Tips for the Coming Tax Code

Andrew Busa:

Hello, this Andrew Busa, and I’m a financial planner here at Adviser Investments. Welcome to another episode of The Adviser You Can Talk To Podcast. Today, I’m joined by two of my colleagues, Patrick Carlson.

Patrick Carlson:

Hi, Andrew.

Andrew Busa:

He heads up Wealth Services. And Diana Linn.

Diana Linn:

Hey, there.

Andrew Busa:

She is a fellow CERTIFIED FINANCIAL PLANNER™ and account manager at Adviser Investments. So great to have you both. Well, Congress is at it again. As soon as we think we’re comfortable with the tax code, things get changed. This tends to happen, it feels like.

Patrick Carlson:

Yeah. Andrew, that’s true. We can never really get too comfortable. Major tax bills, it seems like every couple of years now, just keeping us on our toes.

Diana Linn:

Yeah. But let’s look at the silver lining here. Right? So potential changes means new planning opportunities. So we can’t forget that.

Patrick Carlson:

Absolutely. And I think we’re going to talk about some of those later in the episode too.

Andrew Busa:

We definitely will. I like looking on the optimistic side of things. And as a reminder, this is a really important point. This legislation that we’re talking about today is still pending. So none of what we’re talking about today is actually law yet. All this information is subject to change and we will be doing another episode when a bill actually does get passed. But we think it’s important to update the listeners with sort of where the conversation is right now in the House of Representatives to keep you all posted about where the conversation is headed.

Andrew Busa:

Now we’ll keep today’s episode relatively quick, we’re going to move through our topics pretty quickly. And we’re going to focus in on how this new pending legislation will really affect three broad categories of individuals. So we’re going to talk about those in the accumulation phase of your financial planning life, those in the withdrawal or the retirement phase, and finally, for those clients who are planning for a legacy in their heirs and the next generation.

Patrick Carlson:

Andrew, I think that’s a great way of approaching it because the bill has very different consequences depending on where you are in life’s financial journey.

Diana Linn:

Yeah. I think we should also preface this by saying that if you earn less than that $400,000 to $450,000 threshold that’s being laid out in these proposals, or if your net worth is below $6 million, a lot of these new provisions are not going to affect you. I mean, that’s not totally true across the board, but that’s mostly who this new bill is aimed at. Would you, gentlemen, agree?

Andrew Busa:

Yeah, I think so. I mean, that’s definitely who the bill is targeting. But like you said, there are some implications for other folks, but I think that’s a good point to start off with. Now, we won’t hit everything in this new 800 plus page proposal because frankly nobody has time for that on this episode, but we’re going to hit the highlights. Let’s talk about this first group of folks here who are in the accumulation phase of their lives. So here, we’re thinking about for the most part, people who are in their 30s, 40s, and 50s. You’re in your high-income earning years. You’re trying to save and put away for retirement as best you can. So Patrick and Diana, where do we go first here?

Diana Linn:

Well, I think we need to start with talking about the income tax bracket, right? I mean, part of me, I think back to that movie of like “It’s Back,” that 39.6% income tax bracket. As you may recall, that was previously the top rate through 2017 until the Tax and Jobs Act dropped it to 37%. So if enacted, this top 39.6% will be back and take effect in 2022.

Andrew Busa:

Right. And that goes back to what you said in the intro. Those income thresholds, that $400,000 and $450,000, that’s sort of who this income tax bracket will affect. And then also capital gains brackets are changing around a bit, right?

Diana Linn:

Yeah, it seems to look that way. I mean, currently, if you are a single… If you file your taxes as single and you’re earning less than $40,400, you pay nothing right now. So 0% on those long-term capital gains. And then the next tax bracket is actually quite large. So anyone earning anywhere from $40,401 to all the way up to $445,850, their long-term capital gains tax rate is 15%. And then anything beyond that, so $445,850 is taxed at 20%. This new bill, it seems as if they’re proposing lowering that 15% income cap to $400,000. So anyone below that $40,400 will remain at 0% and then $40,401 through $400,000 will be 15%. And then anyone beyond that will now pay 25% rate.

Diana Linn:

While this isn’t great news for high-income earners, it’s not as bad as we initially braced for as there were rumors of removing those long-term capital gains treatment altogether. So I also wanted to note that these new capital gains rate are set to begin immediately. So if written into law as proposed, these would be effective as of September 14. It’s already October 26. So that date has passed. So those taxpayers with large unrealized gains, you won’t be able to make any changes or sell those assets and avoid that higher tax treatment.

