The House Ways and Means Committee recently unveiled their draft tax plan, part of President Biden’s new “American Families Plan” proposal. While many ideas were floated to increase tax revenue, the version lately published (though which has not yet been voted upon in Congress and signed into law) encompasses a few significant changes – most notably affecting taxpayers earning above $400k ($450k Married Filing Joint (MFJ) and slashing the lifetime estate exemption while also eliminating certain estate planning strategies that taxpayers have used in the past.
The majority of these changes (the bulk of which are expected to pass though details are currently being hashed out) will not go into effect until January 1st, 2022, giving taxpayers a brief window to conduct additional tax and estate planning.
We suggest you take advantage of the following strategies before the end of the year when these strategies are either eliminated or are rendered less effective once the new bill takes effect.
Income Tax Planning
1. Accelerate Income (if possible)
With those earning above $400k ($450k MFJ) potentially jumping from the 35% tax bracket to the 39.6% tax bracket in 2022, it can be meaningful to recognize more dollars in 2021 at the lower marginal tax rate than in 2022 or beyond when the tax brackets compress, and taxpayers sit in a higher marginal tax bracket.
What could this look like? If you are able to make an election to receive income in 2021 versus 2022 or beyond, such as when choosing a deferred compensation schedule, consider recognizing the income in 2021 instead to potentially save on taxes in future years.
Notably, this applies only to accelerating ordinary income since capital gain rates will be retroactively increased for high earners as of September 14, 2021. Therefore, unless you already had a signed agreement to sell property that is set to close before the end of the year, accelerating capital gains into the last quarter of 2021 does not avoid this increase in capital gain taxes.
2. Aggressive Roth Conversions
Roth conversions have long been a popular strategy for taxpayers who expect their tax bracket to rise in the future or who want to pay taxes on the money now to allow future growth to be tax free for the account beneficiaries. The new tax bill aims to disallow Roth conversions – but notably, not until 2032 – 10 years after the bill is passed. Therefore, taxpayers have a 10-year window to convert as much of their pre-tax retirement accounts as they are willing/comfortable paying for the resulting taxes now. If taxpayers act quickly, they can begin conversions this year, giving them a bonus year to spread out the tax bill.
An additional change related to Roth conversions is the closing of the backdoor Roth conversion loophole. Previously, wealthy taxpayers who didn’t qualify to directly contribute to a Roth IRA because of their income level were nevertheless able to contribute to their Roth IRA via a back-door conversion where he/she first contributed to a pre-tax IRA and then converted the funds to his/her Roth IRA. This loophole closes as of 1/1/2022, so if you typically make use of this strategy and haven’t yet for 2021, make sure to contribute to your pre-tax IRA and convert by the end of the year.
3. In-service Distributions of After-Tax Assets from 401(k)
Some employers offer employees the ability to make additional after-tax contributions to their retirement accounts in excess of the pre-tax contribution limit. While most employees have to wait until they leave the company to rollover these assets, some employers allow in-service withdrawals – meaning a taxpayer may have the ability to take distributions while still working. If permitted under plan documents, a helpful strategy can be to make an in-service distribution of contributed after-tax assets and roll these into a Roth IRA to allow any future growth to be income-tax free. Many taxpayers who have been taking advantage of this “mega backdoor Roth Conversion” have been regularly contributing and converting, while others have been waiting for an optimal time to convert their after-tax assets. That time is now – this strategy would be eliminated in 2022.
The new tax bill would still allow taxpayers to contribute after-tax assets to 401(k)s that allow this feature – but taxpayers would no longer be allowed to convert that money to a Roth and would instead need to pay income tax on the investment gains at the time of distribution.
For any taxpayers who have been making after-tax contributions to their 401(k)s, it is a good idea to speak to your plan administrator about whether your plan allows in-service distributions before the end of the year.
4. Delay Itemized Deductions to 2022 or Beyond
Given the increase in the standard deduction following the passage of the Tax Cuts and Jobs Act of 2018, many taxpayers have begun grouping itemized deductions in specific years when more effective and claiming the standard deduction the rest of the time. Given the proposed changes to the marginal tax brackets for high earners, taxpayers earning over $400k ($450k MFJ) may find if beneficial to delay claiming certain deductions until 2022 when an increase in their tax bracket will make the tax benefit of the deduction greater.
For example, a taxpayer filing Single with an AGI (adjusted gross income) of $500k would fall in the 35% tax bracket in 2021, but the 39.6% tax bracket in 2022. Therefore, the same charitable deduction of $50,000 would be worth more in 2022 than if claimed in 2021 because the deduction saved funds from being taxed at a higher rate.
5. Net Unrealized Appreciation: Options for Realizing Gains on Company Stock
For taxpayers who own company stock, the difference in value between the cost basis of their employer stock and the current market value of the company is known as Net Unrealized Appreciation. Distributing shares of the company stock from an employer-sponsored retirement plan, typically subject to ordinary tax rates, can receive more favorable capital gains treatment after certain qualifying events are met, namely distributing the entire balance including all shares of the company stock (in kind) from the retirement plan within one year after a specific triggering event, i.e., having left employment, achieved age 59.5, become disabled, or died.
