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Will possible tax increases affect your client’s retirement planning next year?

SEP. 30, 2020

Election day is rapidly approaching and while President Donald J. Trump and his Democratic opponent, former Vice President, Joseph R. Biden, have wildly divergent tax policies, there could be significant changes to the tax law regardless of the election’s outcome. There would likely be fewer changes if President Trump and Republicans prevail, but either party could legislate tax increases to fund government expenditures for COVID-19 relief.

Revisions to individual, corporate, and estate and gift taxes Congress may pass in 2021 could be made retroactive to January 1, 2021, so it is critical to plan before the changes are effective. There are some strategies taxpayers should consider now in anticipation of possible income, estate, and gift tax increases.

Individual income tax and capital gains rates may increase

The current tax law provides for seven tax brackets, with a maximum rate of 37% for single individuals earning $518,400 and married couples earning $622,050.1 While Trump has proposed no tax-rate increases – and has indicated he would like to see cuts – Biden’s tax plan includes an increase in the top rate to 39.6% that would affect taxpayers earning $400,000 or more.2 Under current law, the tax rates are scheduled to revert to a top rate of 39.6% in 2026.3

Currently, the top rate on long-term capital gains and qualified dividends is 20%. Certain long-term gains and dividends are also subject to the additional Net Investment Income tax of 3.8%. The Democratic plan would increase the top capital gains rate to 39.6% for taxpayers with an adjusted gross income (AGI) of $1,000,000 or more. On the other hand, the President has indicated he would like to see a top capital gains rate of 15% in the future.

The Tax Cuts and Jobs Act of 2017 (“TCJA”) eliminated the phase-out of itemized deductions through 2025 but capped the allowable itemized deduction for state and local taxes at $10,000. The Democratic tax plan would end the cap on state and local taxes but reinstate the limitation on itemized deductions for taxpayers with AGI over $400,000. Itemized deductions would be capped for taxpayers in a tax bracket higher than 28%.

Under the TCJA, the maximum Child Tax Credit is $2,000 per child through 2025. Additionally, an Earned Income Credit and Dependent Care credit may be available, depending on income and family size. The Democratic tax plan increases the Child Tax Credit to $8,000 per child, subject to a $16,000 maximum and includes a new $5,000 credit for caregivers for individuals with certain physical and cognitive needs. The Democratic tax plan also includes a modest expansion of the Earned Income and Dependent Care credit for older and childless workers. A credit for first time homebuyers and renters is also added in Biden’s plan.

Certain tax deductions, incentives, and credits may change

The Tax Cuts and Jobs Act of 2017 (“TCJA”) eliminated the phase-out of itemized deductions through 2025 but capped the allowable itemized deduction for state and local taxes at $10,000. The Democratic tax plan would end the cap on state and local taxes but reinstate the limitation on itemized deductions for taxpayers with AGI over $400,000. Itemized deductions would be capped for taxpayers in a tax bracket higher than 28%.

Under the TCJA, the maximum Child Tax Credit is $2,000 per child through 2025. Additionally, an Earned Income Credit and Dependent Care credit may be available, depending on income and family size. The Democratic tax plan increases the Child Tax Credit to $8,000 per child, subject to a $16,000 maximum and includes a new $5,000 credit for caregivers for individuals with certain physical and cognitive needs. The Democratic tax plan also includes a modest expansion of the Earned Income and Dependent Care credit for older and childless workers. A credit for first time homebuyers and renters is also added in Biden’s plan.

Payroll tax rules may be revised

Under current law, Social Security and Medicare taxes (FICA) and Railroad Retirement taxes are withheld and paid at a total 12.4%, which is split between employer and employee. Under current Executive Action, employers may defer the employee’s portion of payroll tax withholding under certain conditions. The President has stated a desire to eliminate deferred payroll taxes and eliminate or reduce future payroll taxes. The Democratic plan retains the current payroll tax rate and eliminates the wage base cap on income over $400,000.

Retirement plans may be encouraged

The Democratic plan calls for greater incentives for taxpayers to enroll in qualified retirement plans and give lower income workers greater retirement benefits. This could include automatic enrollment with an opt out provision and employer-facilitated IRA savings for certain workers.

It also converts the deduction for contributions to Individual Retirement Accounts and employer sponsored qualified retirement plans into a 26% tax credit, which would provide a larger benefit to lower income workers. Existing contribution limits would remain the same, and Roth IRAs would not be affected. The Republicans have not called for a change to current law.

State income taxes could be raised

Regardless of the outcome of the 2020 elections, many states are experiencing an economic crisis from the financial impact of COVID-19. States may consider increasing revenue through raising tax rates, expanding the tax base, limiting deductions, incentives and credits, or imposing new taxes.

Given these possible changes, there are a few strategies and planning opportunities to consider with clients – this is especially true if they are at or near retirement age.

Planning opportunities to consider

  • Accelerate earnings to 2020: Typically, tax deferral is a major goal, so this seems counterintuitive. However, if your earnings will be taxed at a higher rate in 2021, it may make sense to take bonuses in 2020, if possible.
  • Analyze Required Minimum Distributions (RMDs): Individuals are not required to take required minimum distributions from their qualified plans in 2020 under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”). In many cases, the value of longer tax deferral may outweigh the value of a lower tax bracket; however, if you expect $400,000 or more in AGI in 2021, you may want to run the numbers to decide if you should take or defer 2020 RMD.
  • Think about Roth conversions: If you have been considering a Roth conversion, 2020 may be an optimal year to convert a traditional IRA to a Roth IRA. While taxes are due as a result of the conversion, it may be at a lower rate than the rate at the time you start receiving your traditional IRA distributions. Additionally, earnings on the Roth IRA will grow tax-free.
  • Use after tax dollars to invest in tax-advantaged assets: Now may be the time to explore tax-free bonds or cash value life insurance. While you will be repositioning after-tax dollars, if tax rates increase, the benefit of tax-free income later may outweigh the current cost.4 You may also consider a tax-deferred product, such as a variable annuity, but distributions will be subject to income tax if you take them later, so be aware of future income tax consequences.5
  • Review your portfolio: While selling assets that will result in large capital gains often makes sense when the capital gains rate is going up, it’s impossible to predict whether the rate will go up, down or stay the same. However, it may make sense to review your portfolio to ensure you are properly diversified and have an appropriate asset mix. If you need to sell some assets to re-balance the portfolio, the top capital gain rate in 2020 is 20%, which could increase next year.

Regardless of the outcome of the 2020 election, some taxes may increase in 2021. The federal government has allocated trillions of dollars in fiscal and monetary support to the COVID-19 crisis, and many states are facing budget shortfalls. Tax changes passed in 2021 may also be made retroactive to January 1, 2021, so now is the time to analyze finances and plan for the coming tax year.

 

Disclaimer:

This information is general in nature and is not intended to be tax, legal, accounting or other professional advice. The information provided is based on current laws, which are subject to change at any time, and has not been endorsed by any government agency.

Neither Nationwide nor its representatives give legal or tax advice. Please have your clients consult with their attorney or tax advisor for answers to their specific tax questions.

Sources

NFM-20167AO