The American Families Plan, announced on April 28 by President Biden aims to make education and child care more accessible for middle-class families. The proposal seeks $1 trillion in spending with an additional financial incentive of tax cuts worth up to $800 billion.
But, who will be footing the bill for all these changes? Taxpayers, of course. Though the proposal still has a long way to go, including making it through an equally divided Senate, understanding the proposal will allow you to begin preparing for potential tax hikes as soon as you can.
Increased Top Federal Tax Bracket Rate
The most notable change in the American Families Plan is that the top federal marginal tax bracket rate would change from 37% to 39.6%. The jump is no surprise. It is essentially a reversal of the ardently opposed tax rate change lowered by the Trump administration in 2018. The 37% rate would have lapsed with or without Biden’s proposal, however, as it was scheduled to revert back to 39.6% in 2025.
This tax bracket increase will affect anyone with a taxable income over:
- $400,000 for single and head of household filers.
- $450,000 for joint filers.
The taxpayers who stand to be the most impacted by the new rates are those in the $400,000–$500,000 income range – in other words, a lot of Bay Area dual-income tech professionals — who will see their marginal tax rate jump almost 5%, from the current 35% bracket to the new 39.6% bracket. Higher earners who were already in the 37% bracket will see ‘only’ a 2.6% increase to 39.6%.
The Department of Treasury estimates that this tax rate increase could generate an estimated $132 billion over five years.
Planning Tips:
For individuals on the cusp of this threshold, consider income reduction strategies such as:
- funding retirement plans
- opening defined benefit or profit-sharing plans
- charitable giving
- accelerating deductions and anticipated purchases
You can also consider both decreasing dividend or other income-producing investments and repositioning income producing investments into retirement accounts.
Long-Term Capital Gains
Other notable components of the proposal will affect how long-term capital gains and qualified dividends will be taxed. Currently, these profits have their own marginal tax bracket system with a top tier of 20% for income over $441,451 for single filers and $496,601 for joint filers.
In the latest revision of the American Families Plan, the capital gains rate will increase to 25%. This rate applies to single filers with taxable income over $400,000 and joint filers with income over $450,000. This income would also be subject to the current 3% Net Investment Income Tax (NIIT). Furthermore, the changes would apply retroactively to capital gains realized after September 14, 2021.
This policy change openly targets the wealthiest Americans, affecting about 0.3% of the population.
Planning Tips:
If you fall into this category, all is not lost! You can consider taking steps now to reduce your capital gains. How? There are a few options:
- tax-loss harvesting
- gifting highly appreciated assets to charity
- increasing retirement contributions
- increasing business expenses
Finding ways to level the income will be the key to avoiding being in the highest tax bracket the next year as well as to not exceeding the capital gains threshold in subsequent years.
No Mention of The Rumored Elimination of the Step-Up in Basis on Estate Taxes
Biden’s latest proposals do not include the rumored measures to eliminate the step-up in basis. However, since legislation is far from final, and understanding how this could have impacted your taxes is never a bad piece of information to have, we are going to explain below what this provision could have meant for you.
One strategy taxpayers can use to reduce estate taxes is the step-up in basis. This provision allows inheritors to revalue inherited assets at their Fair Market Value at the time the decedent passed away rather than when she purchased them, thus avoiding paying capital gains tax on the appreciation that occurred during the lifetime of the decedent. When we’re talking about a long timeframe, the savings can be substantial.
For example, if you had a grandfather who purchased $10,000 of stocks and left them to you when he passed away, those stocks might now be worth $100,000. With step-up in basis, if you sell those stocks two years later for $115,000, then you’d only have to report capital gains of $15,000 on your tax return because your basis was stepped-up from $10,000 to $100,000 at the time you inherited them.
The original version of the American Families Plan from April proposed eliminating the step-up exemption. Instead, heirs would pay the capital gains on the assets they receive, significantly reducing the net benefit. In the previous example, the heir would be responsible for paying taxes on the $90,000 capital gain.
Luckily, this provision was not included in the latest proposals.
Elimination of the Backdoor Roth IRA
One of the most popular ways for high-income earners to save taxes in retirement is under fire and may be lost—the so-called “backdoor” Roth IRA.
The new bill’s aim to eliminate the “backdoor” Roth strategy would:
(1) Prohibit Roth IRA conversions of after-tax funds in retirement accounts altogether, effective in 2022. This includes not only after-tax contributions to regular IRAs, but also the so-called “mega-backdoor” contributions to company 401(k) plans that many Silicon Valley companies have endorsed.
(2) Slowly prohibit all Roth conversions for those in the top income tax bracket. The key word here is “slowly,” as it would be phased out after a 10-year window to (not so subtly) encourage high-income taxpayers to convert to Roth accounts (and pay taxes on their conversion) sooner rather than later.
The idea here is to offset the $1.8 trillion of spending outlined in the bill and (some say) to minimize the wealth divide. Whether this is true or not, or whether this bill is necessary, achievable, or realistic is beyond the scope of this discussion. What we do know is that ending this Roth-related strategy is very much the intent of current lawmakers
Extending the Increased Child Tax Credit
The American Rescue Plan was signed into law on March 11, 2021. In addition to issuing the third round of relief checks to most Americans, the stimulus package also included a provision to temporarily change the child tax credit from $2,000 per child to as high as $3,600 for the 2021 tax year. This increase expires in 2022—unless the proposed American Rescue Plan is signed into legislation.
If the plan passes as written, the increased benefits will last until 2025. Under the current terms, half of the child tax credit will be paid monthly throughout the second half of the 2021 tax year. The other half will be available as a credit come tax time in 2022. The proposal also raises the refundable amount from $1,400 to the entire amount of the credit, a significant benefit for lower-income families with young children.
While this is good news for the recipient families, the benefit phases out more quickly for middle-income earners. According to the new rules, the credit begins to reduce at a taxable income of:
- $75,000 for single returns
- $112,500 on head of household returns
- $150,000 on joint returns
These figures are down from the previous limits of $200,000 for single filers and $400,000 for joint filers. Under the new limits, payments would decrease by $50 for every $1,000 of taxable income above the limit.
From the Planning Perspective
Even though we’d like to think the tax planning tail doesn’t wag the investment dog, proper tax planning does translate into wealth planning. The less tax drag on your wealth, the more growth potential there is to be realized.
Some of these implications will fall squarely in the laps of high-earning taxpayers. As we shared, though, there are still ways to avoid a significantly higher tax bill. For example, a study done by Wharton Business School suggests that completely legal tax mitigation strategies could help avoid 90% of the proposed tax increases on capital gains alone. So, perhaps this proposal’s bark will be worse than its bite.
If you have questions about any of these provisions, how they apply to your situation, and how you can take the best advantage of them, please get in touch with your Griffin Black advisor.
Image by Jason Yoder from Shutterstock.com