At this time, the taxpayer must pay ordinary income tax on the cost basis of the shares selected (the taxpayer may choose which shares to distribute in kind to a taxable account versus roll over to an IRA), and any investment gain will be subject to long-term capital gains when sold (any additional gain after distribution will be subject to either short or long-term investment gain depending on time held). The advantage here is the savings between the taxpayer’s ordinary income rate and the lower capital gains rate!
Before electing this strategy, consider the tradeoff of receiving a preferential tax treatment on part of the value versus how much tax is owed immediately and also how long you anticipate keeping this employer stock before selling – it may be more advantageous to simply roll over the entire account to an IRA if you would not need to touch for many years, particularly if the embedded gain is not large at the time of distribution.
Why should this be evaluated now? For taxpayers earning over $400k ($450k MFJ) with highly appreciated company stock holdings and who recently experienced a triggering event (reached age 59.5, separation of service, disability, death), making the election to pay capital gains taxes instead of ordinary income tax rates on the embedded gain can result in significant tax savings.
Let’s shift to estate planning – the important discussions are around taxes and death. Perhaps not the most exciting topic at the dinner table, but certainly a timely one in this current environment. At its core, an estate plan should be designed to protect and transfer assets at some point in time, while minimizing taxes.
We are in a situation of “Use it or lose it so act now!”. Sounds like a commercial, but really, you don’t want to change the channel just yet. Of the many proposed changes, let’s get the ball rolling with a couple that may require your immediate attention.
What’s changing: The lifetime gift tax exclusion.
Lawmakers are proposing to reduce the estate and lifetime gift exclusion to approximately $6 million per person. Today, you can gift up to $11.7 million during your life or upon death and not be subject to a 40% federal estate or gift tax.
- Consider gifting away assets before year end: Yes, the estate and gift tax exemption will be cut in half next year, but the IRS will not impose a claw back on lifetime gifts made in 2021. What does that mean? You can take advantage of the nice $11.7 million exemption this year and never be subject to the 40% federal estate tax or gift tax on that money, ever. The exemption could go down to ZERO next year and that gift you made in 2021 – still not taxed! Of course, there are many ways to “gift”, either outright or by trust.
You may be thinking that you love the idea of using your lofty 2021 exemption, but don’t want to lose total control or access to your money. When you gift an asset, it doesn’t always mean giving up full control. Consider the following strategies:
- SLAT: Married couples may consider a Spousal Lifetime Access Trust (SLAT). A SLAT is an irrevocable trust used to transfer wealth out of an estate, including any future appreciation. This trust is created by one spouse (grantor) for the benefit of the other spouse. The grantor may have some level of benefit through the spouse’s lifetime access to the trust funds, typically to maintain a standard of living, assuming they remain married.
- GRIP: For those who may be single and ineligible for a SLAT, get a GRIP! AGrantor Retained Income Partnership is an option to utilize the lifetime exclusion while retaining access to funds. The trust can be set up to provide an income stream to the grantor. Essentially, this strategy allows one to use their exemption while maintaining control and access to the assets.
What’s changing: Rules for grantor trusts.
A grantor trust is a trust considered “owned” by the grantor (the person setting up the trust and funding with their assets) for income tax purposes but not for estate tax purposes. The proposed legislation wants assets held within a grantor trust to be included in the grantor’s estate upon death. It was fun while it lasted so what now?
- Fund existing or new grantor trusts ASAP: Existing grantor trusts would not be affected so long as no further contributions are made past the Effective Date if this law is enacted. They are essentially “grandfathered” into the old rules. This also holds true for any new grantor trusts created AND funded before the Effective Date. If you plan to make contributions to existing grantor trusts or create a new trust, you would be wise to act now, before legislation is signed into law. Remember the SLAT we talked about? That’s a grantor trust. Other types include grantor retained annuity trusts (GRATS), qualified personal residence trusts (QPRT), and intentionally defective grantor trusts (IDGTs) to just name a few.
- Irrevocable Life Insurance Trusts (ILITs): *Also a grantor trust*When life insurance is owned by you, the death benefit proceeds will be included in your estate. If owned by an ILIT, the death benefit will not be included in the gross estate of the insured. For those who have created ILITs that hold life insurance policies to which you make annual “gifts” to pay the premium, you may want to consider making a lump sum gift now. Also, if you have large life insurance balances, there could be a benefit to retitling the life insurance into an ILIT before the Effective Date.
Please keep in mind that these changes are not set in stone and still subject to further change. There is also a whole lot more to this tax reform and the strategies to consider other than what is discussed here. We strongly encourage you to revisit your financial situation with your trusted adviser to help you navigate the road ahead. Please be warned that the road ahead will be congested, so the earlier you start planning, the better chance of success you will have.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.