"The difference between death and taxes is death doesn't get worse every time Congress meets."
Will Rogers, American actor
As most business managers and tax professionals know, the 2017 Tax Cuts and Jobs Act ushered in significant changes to the tax code. Some good. Some bad. The $10,000 cap on state and local taxes certainly was not a fan favorite, while the changes in marginal tax rates were welcomed. Of course, some of the more important business deductions were protected.
For example, the IRS allowed a junkyard owner to deduct the cost of cat food as a business expense. The taxpayer claimed that the food was necessary to attract feral cats, who kept rats and snakes from infiltrating the property.
In a year of uncertainty, one thing we can be sure of is that because taxes are based on legislation, they will continue to change over time.
No matter your political affiliation, the results of the 2020 election were an incredibly unsatisfying result for financial planning. The political clarity, which leads to planning clarity, did not materialize and we are still left asking who will control the Senate come 2021. Will there be political gridlock for the next two years? Or will Democrats be able to drive their legislative agenda? Unfortunately, we won’t have those answers until January 5th, meaning many year-end tax planning decisions will be harder than ever.
According to the Bureau of Labor Statistics, taxes are the largest expenditure (33.5%) for households earning over $200,000 and are 67% higher than the second largest expense, housing (20.1%). The incoming Biden administration has made tax reform one of their top priorities. Should Democrats win both Senate seats in Georgia run-off election this coming January, there’s a high probability we see tax reform in some capacity over the next two years.
Some of the more notable components of President-Elect Biden’s tax proposal include:
- Increased ordinary income tax rates for incomes greater than $400,000.
- Cap on itemized deductions at 28%.
- Tax long term capital gains at ordinary income rate for households earning over $1 million (20% -> 39.6%).
- Tax unrealized capital gains at death – eliminating step up in cost basis.
For high-income earners, accelerating income into 2020 may make sense if you’re already in the highest marginal tax bracket. One of the more common techniques for accelerating ordinary income is through Roth conversions, which locks in today’s tax rate, allowing those funds to grow tax-free for the future. Business owners may also benefit from accelerating their billing in 2020, while delaying expenses until 2021.
With regard to investment management, the effective tax management of investment portfolios only becomes more crucial with the prospect of higher capital gains rates. The most challenging question for the rest of 2020 is whether to harvest capital gains or losses. Put another way, do I want tax insurance or a tax asset?
Realizing long-term capital gains in 2020 effectively captures today’s tax rates. If you believe that capital gains rates will substantially increase, the realization of those gains is effectively an insurance policy against the future. Conversely, realizing capital losses creates a tax “asset” that can be carried forward to offset future gains or even some ordinary income (up to $3,000). However, if capital gains rates increase to nearly 40% (not including any applicable state taxes or net investment income tax), it may be more advantageous to bite the tax bullet at today’s lower rates. Reinvesting the proceeds into a qualified opportunity zone is one way to make the tax bill more palatable, as gains can be deferred and reduced over the holding period.
Academic research concludes that taxable investors are giving up one to two percent of return to taxes each year. Deploying effective tax-management adds significant value and is at least as important as managing fees and expenses. Tax loss (or gain) harvesting, capital gain allowances, and wash sale avoidance are just a few of the tools that improve after-tax returns.
For those charitably-inclined, gifting appreciated securities or utilizing other tax minimization techniques such as donor advised funds (DAFs) or qualified charitable distributions (QCDs), should become more valuable with the prospect of higher future tax rates.
Going into the final weeks of 2020, tremendous uncertainty exists with regard to tax reform for 2021. Many year-end planning decisions will need to be made on a case by case basis with the understanding that we could see significant changes to the tax code in 2021, or none at all. Maybe we’ll get to deduct pet food for our emotional support animals or the therapy sessions needed to get through 2020, or maybe not. No matter the potential changes, your team at Stonebridge is committed to helping you navigate these difficult decisions with proactive planning and tax-managed investment strategies. We are guides in a changing landscape, not defenders of a map.
Over the course of 2020, our Purposeful Planning series has focused on goals-based wealth management, financial planning, retirement, risk management, asset protection and taxes. We’re hopeful that you found this series informative and instructive.
Thank you for your continued trust and confidence. We wish you a wonderful holiday season and new year that can’t get here soon enough.
Tyler Martin, CFP®
Director of Financial Planning