When we talk about estate planning in 2021 and beyond, what are we doing with our wealth and investing if tax rates start going up? How has technology changed the estate planning process? Should you sell a business or change your succession plan in light of potential legal changes coming from D.C.?
Estate planning is a complex area that needs to be reviewed over time. Laws can change, markets move and goals will shift, requiring estate plans to be updated.
Right now, there are multiple legislative proposals that may impact your estate planning at some point – the most notable being the American Families Plan Act, which includes proposals to increase the ordinary income tax rate and capital gains taxes. Additionally, there are estate law-specific proposals that would dramatically impact many existing plans.
Let’s take a dive into three distinct areas of your estate plan that could be impacted by the American Families Plan Act.
Ordinary income might not stand out as an estate planning driver. However, it drives a lot of our day-to-day behavior – who’s getting paid for what, what we have left over to invest – and that’s why it’s a good starting point for this conversation.
Changes in ordinary income rates could change which assets you continue to hold onto during life and what assets you might transfer sooner to heirs. In some situations, if ordinary income rates go up or down, you might be incentivized to transfer ordinary income-producing property to a lower-income family member or loved one as part of an overall estate planning process.
The American Families Plan Act proposes to restore the top marginal tax – which was lowered by the Tax Cuts and Jobs Act – to 39.6%. That rate is currently 37% and, according to the White House, exclusively benefits the top 1% of households. Additionally, it would change other tax ranges, creating some tax breaks for lower-income Americans.
The Biden administration’s plan would, in essence, be a mix of tax cuts and tax increases when it comes to ordinary income. For higher-income Americans, it would likely be a tax increase, but for more middle-class Americans, it could be a tax cut. But a lot of this comes down to framing. For instance, I recently listened to a presentation from Bob Keebler, CPA/PFS, MST, AEP, CGMA, on proposed tax changes, and he compared the tax rates pre-TCJA, today’s rates and proposed rates in the American Families Plan Act.
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Interestingly, people don’t pay attention to the American Families Plan Act ranges in relation to past rates. In some of the bottom ranges – which are healthy income ranges, up to $200,000 – the American Families Plan Act actually proposes more favorable tax rules than pre-TCJA. So, had the American Families Plan Act proposal been passed in 2017, it would have been a tax cut in a lot of areas – including for corporations and individuals.
For example, let’s say you make $300,000 annually. You used to pay 33% in 2017. Under the American Families Plan Act, you’d be paying 24%. That’s a 9% decrease for the majority of Americans on that marginal amount.
Additionally, there is a lot of spending attached to this bill, including expanded tax credits for families with kids and seriously expanded education funding. But with all of these new tax cuts and spending, there has to be tax revenues somewhere, and the Biden administration has prioritized making the wealthy “pay what they owe.”
Ultimately, this change could impact estate planning in two main ways. First is what we discussed early – shifting income-producing property to other family members if you are subject to higher income tax rates.
Second, it impacts how much money you bring home to invest and save. With higher tax rates, this could change your long-term wealth accumulation and spending strategy, impacting your overall estate plan.
Capital Gains Hikes
Today, married-filing-jointly filers must have over $500,000 of income before they hit the 20% capital gains tax rate. In fact, most Americans fall into the 0% capital gains tax rate.
However, the American Families Plan Act proposal would significantly increase the rates on long-term capital gains and qualified dividends, from 20% to 39.6% – plus the 3.8% net investment income tax – at income over $1 million.
While roughly only 0.3% of Americans have $1 million in income each year, this would end up impacting a lot of estate planning and business owner decisions. A business owner who has $1 million in income and a lot of capital gains when he or she sells the business, could reduce their true after-tax money they receive from sale by almost 20% under the changes. Tax changes like this are hard for people to accept because we’ve framed it for so long that long-term capital gains get preferential tax treatment, and this change would put those rates more in line with ordinary income rates for higher-income individuals.