Andrew Busa:

Those are all really good points. And one thing I’m thinking about is in these future years, if you have capital losses that are sort of embedded into your investments, those are probably going to be more valuable to you in future years to offset some of those gains. Right?

Diana Linn:

I couldn’t agree with you more that tax-loss harvesting is going to become a pretty important component of your financial plan.

Andrew Busa:

And Patrick, I’m hearing about a new surtax as well.

Patrick Carlson:

Yeah. I get to play the part here of, “And that’s not all.” I’m reminded of that sort of expression we’ve all heard on TV before. Unfortunately, in this case, it’s not a bonus that we really want. It’s not just that capital gains rate that’s increasing and that top marginal tax bracket that Diana talked about earlier. There’s actually a proposed new 3% surtax on income above $5 million.

Patrick Carlson:

Now, I know I’m sitting here thinking to myself, “Gosh, $5 million income sounds pretty good.” Probably not very many people have that. But you think about the times in life where you might have an occasional pop into that income because maybe you had some rental properties you sold, you sold your home, you have a business that sold. Maybe you came into some company equity and the company has gone public. So this tax doesn’t care if it’s just a one-time thing, you might get trapped into it.

Patrick Carlson:

And the other thing with this tax is that once these things are written into law, what we’ve tended to see is that there’s not like a wholesale wiping away of taxes. Once they’re added in, then they get tinkered with, they get played with. Maybe that $5 million threshold lowers to some other threshold in the future when Congress needs to do that in order to hit some kind of budgetary guidelines. So that’s a concern for us over time because there’s a lot less planning that we can do with this. And Diana, I know that you were sharing that with me as we were preparing for the call about how this is really hard to plan around.

Diana Linn:

Yeah. No, you’re exactly right, Patrick. This is really tough to plan against because that modified adjusted gross income, it doesn’t allow for many deductions as opposed to taxable income. So that’s after all those deductions have been made. So that’s why the modified adjusted gross income is a key qualifier here.

Andrew Busa:

Right. All of a sudden, these terms and distinctions become very important when they might apply to you. Now, I’m going to shift gears for a second. We’re still talking about accumulators. What we’ve talked about so far is mostly going to affect the very highest income earners, but this next one, this could affect actually a broad swath of people if it is actually enacted. So Diana, we have to talk about the potential closing of the window on backdoor Roth contributions, or I should say closing of the door on backdoor Roth contributions.

Diana Linn:

Unfortunately, it seems that way. And I know there are going to be a lot of people that are really disappointed about this because converting assets is such a common strategy for so many people, especially those high earners who often utilize that backdoor strategy. So if enacted, there will be a provision which prohibits converting after-tax retirement assets. Things like your non-deductible IRA and employer-sponsored 401(k) plans, and that’s beginning in 2022. So all of those plans we built, Andrew and Patrick, where we strategically thought of when and how much we should convert to help the client looks like it might be a thing of the past.

Andrew Busa:

Yeah. And again, for folks now who are pretty quickly phased out of making regular Roth IRA contributions, this was a way for them to get excess cash flow into a Roth by doing these backdoor Roth contributions. And this will also apply, like you said, to this sort of less utilized but also very powerful strategy, the mega backdoor Roth. And we’ve talked about that in some past podcasts on the employee benefits maximizing episode and things like that, if you want to learn more about that, but this would also shut the door on that as well. I want to linger on this for one more second and maybe we just talk about…if this does pass as written, where do you both think folks might go with extra cash flow?

Patrick Carlson:

We still have the idea of doing the non-deductible IRA. It’s less advantageous from a long-term standpoint. I think that might still be a strategy for some clients just to continue with that. Obviously, we were getting a lot of extra value with the backdoor Roth, being able to take that money and convert it to Roth, but the tax-deferred investment environment inside of a traditional IRA that’s non-deductible is still a fairly favorable place to invest. It’s just not quite as favorable as it was with the backdoor Roth.

Andrew Busa:

All right. So still get a little bit of tax juice, but not as much as before. But we’ll keep our eye on that one obviously. If things get rewritten or revised, we’ll definitely pay attention to that provision. And then I want to end up this section here, Patrick, there’s this sort of conversation around getting rid of these supersized retirement accounts.

