Could New Tax Legislation Impact Your Wealth Plan?

The latest, but almost certainly not the last and final, tax proposal is the $3.5 trillion tax and spending bill proposed as part of the budget reconciliation process. As the package is debated and negotiated in Congress, changes are likely to be made. In addition, given the thin majority margin the Democrats hold, the only way the bill is likely to pass in the Senate is if every Democrat votes in favor of the bill and Vice President Harris breaks the tie. Given that some Senators have taken positions against the bill, the Committee could still make changes to the bill to gain their vote, or the bill will simply fail to pass.

So, while we do anticipate that tax legislation will be enacted this year, there is still a high degree of uncertainty about what the final provisions will be. The major categories targeted in the current proposal include:

• An increase in tax brackets and rates for income and capital gains
• Changes to estate and gift tax exemptions
• Eliminating planning options with grantor trusts
• Restrictions on the use of Roth and traditional IRAs

What's Not In The Bill?

Several significant items that appeared in earlier proposals and were widely reported in the media did not make it into the House bill.

• The step-up in basis, which would treat the inheritance of appreciated assets as a “sale” triggering capital gains, is not mentioned
• The proposed top marginal income tax rate and capital gains rates have not been equalized
• A “wealth tax”, or tax on one’s assets or net worth, was not introduced

Top Marginal Income and Capital Gains Tax Rates

Similar to previous proposals, the top marginal tax rate would increase from 37% to 39.6%. In addition, the top income bracket would be lowered (to $400,000 for a single filer, $425,000 for heads of household, and $450,000 for those married and filing jointly). For those in the top income bracket, the tax rate on capital gains also would rise from 20% to 25%, effective September 13, 2021, the day the proposal was introduced. The current 3.8% surtax on net investment income also would now apply to anyone in the top income bracket. An additional 3% surcharge would apply to individuals with more than $5.0 million in modified adjusted gross income (adjusted gross income minus investment interest expense).

Estate and Gift Tax Exemptions are Reduced

The proposal would lower the federal estate tax exemption back to $5.0 million ($10.0 million per married couple). This would take place January 1, 2022, rather than December 31, 2025, the original sunset date of current exemption levels. There are also some changes in valuation methods on some assets for estate tax calculations.

• On the plus side for taxpayers, qualified real property used for farming, a trade, or other business allows the estate to value the property based on its actual use rather than its fair market value.
• On the negative side, the proposal eliminates valuation discounts to nonbusiness interests in closely held entities, such as Family Limited Partnerships, which are often created specifically for investment and wealth transfer purposes. Currently, nonbusiness minority interests in a family partnership or limited liability company that are closely held are discounted for estate valuation purposes to reflect the lack of control and marketability. The proposal would treat holdings as a pro rata share of the assets and would likely result in a substantial increase in value for many of these interests.

Intentionally Defective Grantor Trust (IDGT) Tax Planning Option Eliminated

Unexpectedly, the proposal eliminates the IDGT tax planning strategy. In an IDGT, the grantor is considered the owner of the trust for income tax purposes, but (if properly structured) the IDGT assets are not considered part of the grantor’s taxable estate. The new provision would consider transfers to the IDGT by the owner a taxable event. While this change would not apply to assets already in IDGTs, it would apply to new IDGTs and additions to existing IDGTs.

Changes to Backdoor ROTH IRA and “MEGA BACK-DOOR ROTH”

So called backdoor Roth IRAs and mega Roth IRAs have been a high-profile topic of discussion. With these accounts, owners pay the income tax, the assets grow tax free, and qualified distributions are not taxable. A backdoor Roth IRA refers to establishing a traditional IRA, then converting it to a Roth IRA to circumvent both income and contribution limits. A mega back door Roth IRA can be created by converting after-tax contributions to qualified plans or IRAs to a Roth IRA. The House proposal would eliminate back door Roth conversions for those in the top tax bracket and would eliminate mega back door Roth conversions for everyone, regardless of income level.

Changes to IRAs For High-Income Individual with Large IRA Balances

For a high-income individual whose aggregate IRA and 401(k)/defined contribution accounts exceed $10 million as of the end of the prior taxable year, IRA contributions would be prohibited and the required minimum distribution (RMD) is greatly accelerated, as the owner, regardless of age, must take 50% of any amounts over $10 million and 100% of any amount greater than $20 million.

Restrictions to IRA Holdings

The proposal also covers restrictions on holding special assets in IRAs, placing a 10% cap on certain investments in which the owner has an interest (e.g., family-owned businesses or real estate held for investment). IRAs would also be prohibited from owning assets limited to “qualified investors.” IRAs that do have these holdings must unwind them within two years or lose their status as an IRA.

Conclusion

If some, or all, of these tax law changes are enacted they could have repercussions for your wealth plan. A conversation with your Advisor can help you assess how any changes might impact your investment strategy and provide advice and guidance to help keep your plan on track to meet your goals.