Tax Planning In Uncertain Times

We are living in a time of increasing political uncertainty. In 2017, Congress cut corporate and individual tax rates dramatically. Former Vice President Joe Biden now campaigns on a platform to increase taxes. He proposes the following:

1. Revert the top individual income tax rate for taxable incomes above $400,000 from 37% to 39.6%.

2. Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1 million and eliminate the step-up in basis for capital gains taxation at death.

3. Cap tax benefits for itemized deductions.

4. Phase out the qualified business income deduction (Section 199A) for filers with taxable income above $400,000.

5. Increase the corporate income tax rate from 21% to 28%.

6. Create a minimum tax on corporations with book profits of $100 million or higher.

7. Double the tax rate on Global Intangible Low Tax Income (GILTI) earned by foreign subsidiaries of U.S. firms from 10.5% to 21%.

8. Impose a 12.4% Old-Age, Survivors and Disability Insurance (Social Security) payroll tax on income earned above $400,000.

What can be done to plan for these potential changes? Some tax advisors suggest selling appreciated assets in 2020 for fear that tax rates will increase in 2021. Warren Buffett once noted, however, that taxes should not drive investing decisions. If you have made a good investment, why exit the investment and put your money in cash, for fear that you might pay more taxes on investment gains? Instead, Buffet has established a tax efficient structure with Berkshire Hathaway to make long-term investments. Its operating companies distribute profits to their parent tax-free; the parent then reallocates capital where it is most needed. You too can plan for proposed tax increases by creating a flexible, tax-efficient plan to grow and reallocate savings. Although every individual has different circumstances, below are some general strategies to do so:

Invest in a Roth 401(k). A Roth 401(k) allows younger taxpayers to set aside more money each year for retirement than a traditional 401(k) and exempts income and gains from tax. Today, you can invest $19,500 of after-tax income annually in a Roth 401(k) but only $19,500 of pre-tax income in a traditional 401(k). If the $19,500 grows 5% (compounded) each year for five years, you will have $24,888 in savings for retirement with the Roth 401(k). You will have only $16,177 in savings with the traditional 401(k) in the fifth year, because the total amount is taxed upon withdrawal at ordinary income rates (assuming a 35% tax rate). Most employers offer Roth 401(k)s in addition to traditional 401(k)s. 

Save and invest for the long-term. Short-term investing lends itself to higher transaction costs and taxes. Investing for the long term helps minimize such costs even as tax rates increase. Consider investing in individual stocks or index funds rather than traditional mutual funds. Traditional mutual funds typically buy and sell stocks more frequently, incur greater transaction costs, and make more frequent taxable capital gains distributions. Such distributions generate higher costs as tax rates increase.

Establish a flexible estate plan. The current lifetime federal estate tax exemption amount is $11,580,000. This federal exemption amount is set to revert to $5.6 million in 2026. The IRS recently issued a ruling that it will not claw back the gift tax exemption allowed for large gifts should the estate tax exemption revert to $5.6 million after 2025. This ruling provides taxpayers assurance that any planning they do now (to avail themselves of the current federal estate tax exemption) will hold up in the future. States such as Massachusetts have their own state level estate tax exemptions, which are much lower than the federal exemption. You must consult with your advisor to consider these exemptions in your estate planning. 

To plan for a reduction in the federal estate tax exemption, older taxpayers can do the following:

a. Make annual gifts equal to the annual gift tax exclusion amount ($15,000 per person in 2020). In addition, consider paying the medical or educational expenses of your family members. Such direct payments are not treated as gifts requiring tax filing obligations, nor do they reduce the lifetime gift tax exclusion of $11,580,000.

b. Make lifetime gifts that utilize a portion of the lifetime estate tax exemption. If you transfer a minority interest in property, the transfer may qualify for a discount in value for gift tax purposes. Consider using an irrevocable trust as the vehicle for annual gifts as well as larger gifts. Bear in mind that appreciated assets in irrevocable trusts will not receive a step up in basis if the step up remains. 

c. Transfer life insurance policies to an irrevocable life insurance trust. Such transfer removes death benefits of existing life insurance policies from your estate. 

d. Give property other than cash to charity. If you donate appreciated property to charity, you receive a deduction for the full value of the property. You may also consider establishing a charitable remainder trust (“CRT”), where you transfer an appreciated asset into an irrevocable tax-exempt trust. This transfer removes the asset from your estate and affords you an immediate charitable income tax deduction for a portion of the asset value. Because the trust is tax-exempt, its trustee can sell the donated asset at fair market value and pay no capital gains tax and re-invest the proceeds in income-producing assets. The trust pays you income for life and, when you die, transfers the remaining trust assets to the charities you have chosen.

A flexible plan to grow and reallocate savings over the long term minimizes taxes and other transaction costs. In these uncertain times with potentially increasing tax costs, focus on the long term rather than the whims of markets and politics. Work with your advisor on a flexible plan that you may reevaluate each year to adapt to life’s changing circumstances.

Source: https://www.fa-mag.com/news/tax-planning-in-uncertain-times-57136.html?section=40