Coming soon: Higher taxes? Here’s how you can prepare

September 23, 2021

THE SPECIFICS HAVE YET TO BE WORKED OUT in Congress to determine how the administration’s proposed $3.5 trillion economic spending plan could be funded, but we are getting closer. All signs point to higher taxes for high earners.

The administration’s fiscal year 2022 budget, introduced on May 28, proposed a host of changes to raise revenue, aimed specifically at businesses and high-income individuals. “This was intentional,” says Mitchell Drossman, head of National Wealth Strategies in the Chief Investment Office (CIO) for Merrill and Bank of America Private Bank. “The administration seeks not just to pay for a comprehensive infrastructure bill but also to address a social justice goal of narrowing wealth inequality.”  

As a next step in the legislative process, in mid-September, the House Ways and Means Committee drafted a tax plan that would raise more than $2 trillion in new tax revenue over 10 years (and create more than $1 trillion in tax relief). The Ways and Means proposal picks up on the administration’s theme of focusing tax increases on high earners but generally applies lower income thresholds than the administration’s proposal.  Just as noteworthy as the proposed Committee changes, are the Committee’s omissions. For instance, the plan does not include a proposal to modify the century-old “step-up in basis” rule or other rules that could make the transfer of property during life or upon death a taxable event. Moreover, the proposal abandons efforts to curtail like-kind real estate exchanges.

The House Ways and Means Committee proposal, of course, represents just an opening bid in Congress’s negotiations. Not all of its proposals will make it into a final reconciliation bill, let alone survive a Senate vote and become law. Most political analysts expect the numbers to be negotiated down. “Still, the Committee’s proposal will form the basis for any upcoming tax changes, with tweaks to increase or decrease revenue to accommodate the ultimate size of the spending measures,” says Drossman. 

A recent Tax Alert from the CIO, “Democrats Release Details of Tax Plan to Pay for Social Spending Expansion,” focuses primarily on the implications for individual taxpayers. Here, Drossman and Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank, highlight some of the latest proposals and how taxpayers can prepare.

Higher taxes on ordinary income for some

The House Ways and Means Committee proposal would return the top income tax rate from 37% to 39.6%—the rate prior to the Tax Cuts and Jobs Act of 2017. The top rate would apply to incomes at or above $450,000 for joint returns and $400,000 for individuals (for 2022), compared with the current $628,300 for joint returns and $523,600 for individuals. For married taxpayers earning $628,300 that would roughly translate to an extra $8,202 per year in taxes, while those earning $1.5 million would pay about $30,866 per year more. Taxpayers whose income falls below the new top rates would see no change. Since these thresholds are lower than the administration’s proposal, they are anticipated to raise an additional $38 billion.

When the change could take effect: Consistent with the administration’s proposal, the House Ways and Means Committee plan proposes January 1, 2022 as the effective date, meaning the new rates would apply starting with income earned in 2022. The change would generate an estimated $170 billion in revenue over the 10-year budget window.

Capital gains and qualified dividends

The current top tax rate for long-term capital gains—owed when you sell certain appreciated assets that you’ve held for more than a year—stands at 20% (23.8% when you include the net investment income tax). While there has been much talk about raising rates for taxpayers with adjusted gross income greater than $1 million, the House Ways and Means Committee cuts that threshold in about half.  On the other hand, the Committee does not raise the capital gains and qualified dividends to the far higher ordinary income tax rates. Instead, the proposed top rate would jump to 25% beginning September 14, 2021 (with grandfathering for certain sales pursuant to a binding contract made on or after that date but before year-end). “When you take into account the 3.8% net investment income tax for wealthy taxpayers, the new top capital gains rate would reach 28.8% in 2021 and could even reach 31.8% in 2022, when a proposed surcharge of 3% for income above $5 million would take effect,” Drossman says.

