Tax Hikes Are Coming—Here’s How to Prepare

Even before President Biden took office, many high-net-worth individuals began preparing for the possible tax changes ahead. And now that lawmakers are hard at work figuring out how to pay for the $3.5 trillion budget resolution they passed in August, pre-emptive tax planning seems even more prudent.

So far, we can’t be sure which adjustments to the current tax laws, if any, will make it through the House and Senate. Key details differ from one proposal to the next, and it’s likely there will be more negotiations and compromises going forward.

Still, it appears some reforms could take effect as early as the start of 2022—and possibly sooner, if a proposed increase in the capital gains tax rate is retroactively tied to its “date of announcement.”  That means now is the time to consider how you might reduce the short- and long-term impact various potential tax changes could have on your finances.

Here are some of the proposals that currently are on the table—and actions that could help mitigate the challenges they might pose.

Proposed Change: An Increase in the Top Income Tax Rate

When President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law in 2017, the top marginal income tax rate went from 39.6% to 37%. The reduction was only temporary, and the lower rate is set to expire at the end of 2025. But House Democrats have proposed reinstating the rate to 39.6% in 2022 instead, and applying it at substantially lower income thresholds than the TCJA established—$400,000  for single filers, for example, and $450,000 for joint filers.

Possible Strategies:

• Accelerating Income from 2022 to 2021. One way to protect yourself, if your tax rate does indeed increase in 2022, may be to sell appreciated stocks or other assets before year-end. Other possibilities might include taking next year’s annual bonus in December rather than January, or asking clients if they can pay on their accounts a month or two earlier than planned.
• Converting to a Roth IRA. Advisors have been discussing the pros of a Roth conversion ever since the TCJA first lowered tax rates in 2018. And there’s still time. If it looks as though you’ll be in the highest tax bracket in 2022, you can convert an existing traditional IRA to a Roth IRA now and be sure the conversion will be taxed at your current rate instead of a possible 39.6%. (You won’t have to worry about higher tax rates in the future, as qualified withdrawals from a Roth aren’t taxable.)
• Increasing Retirement Contributions. If you have a 401(k) or similar tax-deferred plan, you may want to consider boosting your contributions in 2022, to lower your taxable income.
• Upping Charitable Donations. Giving more to your favorite charities next year may be another way to save if your tax bracket changes and/or your tax rate increases.

Proposed Change: An Increase in the Long-Term Capital Gains Tax Rate

The most recent proposal from House Democrats would increase the top long-term capital gains tax rate from 20% to 25%. Though higher numbers have also been mentioned, this seems the most likely amount to make it through Congress. What’s still up for debate is when the new rate would become effective, as there’s some talk of making it retroactive. Whether that happens or not, starting in 2022, single filers would pay the top federal rate if their taxable income exceeds $400,000, and the threshold would be $450,000 for those filing jointly. (This plan differs from a previous White House proposal, which called for a top rate of 39.6% for individuals who earn more than $1 million a year.)

Possible Strategies:

• Realizing Gains This Year. It might make sense to look at selling highly appreciated public stocks before the rate changes—especially if you were considering making the sale anyway.
• Smoothing Income. Consider spreading out any gains that might trigger the new, higher tax rate. Instead of accepting a lump sum for the sale of a business or other asset, for example, could you receive the amount over a period of a few years?
• Harvest Capital Losses to Offset Taxable Gains. Now is the time to check your holdings for harvesting potential.
• Switch to Tax-Free Assets. It may make sense to move some money into municipal bonds or other investments that are exempt from federal taxes.
• Wait for More Favorable Reforms. It’s possible the next administration to take office will reverse or modify some of the current tax changes. If you don’t need the money from the sale of your asset, you may want to hang on and see what happens down the road.

Proposed Change: A Smaller Gift and Estate Tax Exemption

Thanks to the TCJA, the estate and gift tax exemption is more than twice what it was in 2017. This year, the exemption is $11.7 million for individuals, adjusted for inflation, and double that for married couples. Under the TCJA, the exemption was set to expire at the end of 2025 and return to what it was in 2017 (adjusted for inflation). But some lawmakers have proposed reinstating the 2017 exemption amount—or possibly lowering it further, to $3.5 million—in 2022.

Possible Strategy:

• Make Gifts Earlier than Planned. If you intended to use the full exemption but haven’t gotten to it, consider following through before any reduction takes place—whether it’s in 2022 or 2026. The cost of delaying could be millions of dollars that might have gone to your loved ones.

There’s a Difference Between Preparation and Panic

Mitigating tax risk is always a critical part of the financial planning process, and it will be especially important if new tax laws are enacted.

However, the potential for tax savings should never be the sole consideration when making investing or gifting decisions.

And remember, all of these proposed reforms are subject to change during the legislative process. Moving too soon could be a mistake.

The team at Opal Wealth Advisors will continue to monitor the changes as the situation evolves, and we’ll provide updates when we’re clearer on what’s coming. In the meantime, if you have any questions please contact your Opal advisor and he/she will be happy to discuss how specific tax reforms might affect you and your family.