President-Elect Biden has proposed significant tax hikes on the wealthy. The Tax Policy Center summarizes the tax increases on high income taxpayers as:
Biden’s plan would roll back income tax reductions from the Tax Cuts and Jobs Act of 2017 (TCJA) for taxpayers with incomes above $400,000. It would also limit the value of itemized deductions for taxpayers in income tax brackets above 28 percent. His plan would tax capital gains and dividends at the same rate as ordinary income for taxpayers with incomes above $1 million and tax unrealized capital gains at death. Biden also would subject earnings over $400,000 to the Social Security payroll tax.
Although the Democrats control the White House and the House of Representatives, a runoff election for both Georgia Senate seats will determine control of the Senate. If that happens, there may be some concern about Biden’s tax proposal becoming law without any major modifications and how that impacts you.
How worried should you be? The short answer is: There is no need to panic or be overly concerned.
Is a Tax Increase Likely?
If 2020 has taught us anything, it is that the future is extremely hard to predict. The honest answer is we don’t know.
With that said, the national debt now stands at $27 trillion, and is up more than 36% since Donald Trump became President in 2017. Income and wealth inequality has been rising for decades. A tax increase on the wealthy to fund health care and education for the poor and middle class may reduce that inequality. The ongoing discussion continues about the need to repair and build the country’s aging infrastructure at a considerable cost. The Council on Foreign Relations noted in September 2020 that “U.S. infrastructure is dangerously overstretched, with a funding gap of more than $2 trillion needed by 2025.”
Between the rising federal debt, rising income inequality, and the need for infrastructure spending, it is easy to imagine the push for a tax hike in 2021. We don’t know it will happen, but it might.
Will the Biden Proposal Pass?
Probably not. Democrats would control the Senate with the slimmest of margins. If the Democrats win both Georgia Senate runoff seats, the Senate will be evenly divided at 50/50. Democratic control will hinge on Vice President Harris casting the tie breaking vote to give the Democrats control.
To pass the tax legislation as proposed, Biden would need, at a minimum, to have all 50 Democratic Senators support the legislation. That would be a big step for moderate Democrats such as Kyrstein Sinema of Arizona, John Tester of Montana, and Joe Manchin of West Virginia, among others.
It will take bipartisan support for Congress to pass meaningful legislation in 2021, requiring compromise on both sides. The recent stimulus talks are a recent example. After months of going nowhere, progress has emerged as Democrats and Republicans have focused on a $908 billion dollar bipartisan package, although, admittedly, the deal is far from being done. Think of Biden’s tax proposals as a first offer or wish list in a complex negotiation.
What About Capital Gains Taxes?
If passed as proposed, the Biden tax plan will increase capital gains from 20% to almost 40% for taxpayers earning more than $1,000,000. If your income is less than $1,000,000, this provision does not apply to you.
If your income exceeds $1,000,000, you might be concerned about Congress keeping this provision because it applies to only the top tier of earners. For individuals who are considering selling a highly appreciated asset, such as a business or piece of real estate, this tax hike can feel particularly onerous.
Will it happen? Again, we don’t know. From a historical perspective, it would be out of the normal range of capital gains tax rates for the last 40 years. The tax changes in 1981 reduced the top capital gains tax rate to 20%. Since that time, the highest capital gains tax rate has fallen between 15% and 28%. Since 1998, the rate hasn’t exceeded 20%. An increase in the capital gains rate to 40% would be unprecedented over the past 98 years and would be almost double that of the highest rate in the last 20 years.
Focus on What You Can Control
Taxes may or may not go up. That decision is outside of our control. There are, however, things within our control that we can do to reduce our investment tax burden, including:
- Increase Your Exposure to Exchange Traded Funds (ETFs) – ETFs are often more tax efficient than comparable mutual funds. In most cases, ETF managers don’t pay out capital gains distributions, and ETFs generally have fewer taxable events than mutual funds.
- Systematically Harvest Tax Losses – Taxable losses offset capital gains. Tax loss harvesting involves selling an investment that has lost value, replacing it with a reasonably similar investment, and then using the investment sold at a loss to offset any realized gains.
- Build a Portfolio of Municipal Bonds – Municipal bonds are often exempt from federal taxation and may also be exempt from state and local taxes. The taxation of municipal bonds can be tricky, which is why we suggest using a bond manager with extensive municipal bond experience.
- Consider Charitable Giving Strategies – For those families who make regular charitable contributions, your generosity may offer you the opportunity to reduce your capital gain taxes. Instead of giving cash, you can give away appreciated securities and eliminate some of your capital gains. If you find this strategy appealing, call your financial advisor to learn more.
- Take Advantage of Tax-Favored Investing – The tax code offers many opportunities to accumulate wealth in a tax-favored manner. These include qualified retirement plans such as 401(k)s and IRAs, 529 college savings plans, health savings accounts, Roth IRAs, cash value life insurance, and annuities. Although all these options are not right for everyone, some of them are an excellent choice for most people. Sit down with your financial advisor to figure out which of these tax-favored investment vehicles is right for you.
Don’t Worry; Be Happy
The Biden tax proposals are focused on taxpayers earning more than $400,000, and for capital gains, taxpayers with $1,000,000 or more of income. If you are in this group, take a moment and be grateful. Through a combination of hard work, talent, and good fortune, you have climbed your way to the top of the economic ladder. Although you almost certainly know people who earn more and have more money than you, the vast majority of Americans earn less and have less. You are among the fortunate few.
So, take a moment to acknowledge what you have accomplished, be grateful for your good fortune and abundance, and consider what steps you can take to help reduce your taxes. Then stop thinking about taxes and focus on the things that matter most to you – your health, the people you love, and all those experiences that help you feel fully alive.
Related: Understanding Biden’s Tax Plan