Patrick Carlson:

Andrew, it’s interesting hearing this. We mentioned this in the accumulator phase here as well because some people have done a fantastic job of saving and investing in their accounts. So not only did they put that money in perhaps while they were younger, but they’ve really experienced some fantastic gains over time. And the general rule in this legislation is that there’s not going to be supersized retirement accounts anymore.

Patrick Carlson:

Now, the number they have selected is $10 million as the first threshold. So if you have more than $10 million in the account, one way to think of this is it’s a required distribution. And unlike the required minimum distributions that we’ve all heard about that begin when you’re in retirement age at age 72, this new sort of “no more supersized account distribution” is a dollar-based threshold. It’s not age-based. So if you’re 40 and you’ve done a great job saving and building, and you’ve got $12 million in there, some of that’s going to have to come out if this bill becomes law.

Patrick Carlson:

And over $20 million, the government, basically, this legislation puts a ceiling. It says the largest retirement account you’re allowed to have is $20 million. And it accomplishes that by forcing you to take a distribution of every dollar over that $20 million.

Andrew Busa:

Wow, that’s interesting.

Diana Linn:

Interesting.

Andrew Busa:

So, again, won’t hit a ton of people, but like you said earlier in this section, Patrick, if you are one of those folks, maybe you sold a business, maybe you had a company equity windfall, something like that, maybe you’re starting to think about you might hit those large numbers sooner than you think, it might change maybe a little bit how you save and allocate. And we’ll talk about this a little bit in the next section, actually, with the withdrawal phase of clients. This is a good segue. This is now a large group of clients and individuals we’ll be talking about, folks who are approaching retirement or in retirement. These are people who are living off of required minimum distributions, they’re living off withdrawals from their portfolio. Let’s actually stay with what we were talking about before, Patrick, with these potentially huge RMDs.

Patrick Carlson:

Yeah, absolutely, Andrew. The withdrawal phase clients, these are people who are now retired and living off of their retirement accounts. They’re going to be hit by this potential dollar-based RMD as well. And again, one thing that I should have mentioned earlier that I want to add to the discussion here is you also have to have high income. So these rules of this distribution requirement are that you have to have that adjusted gross income above $400,000 for single tax payers and $450,000 for married filing joint. So there’s a little bit of a marriage penalty also baked into that threshold for married filing joint.

Patrick Carlson:

So again, we might have some clients that have done a great job of building those assets where now we’ve got a dollar-based required distribution that is maybe going to occur before they turn 72. So something that’s going to need to be watched because, again, as far as I understand it, the ordinary penalty rules of 50% of the distribution you should have taken continue to apply. So there could be potentially huge penalties for people who miss it if this in fact becomes law.

Andrew Busa:

Right. And remember, like you said, both of those things need to be true. You need to have high income and the retirement account needs to be in that over $10 million or $20 million range for that big RMD to come out.

Patrick Carlson:

Absolutely.

Andrew Busa:

So we’ll keep that in mind. Now, Diana, I’m going to come back to you. We were talking about the Roth earlier. What’s going on here with potentially Roth conversions being stifled a little bit? This is a huge strategy for folks in retirement.

Diana Linn:

You just want me to be the one to deliver all the disappointing news here. But yeah, for high income earners, so again, keeping those tax brackets the same. So those single filers over $400,000 or joint filers over $450,000, this new provision will prevent Roth conversions all together. So that’s not effective immediately, not effective for 2022 like the other Roth conversions. This will take effect in 2032. You’ve got a couple of years to start to strategize. And Some people are going to have to be really careful here with any Roth conversion planning as just a single dollar could really push you over that edge in terms of income. If you made $450,001, you have exceeded that bracket.

Diana Linn:

We also wanted to know that there seems to be a little bit of a discrepancy in the proposed legislation as to if the amount of assets that you convert to a Roth is included in that adjusted taxable income or not. So if it is included, then that figure will have to be part of your calculation as well in terms of how much to convert.

Patrick Carlson:

Correct. And mathematically, it might just kind of impose that cap. Think of a single taxpayer, if they have that $400,000 income limit and they have $300,000 of other income, does it mean that most we could ever convert is $100 because we can’t go a dollar over that $400 limit in that year? I mean, this could mean for certain clients, that there may be limited ability to do any Roth conversions if you have a lot of other income from investments or otherwise.

Andrew Busa:

If this becomes law generally, that 2032 date you were mentioning earlier, Diana, it’s just really more of an incentive to start doing conversions in the next 10 years. Right? If this is something that made sense for you before, it’s going to make even more sense for you after if this does become law to get those done. Switching gears back to capital gains, this is now also obviously going to affect folks in this phase of life.

