BFSG Presents “Great Client Questions”: Capital Gains

By:  Andrew Donahue, CFP®, MHA, |Wealth Manager|Financial Planner

As a firm we take pride in having some of the brightest clients around the U.S. (and beyond). In fact, we are often reaching out to you for insights within the various industries you work to check the pulse of the U.S. economy. Occasionally, during these conversations, our team is so taken by the caliber of question and observation we receive from clients that we want to share them with you as we receive them (including our team’s response).

This week’s “Great Client Question” comes from “Client X,” who recently noticed something interesting about President Biden’s proposal to increase taxes on long-term capital gains.

Client X Question:

I am expecting a large capital gain this year. I’ve heard the Biden administration just announced an April 2021 effective date for their new tax increase on capital gains. Is this true? I’d like to realize my gain at the existing (lower) tax rate before the new (higher) rate takes effect. Obviously, I won’t be able to do that if the new law will be effective as of two months ago, in April.

To respond to Client X, we asked one of our in-house congressional experts (former Hill staffer and BFSG wealth manager, Andrew Donahue, CFP®) to share his insight. Here is his response:

Situation

As a refresher, the long-term capital gains tax usually applies to a stock, a bond, or a real estate property (although there are other types of capital assets).

Here’s how the tax works:

  1. After you hold a capital asset for more than a year, if you sell it for a gain, the federal government will apply a “long-term capital gains tax” on the amount of the gain.
  1. The exact tax rate (%) will depend on your income in the year of gain.
  1. As it stands right now, the highest possible tax rate (20%) is reserved for “high earners” ($445,850+ for single filers, $501,600+ for married filing jointly or qualifying widow(er), $473,750+ for head of household, or $250,800+ for married filing separately). For everyone else, the tax rate is most likely 15% but for some “low earners” it might be 0%.

On April 28th, before a joint session of Congress, President Biden announced his desire to increase the top capital gains tax rate from 20.0% to 39.6% for the highest of high earners (households earning $1 million or more annually). Most insiders in Washington expect this tax increase to be signed into law this year. Where the speculation gets more interesting, however, is when the new law would take effect.

It’s an important question not only for households earning more than $1 million annually, but also for anyone who expects a unique or one-time capital gain this year that could push their income above $1 million. If so, depending on your tax professional’s advice, you may want to realize (quickly) long-term capital gains at the existing rate (15-20%) to avoid paying higher taxes at the Biden rate (39.6%).

This tax avoidance strategy is not possible, however, if the effective date of the pending law is April 2021, as Client X heard.

Background

Rumors of an April 2021 effective date are based primarily on a report released by the Treasury Department in May, referred to as the “green book.” Traditionally, green books are published by the Treasury Department in conjunction with the release of the president’s budget to help legislators and staff understand the impact of revenue proposals the president has proposed. If a president claims that he or she can generate revenue to pay for social programs, legislators usually want to know exactly how much revenue the president thinks he or she can raise to cover the expense.

Green books include effective dates for major revenue proposals simply because an assumption for a start-date is needed for Treasury to generate a formal revenue estimate. In the latest green book, which accompanied President Biden’s first budget, the Treasury Department included an assumption that the long-term capital gains tax increase would be retroactive to the “date of announcement” (presumably the joint session of Congress on April 28th).

Analysis

The effective date in the green book is not authoritative. Instead, April 28th is better understood as a starting point for negotiation in Congress. Pretty soon, legislators will shift to using other agencies, departments, and staff to score their own analyses of their own tax bills. These legislative drafts are what drive changes to law, not presidential budgets which are largely aspirational. Future congressional scores will explore other effective dates for the proposed tax increase.

Here is another way to think of it: These are complex policy issues and complex revenue calculations; sometimes in Congress it just helps to get everyone on the same page by starting with a shared assumption.

Furthermore, politically, an argument could be made that a retroactive change is unlikely to move the revenue needle enough for the Biden administration to justify further offending a well-heeled constituency (read: donors) with congressional elections around the corner and the House up for grabs. In other words, the juice from a retroactive effective date – which is a bit unusual from a tax policy perspective – may not be worth the squeeze.

Recommendation

Is an April effective date possible? Yes. These legislative proposals are dynamic, and they interact and clash with one another daily behind the scenes (for example, infrastructure talks could impact policy decisions on capital gains). If at any point the Biden administration and/or Democrats need to find revenue to secure their legislative plans, they may negotiate for the April effective date.

Ideologically, too, White House officials have been vocal about a desire to design a tax increase that prevents taxpayers from taking advantage of any gap before the increase begins. They cite a long history of taxpayers accelerating capital gains before tax increases take effect. For instance, according to the Tax Policy Center, capital gains realizations jumped 60% and 40% in 1986 and 2012, respectively, when similar capital gains tax increases last took effect.

