What Could it Mean for You if He Wins?
2020 has been an eventful (and chaotic) year, to say the least. The pandemic is raging, the stock markets crashed in March, many businesses are closing their doors, and we appear to be some ways away from returning to normalcy. Before the year concludes, we also have an upcoming presidential election. This article focuses on what a Biden presidency and his tax proposal may mean for your taxes, and what, if anything, we recommend doing to prepare for the possibility. Please note that we are not providing tax advice and recommend speaking with a tax professional before adjusting your finances.
At a high level, Joe Biden’s tax proposal moves toward a more progressive tax regime than we currently have. The motivating idea is that those who earn less will pay less in taxes (as a percentage) than those who earn more. The proposal draws an unofficial cutoff for high vs. low annual earnings at $400,000 for a single person. As stated in the proposal on Biden’s website, he “won’t ask a single person making under $400,000 per year to pay a penny more in taxes”. In the sections below, I outline some of the changes that could evolve from a Biden presidency and actions you might consider.
Biden’s proposal increases the top marginal tax rate to 39.6%. Under current law, the 37% top rate is scheduled to revert to 39.6% in 2026. In addition, the proposed plan lowers the threshold for the top tax rate to $400k, down from $518k for single filers.
Capital gains and dividends
Taxpayers earning over $1M per year will see an increase in their capital gains and qualified dividend tax rates. Currently, the top rate for these types of income is 20% (plus a potential 3.8% Net Investment Income Tax, which remains unchanged under the Biden plan). Under the proposal, capital gains and qualified dividends would be taxed as ordinary income instead of at the current preferred rates. For filers in the top tax bracket, this translates to a rate of as much as 43.4% (39.6% ordinary income + 3.8% Net Investment Income Tax), or a potential increase of almost 20%. Importantly, this top rate only applies to capital gains and qualified dividends above $1M. For example, if you earn $950k from your employer and receive $51k in qualified dividends, only $1k (the amount of total income that exceeds $1M) is subject to the higher tax rate.
The proposed plan eliminates the Qualified Business Income (QBI) Deduction for those earning more than $400,000. The QBI deduction is currently available to owners of pass-through businesses and those who own certain real estate investments (including REITs). The proposal also caps the value of itemized deductions at 28% for those earning more than $400,000. Depending on your tax bracket, this may limit the value of things like charitable donations, mortgage interest, and state and local tax deductions.
Biden proposes to reduce the exclusion amounts for estates and gift taxes to the levels they were in 2009. This means a reduction from $11.58M to $3.5M per person with a top rate of 45%. The proposal also calls for the elimination of the step-up in basis rules which eliminates unrealized gains for capital assets upon the owner’s death. The proposal would tax unrealized gains at death, regardless of the size of the estate.
Biden proposes changes to four major tax credits (some of these credits phase out or are reduced for higher earners):
- Child Tax Credit increases from $2,000 to $3,000 for children under age 17 or to $3,600 for children under 6.
- Child and Dependent Care Credit increases from $3,000 to $8,000 for one child and from $6,000 to $16,000 for two or more children.
- First-time Homebuyer Credit – Biden would also restore this credit that President Bush introduced in 2008 and President Obama expanded in 2009. The proposed credit appears to be worth up to $15,000, with a cap of 10% of the purchase price.
- Newly established Caregiver Credit is set at $5,000 for individuals providing informal care to those in need of long-term care. According to the proposal, the plan will also “increase the generosity of tax benefits for older Americans who choose to buy long-term care insurance.”
In addition to the tax credits mentioned above, Biden proposes to establish a new credit for retirement account contributions. Currently, contributions to a pre-tax retirement plan receive a deduction equal to your marginal tax rate. For example, for someone in the 12% marginal bracket, a $1,000 contribution to a retirement plan provides a $120 reduction in taxes owed in the year of contribution. For someone in the 37% marginal bracket, the same contribution provides a $370 tax reduction. The new proposal eliminates the tax deduction and replaces it with a refundable tax credit equal to 26% of the contribution, regardless of earnings.
There are also several other changes that do not fall into the categories above.
- Currently, Social Security taxes are collected (through payroll deductions from both the employer and employee) on earnings up to $137,700. The proposal calls for a “doughnut hole” approach that would require paying these taxes on the first $137,700 in earnings as well as on earnings above $400k.
- The proposal restricts 1031 exchanges for those earning more than $400k. These exchanges allow real estate investors to defer paying tax on selling and buying new property.
- Biden proposes to increase the corporate tax rate from 21% to 28% and imposes a 15% minimum tax on companies’ book income.
What does it all mean?
With the numerous changes outlined above, you may be wondering how all these proposed changes will affect your after-tax income and if you can do anything about it.
According to the Penn-Wharton Budget Model, those earning at or below $400,000 would see their after-tax income decrease by 0.9%. Those earning above $400,000 (the top 1.5%) would see a decrease in after-tax income of 17.7%. The Tax Policy Center says that “in total, almost 93% of the tax increases would be borne by taxpayers in the top quintile of the income distribution”.
While there are just days left before the election, much is still unknown. The outcome of the election will have a major influence on what changes the Congress will enact, the components and details of the proposals are still being developed, and even if we knew the makeup of the new Congress and the proposals were final it is unclear whether such a sweeping proposal would pass. With so much yet to be decided, it is probably not reasonable to make substantial changes to your portfolio or income in response to specific components of the proposal.
That said, it may make sense to anticipate a more progressive tax code as the outcome of the election becomes clearer. You may wish to consider some of the following strategies to help lower your tax burden if Biden wins.
Potential tax strategies
- To minimize the impact on changes to ordinary income, capital gains and qualified dividends, and deductions:
- For those earning over $1M, realize capital gains in 2020 while the top long-term gain is 20% instead of ordinary income rates (could be as high as 39.6% if proposal passes next year).
- For those earning over $400k, accelerate ordinary income in 2020 to pay ordinary income taxes at today’s rates.
- Adjust your investments (however, do not let the tail wag the dog, focus on overall after-tax returns)
- Increase the use of tax-free municipal bonds if you are in the top tax bracket
- Reduce dividend paying investments
- Accelerate deductions into 2020 (when they are not capped at 28%)
- Specifically, consider using a donor advised fund to help bunch charitable giving.
- Consider Roth conversions or Roth retirement plan contributions
- Because pre-tax savings would provide a fixed 26% credit instead of deduction at marginal tax rates, the value of pre-tax savings for those in the 32%, 35%, or 37% brackets is diminished, and Roth contributions may be more advantageous.
- To respond to changes to estate tax proposals:
- Consider gifting throughout your life to minimize the size of your estate if the estate tax exclusion decreases.
- Consider large gifts in 2020, in excess of the current annual gifting limits, before lifetime gifting limits are reduced.
- Increased use of advanced estate planning and trust use (GRATs, CLATs, and others) to help decrease the size of your estate.
- Installment sales
- For businesses or other taxable transactions (to spread out income over multiple tax years) and stay under the $400k or $1M income limits that may trigger changes that would increase your taxes.
Within the next few weeks, we will find out the results of the election. If Trump is re-elected, Biden’s proposal will be irrelevant. If Biden is elected and Democrats do not gain control of the Senate, these proposals would be unlikely to pass. Even if there is a Democratic sweep, these proposals may still not pass.
You may wish to await the results of the elections before putting any plans in place. If you fall into the $1M+ or $400k+ income ranges, you may choose to preemptively make adjustments ahead of 2021. Please reach out to your advisor if you have any questions or to discuss how these potential proposals may impact your plan. Consult your tax advisor before taking any steps. Regardless of who you support, please get out and vote and we’ll see you on the other side!