains taxes now, as compared to recognizing the same amount of gains after the potential tax increase. In addition, tax-loss harvesting could become even more valuable after the potential tax increase. Tax-loss harvesting is the process of selling securities with a loss in order to offset capital gains in a taxable account. With the possibility of capital gains taxes increasing, tax-loss harvesting becomes a powerful planning tool to lower the amount of capital gains taxes due.
Lastly, there is a proposed reduction of the federal estate and gift tax exemption to $3,500,000 from its current level of $11,580,000. This proposal makes it incredibly important to examine your estate plan and understand the benefits of certain trusts, especially in a historically low interest rate environment that we are in today. A Grantor Retained Annuity Trust (GRAT) exploits the low IRC 7520 interest rate (0.6% for December 2020) that is used to value retained interests, in this case the grantor’s retained right to receive an annuity. The grantor funds the trust with assets and retains an annuity right for a period of years. The GRAT can be “zeroed out” so that there is no taxable gift of the remainder interest on the GRAT’s formation. As long as the assets held in the GRAT grow at a rate higher than the IRC 7520 rate, at the end of the annuity payment period, the assets that remain in the GRAT pass gift-tax free to the remainder beneficiaries. A GRAT works well for those who have already fully used their lifetime federal gift tax exemption. Along with a GRAT, taxpayers can consider intra-family loans. Intra-family loans are an easy way to shift wealth, gift-tax free, to family members using the AFR interest rate. With the AFR rate at historic lows, the loaned funds can be invested by the borrower and can earn a rate of return in excess of the AFR rate charged for the loan. For example, a parent could loan a child $1 million on a 20-year note and charge 1.17% for the entire 20-year period. If the loaned funds were invested in assets that achieved a rate of return greater than the minimal AFR rate, all appreciation is essentially shifted to the next generation free from gift or estate tax.
A divided government could create hurdles for tax increases and other initiatives proposed by Biden on the campaign trail. However, due to the unprecedented amount of fiscal deficit that the U.S. government has incurred in 2020, it is likely a non-partisan issue to raise taxes to some degree.
Steve Davis is a wealth management associate at Greenleaf Trust, where he supports the development of comprehensive wealth management plans, the execution of goal-based planning, and the management of investment portfolios.