Patrick Carlson:

Yeah, because not everybody is living off of IRA assets that have their own set of rules. Some of us have taxable accounts in retirement. And so here, the name of the game is timing those capital gains. And I suppose one easy way of thinking about this is it’s just another capital gains bracket that we have to manage as advisers for you or as tax advisers for you. So right now, we still have capital gains brackets. We’ve got the 0%, for some people 15%. When you add in that net investment income tax that some clients have to pay, it’s 18.8, it might be 23.8. What this new 25% rate that Diana described earlier is it’s just another bracket we’ve got to think about. That 3% surtax that I shared the news on earlier, it’s just another sort of layering in and another bracket that has to be managed here.

Patrick Carlson:

Now, there is, for some of our clients that are in the withdrawal phase, we have more clients like this, this 3% surtax has maybe an unexpected result for those of you who have maybe a family trust or a marital trust. Diana, can you tell us a little bit about how that’s going to work in those family or marital trusts?

Diana Linn:

Yeah. So it looks like that 3% surtax is going to also apply, just like you mentioned, Patrick, if you have a marital trust that is producing $100,000 of income. And to really throw salt in the wound, the capital gains are going to also be subject to that surtax.

Patrick Carlson:

Basically, the bottom line is that you may not think super-high income, but $100,000 of income in a trust is a lot easier to get to, especially if you’ve kind of mistimed some capital gains perhaps.

Andrew Busa:

Absolutely.

Patrick Carlson:

People who were smart with their estate planning years ago, because these were good estate plans when these were put together with these family trusts and marital trusts, that was good estate planning. Now it’s going to have kind of an income tax staying, unfortunately.

Andrew Busa:

Well, all really good points in this section here. And I want to move us to the last section to talk about folks who are planning for that next generation, thinking about their legacies. A lot of this has to do with estate planning. And this section is where we’ll see the need for maybe some quicker decision-making as some of these strategies that we’re going to talk about could potentially be going away. So Diana, maybe we start broadly with talking about that estate exclusion.

Diana Linn:

Yeah. So currently, the estate and gift tax basic exclusion is $11.7 million. So the proposed bill is essentially cutting that exemption in half to $5 million for 2022 onward. Most likely, once you adjust for inflation, it’ll be around $6 million. So the good news here, and I feel like I’m finally giving some good news, the good news is that your grandfathered into what you’ve already done, but the bad news is it’s sort of now or never. So if you think of your estate, if you think that your estate might be larger than this new limit, we recommend speak to your financial adviser, your CPA, your financial planner, to start to put together a strategy for gifting as much of that current exemption before the end of the year.

Andrew Busa:

Because like you mentioned, if you use up your exemption the way it is written right now, they can’t come in and claw that back. And to build on this point a little bit more with the next strategy, Patrick, that you’re going to talk about, this is something that it’s sort of a now or never idea?

Patrick Carlson:

A lot of this planning does kind of force us into that now or never. I mean, the proposed legislation here basically kills off what are called in a broad sense grant or trusts. Now, these have been a staple of estate planning for the last 10 or 15 years, or even longer for really high net worth people. But this bill basically kills them off. So-called GRATs, the grantor-retained annuity trusts; IDGTs, intentionally defective grantor trusts; many, many irrevocable life insurance trusts or ILITs that many of you may have may be fatally wounded by this as well, depending on how they’re structured. So there is some opportunity to have some of these things that have already been done, grandfathered. So there might be a limited window to still do some planning, but going forward, these incredibly beneficial tools for taxpayers are unfortunately going to go away if this bill is enacted as written.

Andrew Busa:

And this sort of pairs with this next strategy and what you’re talking about here, like you said, these are powerful moves for folks who are a lot of times trying to get assets out of their estate to avoid estate taxes down the road, appreciating assets, getting those out of the estate. That’s when we talk about the family limited partnership discounts, right?

Patrick Carlson:

And those are often paired with those grantor trusts in a lot of cases. And the proposal here now, these family limited partnership discounts and discounts generally have had a target on their back for many years. So this is now just a legislative proposal to sort of do them in in a large sense. But one nice thing is there are still exemptions for small family businesses, farms, and ranches. They don’t appear to be affected by this. What Congress is really trying to do here is really from a tax equity standpoint, they are trying to clean out what they think of as abusive transactions. And I’ll just give a quick example of one. You take fully marketable securities, put them into an LLC, and then take a discount on it. I mean, they’re fully marketable. In reality, this is probably something that, at least from an equity standpoint, probably never should have been allowed because that is so different than a family farm or a closely held business. And that’s what they’re trying to try and root out here.