Let’s look at a potential real-world – if oversimplified – scenario. Let’s say you have $1.2 million of capital gains – $200,000 of that would be at the 39.6% rate. Plus, if you have over $200,000 (for single filers) or $250,000 (for married-filing-jointly filers) in modified adjusted gross income, you would have that 3.8% investment income tax on top of that.
It will be interesting to see if these proposed changes deter people from realizing or cause them to sit and hold in hopes the rates come down at some point.
This could cause some people to change their estate planning process. Some might try to hold assets until death instead of selling them while alive, in hopes that their heirs get a step-up in basis at death. Other people might consider gifting more appreciated property and assets to charity instead of paying higher taxes when selling the property. Business owners might want to sell businesses faster, realize gains year to year or engage in installment sales as opposed to a single-year sale of the business.
Removal of Step-Up In Basis Rules
Another proposal that might have a direct impact on estate planning is one to modify and remove some step-up in basis rules. In general, the step-up rules state that appreciated property at death passes to your heirs at the value it is worth at death, not your basis.
What this means is that many stocks and other properties can appreciate during life and get left to family at death without there being capital gains taxes on the growth. Not all assets get this favorable tax treatment today, as traditional IRAs, 401(k)s and other retirement accounts tend to be taxable to heirs in a similar fashion to the owner and don’t receive step-up in basis treatment.
The American Families Plan Act would close the step-up rules for gains in excess of $1 million, or $2.5 million per couple when combined with the Section 121 real estate exemption for your principal residence. Again, this would mean most Americans would not see a change, but for those with lots of appreciation in their investments, businesses and assets, it would be a substantial change.
This could change which assets you want to leave to heirs and which assets you should spend down in retirement. It could even, in some situations, cause people to do more Roth conversions or charitable giving, including charitable remainder trusts or donor-advised funds. Additionally, some people might consider purchasing life insurance to help offset the increased taxes or liquidity issues created by a change in step-up in basis removal.
If your estate plan relies on step-up in basis rules, you will likely need to revisit your plan if they end up changing.
Three Planning Points
In light of these potential changes I wanted to lay out three planning considerations:
First, consider how charitable planning can play a role in your estate plan. Gifting appreciated property to a donor-advised fund or charity can be an effective way to give while also keeping taxes down. You can get a deduction for your gift and avoid having to pay gains on the appreciated property, as the charity can sell it without paying taxes.
Most people give cash gifts to charities and don’t think about gifting stocks or other appreciated property, which can be more effective, especially in light of potential increases in capital gains or ordinary income rates.
Second, review your beneficiary designations and who gets which assets. It’s good to do a beneficiary review every few years to make sure these are still in line with your goals. In some cases, you might want to shift property between spouses based on their income or your own income.
Leaving assets equally to all children isn’t always the most effective way to plan out an estate. If you leave ordinary income-producing property, like an IRA, to a high-income-earning heir, but leave a Roth IRA to a lower-income-earning heir, you may create additional taxes and less wealth actually passing to your heirs. So when doing estate planning, it’s important to consider the tax consequences – both for yourself and your potential heirs.
Third, make sure your estate has the right amount of liquidity. A big issue can arise with a business or appreciated assets if the estate does not have sufficient liquid assets. This can cause the estate or heirs to have to sell property they otherwise would like to hold onto to pay transfer taxes, estate costs or income taxes.
Life insurance can be an effective way to create tax-free death benefits and cash to the estate for liquidity needs. If the laws change, it could substantially increase taxes for your estate, which means a review of estate liquidity and cash needs would be prudent.
While the American Families Plan Act and other acts are still in the proposal phase, it’s important to understand how these might impact your estate plan. For instance, there are also proposals that would reduce the estate tax exemption amounts and increase the estate and gift tax above the current high-water mark of 40%. If these rules get passed, they would further complicate the estate planning process.
Estate plans have to change as the laws and your goals change. Increased taxes and complexity around which assets will receive preferential treatment if left to heirs could fundamentally change the cost, taxes, ownership structure and liquidity needs of an estate overnight.
If you need help navigating estate planning, contact your financial professional.