When the change would take effect: If passed as is, the higher capital gains rate would be effective for sales made after September 13, 2021,” Drossman says. The higher rate would generate an estimated $322 billion in revenue over the 10 years.

In a surprise to many, the Committee proposal also includes a new 3% surcharge, which would commence in 2022 and would apply to non-corporate taxpayers with certain income in excess of $5 million. The $5 million threshold (which would not be adjusted for inflation in future years) would apply to both married and single taxpayers. Trusts and estates would also be subject to this surcharge on such income exceeding $100,000.  Certain charitable trusts, but not all, would be excluded from this surcharge. The surcharge would apply to all income, including capital gains, qualified dividends and wages, thereby bringing the top ordinary rate to 42.6% (46.4% if such income is also subject to the 3.8% net investment income tax) and the capital gains rate to 28% (31.8% including the 3.8% net investment income tax).

Taxes on gifts and transfers at death

Generations of Americans have enjoyed a provision known as a “step-up in basis,” protecting appreciated assets that they inherit from capital gains taxes when they sell them at a later date. It appears that this century-old provision will remain in place. Instead, the Committee proposal turned to a more traditional approach and plans to cut the estate and gift tax exemption from its current $11.7 million (2021) to approximately half, commencing in 2022. This will likely cause some wealthier taxpayers to consider substantial gifting before the drop in the exemption.

The Committee, however, included a radical new provision that could complicate and likely eliminate many popular estate planning techniques, such as Grantor Retained Annuity Trusts, Spousal Lifetime Access Trusts and even life insurance trusts, unless those and other similar trusts are created and funded prior to the date of enactment of legislation incorporating this proposal. If such a trust is created after the date of enactment of the legislation (or contributions are made to certain pre-enactment trusts), then the value of such trusts would be included in the deceased owner’s estate, with an offset for the amount of the taxable gift previously made to the trust. In essence, the appreciation of such a trust would be an estate asset.

Tax cuts for lower income families

“Amid the increases, there is also momentum for several tax cuts aimed at lower income earners,” Drossman says. For example, the Committee proposal would extend through 2025 the Child and Dependent Care Tax Credit (CDCTC) and transition it to a monthly tax credit in 2023, and with a more flexible definition of “child.”  Prior recent improvement to the Earned Income Tax Credit would be made permanent.

When the change could take effect: Most would become effective in 2022 and together would cost an estimated $834 billion over 10 years.

What could individual taxpayers consider doing now?

It’s important to avoid taking precipitous action in anticipation of new tax laws—especially with changes still in the proposal phase, Hyzy suggests. “While tax increases can cause short-term uncertainty, history shows they don’t stop people from investing,” he adds. “Because the proposed changes affect a relatively small section of the nation’s top earners, most individual Americans won’t be directly affected.” Where appropriate, some taxpayers could accelerate wage or other income into 2021 — even capital transactions, particularly if significant and potentially subject to the proposed 3% surcharge next year.

In addition to the higher taxes on high-earning individuals, the House Ways and Means Committee plan seeks to raise the corporate income tax rate from 21% to 26.5%, while also lowering it for corporations with income of up to $400,000. While investors may have concerns about the impact higher taxes could have on corporate earnings and market performance, companies are experiencing strong growth, increased operating leverage and better than expected earnings, all of which should help them absorb a tax increase, Hyzy believes.

“For individuals likely to be subject to raised rates, now is a good time to review your portfolio and your overall financial picture with your advisor and tax specialist,” he suggests. “Strategies such as tax-loss harvesting could help offset a capital gains tax liability,” says Drossman. “You may also want to consider holding investments likely to generate the biggest tax bills in tax-advantaged retirement accounts,” he adds, noting that retirement accounts such as 401(k)s and IRAs are not subject to capital gains taxes. Rather, for traditional 401(k)s and IRAs, withdrawals at retirement may be taxed at your ordinary income rate. But such changes should only be considered in the context of your overall goals, time horizon and risk tolerance.