For those of you who are Popeye fans, you probably remember Wimpy’s famous request, “I’ll gladly pay you Tuesday for a hamburger today.”
As Congress tries to scurry to push through an infrastructure package, you can expect some significant tax changes to occur to help pay for it. When it comes to taxes, it is important to be aware of what could be coming, but it generally makes sense to take a little bit of the Wimpy approach by not paying taxes today.
There are a few things that we know and on which you should work with your tax advisor to see how you may benefit. The most significant for Minnesota residents who are owners of a limited liability company, partnership or S-corp is that the state has approved a pass-through entity tax election.
Most of us are limited in the amount of state income tax we can deduct (a total of $10,000 between property and state income taxes). But if your business pays state income tax at the entity level, the entity gets to deduct the tax, thereby reducing your income by the tax paid. Voila — a way to bypass those restrictions. Not all entities are eligible, but if you own a business or rental property, for example, you have time to take advantage of this.
There are also a couple of things over which you can breathe a sigh of relief. It doesn’t look like capital gains are going to be taxed at the much higher ordinary income rates, but if the bill goes through as planned, long-term capital gains taken after Sept. 13 would move up from 20 to 25% for the highest earners. While this date is embedded in the proposal, nothing else appears to be retroactive. This higher rate makes using appreciated stock to fund your charity especially attractive.
But in spite of this somewhat good news, we are still likely to see higher tax rates on incomes above $400,000, S-corporations and larger estates. Let’s take these separately.
If tax rates are going up for you, then you want to disregard Wimpy and be careful about deferring income into next year. In fact, if you are in the highest tax bracket this year, once you get clarity around the new rates, you probably want to accelerate income into 2021. You also want to compare the value of deductible retirement plan contributions compared with Roth (non-deductible) contributions.
This is also likely the last year to convert after-tax retirement money to Roths. The back door Roth is when you fund a nondeductible IRA and quickly convert it to a Roth IRA thereby making the tax on the growth of that asset disappear. Voila. Unfortunately, someone told Congress the secret to that magic trick and there are no more rabbits to be pulled out of that hat. This is also the last year where, if allowed, you could fund after-tax contributions in your 401(k) and then convert those into a Roth as well.
There are also provisions for those in the highest tax bracket regarding required minimum distributions for IRAs combined with 401(k)s and 403(b)s in excess of $10 million. If you fall in that camp — congratulations! But watch this closely because there are some year-end planning decisions you may wish to accelerate.
The proposal also includes a Medicare surtax on S-corporation profits above certain limits. This is a tax to the owners, not the S-corp itself. Remember what I said about the MN pass-through entity tax? Hello? Since paying the tax at the entity level reduces the profits of the entity, it also reduces this surcharge. If those with C-corporations are feeling left out, then confer with your CPA about the advantages and disadvantages of converting to an S-corporation.
Estate tax planning is hugely important now. The likelihood of estate tax law changes occurring are very high and this bill may accelerate them. One of the biggest changes that may be happening is the elimination of defective grantor trusts (sounds bad but is actually good); money is moved out of the estate using up some of the unified credit, but the grantor of the trust still pays taxes on the trust.
For those with large estates, this is like a super gift because income tax rates are lower than estate tax rates. These trusts are not for everyone because the money is actually moved out of your estate, but they are a good way to pass money to the next generation.
Be careful about doing too much too soon, though. Even though things could be changing, they may not be changing forever. And don’t make any decisions solely for tax reasons. Make sure they fit all aspects of your plan.
To paraphrase Popeye, “Even if you ain’t no tailor, know what suits you.”