Diana Linn:

So Patrick, would you say that this is sort of amplifying those income-tax inefficiencies that were there before?

Patrick Carlson:

Yeah. I mean, the overall bill here, we’re getting rid of a lot of different trust-based planning options. We are sort of going to be forced probably in the future, at least until we get some time to study and live with the bill if it’s enacted. We’re going to be forced to be in a lot of non-grantor trusts, which are very tax-inefficient. And now we’re going to have higher rates and we’ve got the surtax and we’ve got increased capital gains. I mean, trust-based planning still makes a lot of sense for a lot of clients for a lot of non-tax reasons. But some of the tax things are going to be a little bit more of a painful pill to swallow to get those other non-tax benefits.

Andrew Busa:

Before we leave this section, I just had another question. Say some of these proposals are written into law. You talk about grantor trusts, things like family limited partnership discounts. Is it wrong to think that maybe these might come back someday or how are you approaching that, Patrick?

Patrick Carlson:

Obviously, we’ve seen tax policy swing back and forth over the last 20–25 years or so of legislation. Once something like this goes away completely, we might see it come back, but maybe we wouldn’t. A lot of that’s going to matter kind of how things play out politically. For clients sitting on the fence, if now is the right time to do the planning, if now is the right time and we’ve got the financial plan to support doing large gifting to take advantage of today’s current rules, there’s never been a better time to do it. If the only reason you’re doing the planning is out of fear that the rule is going to change and the financial plan doesn’t look all that great if we take full advantage of it, I’d urge caution. You’ve got to take care of yourself first. We all want to save taxes, but we absolutely need to make sure you have a solid financial foundation for yourself and the rest of your life as well.

Andrew Busa:

That’s a great point. These strategies only make sense in the broader context of a financial plan. So pay plug for the financial planning team here. You’ve got to work, Diana. All right. Well, let’s wrap this up. Diana and Patrick, this has been a really good conversation. I definitely learned a few things and I know that we’ve gotten some questions from clients. I talk to friends and family. People are wondering, where is this tax bill going to land? So let’s just wrap up with our biggest takeaways. I guess I’ll hit lead off here.

Andrew Busa:

I think from a planning perspective, Patrick, point that you mentioned earlier, I think that resonated with me is that a lot of what this bill is going to do is potentially impose more complexity and the need for greater planning when you kind of structure out these potential once- or twice-in-a-lifetime high-income years: Selling a business, selling a highly appreciated stock, your home, a company equity windfall. Those things, you’re going to want to have a little bit more foresight and planning for, is one takeaway for me.

Patrick Carlson:

Absolutely. For me, there’s a lot of what I think of as unfortunate things when it comes from an estate planning perspective. But ultimately, it’s just new thresholds that have to be considered for planning purposes. It sort of changes the way that we might weigh some factors for certain clients, but on the balance, it’s a lot of evolutionary things and responses to what have been very good planning options for clients over the last few years. It’s responses and evolution from that. It’s not really, in my mind, a completely revolutionary proposal. It’s just a lot of response and evolution.

Diana Linn:

And I guess for me, one of the big takeaways is that really everything ties in together, right? It doesn’t feel like that long ago that the three of us were sitting down to talk about the American Rescue Plan and all those wonderful added benefits that came in. And this is just that next layer. So it’s just a nice reminder that these aren’t isolated bills happening in a vacuum. That they all layer on top of each other. So yeah.

Andrew Busa:

That’s a great point. And we’ll be keeping our eye out. Obviously, when a bill does get passed, we will be doing another episode. And again, just to emphasize again, none of what we talked about is law yet. This is all still being discussed. So if you have questions about anything we talked about or about your individual financial plan, definitely get in touch with us. We’re happy to talk to you.

Andrew Busa:

Well, this has been Andrew Busa, Diana Linn and Patrick Carlson from Adviser Investments. And we thank you for listening to another episode of The Adviser You Can Talk To Podcast. If you did enjoy this conversation, please subscribe and review our show. That always helps us out. And you can check us out at www.adviserinvestments.com/podcast. Your feedback is always welcome. And if you have questions or any specific topics that you want us to explore, please send us an email at info@adviserinvestments.com. Thanks for listening.