As negotiations in Washington stand presently, however, we assess the likelihood of an April 2021 effective date as somewhere in the vicinity of less than likely. Rather, based on what we are observing, we might expect an effective date as early as the first committee action (such as late summer or fall when the tax-writing House Ways and Means Committee begins to mark up a bill) or perhaps as late as January 2022 (the start-date of other proposed tax changes).

We advise clients to approach long-term capital gains this year with a sense of urgency and conservatism. As always, we also recommend close consultation with your tax professional.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Financial Spring Cleaning

This is one of our favorite times of the year. We are approaching spring, so the days are longer, air is warmer, and the final snow is melting away. This is also the time of year people begin spring cleaning and getting their house or other affairs in order. Since finances are on people’s minds since we are in tax season, we thought it would be a good time to do some spring cleaning for your finances as well. Below should be a helpful checklist to help with some spring cleaning:

Taxes

  • Prepare and file your taxes (*note the new deadline of May 17th)
  • Review withholding if you owe or receive large refund. Use this IRS tool.
  • Discuss tax strategies for this year with your tax advisor or financial planner
    • Charitable gifting strategies
    • Strategies for business owners
    • Strategies for those with executive benefits
    • Roth conversions

Personal

  • Develop and/or review your budget
    • Contact insurance providers to try and reduce rates
    • Contact internet, cable and cell phone providers to make sure you are getting the best rates
  • Review you credit reports from Experian, Equifax and Transunion. Click here to do it for free.
    • Dispute any wrong information
  • Review your credit score. This can be done with any credit card provider for free or use a site like CreditKarma.com.
  • Develop a plan to pay off your debt

Other Important Items

  • Review your financial plan if you have not done so in last couple of years and/or if any major life changes have occurred
  • Review your estate plan if not done in last five years due to recent changes in the law
  • Review your investment allocation
  • Rebalance your investments if not done in last twelve months

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Five Potential Tax Changes Under Biden

With a new president often comes new agendas and philosophical changes. This is especially true with the Democrats controlling the House and picking up important seats in the Senate. President Biden is expected to pitch his “Build Back Better” infrastructure plan on Thursday and how to fund the estimated $3 trillion price tag.

Democrats will be forced to choose between budget reconciliation, which requires only a simple majority in each chamber for passage or securing at least 10 GOP votes in the 50-50 Senate.

Below are four potential changes to taxes that we are watching closely:

1. Increase in Income Tax for the Affluent

For those in the highest tax bracket (currently 37%) there is chatter in DC to raise it back up to the previous level of 39.5% or higher. The tradeoff they are considering is removing the State and Local Tax (SALT) deduction limit of $10,000 or more likely raising the SALT limit. This would be a great benefit for homeowners in high-tax states like California.

2. Increase in Corporate Tax

The corporate tax rate was lowered from 35% to 21% under the Tax Cuts & Jobs Act (TCJA) law in 2017. Many of the individual tax provisions of the TCJA sunset and revert to pre-existing law after 2025, however, the corporate tax rates provision was made permanent. Biden has previously voiced support for raising the corporate tax rate to 28%.

3. Changes to Estate Taxes

There is some concern that the new Congress may want to make significant changes to estate taxes.

Some of the proposed changes could include:

  • Reducing the lifetime exemption back to $5 million (adjusted for inflation). Currently, the limit is $11.7 million per person but sunsets in 2025 (see the discussion above about the TCJA). Lowering this exemption would also impact gifting and those subject to generations skipping taxes (GST).
  • Removing the ability of heirs to get a step up on a cost basis. For example, under current rules assume a $1 million after-tax investment has a cost basis of $300,000. Currently, the heir gets a new cost basis of $1 million and would not pay capital gains on the inheritance. There is talk of this being changed so the cost basis for the heir stays at $300,000 so they would have to pay capital gains taxes on the $700,000 in gains where under current law they do not have to.

4. Raise Social Security Tax Limits

Under current law, individuals pay 6.2% taxes for Social Security on the first $142,800 in earnings for 2021. Earnings over this amount are not subject to Social Security taxes.  There is speculation that this number could be raised to help meet the social security shortfall. There is also speculation about adding a new tier for payroll tax contributions for incomes over $400,000. There could be additional changes to the Medicare taxes as well. Read here about other possible changes to Social Security and Medicare.

5. Other Potential Changes        

There has been some discussion on making changes to popular planning strategies as well. There has been speculation but nothing concrete as of yet. Aside from federal changes, we may see more changes at the state level as many states are struggling with budgets in light of the pandemic and they will be searching for additional sources of revenue (read more taxes). This could lead to higher property or income taxes, or other potential changes like developing estate taxes or taxing Social Security. For example, California recently passed Prop 19 possibly triggering higher property taxes for inherited property.

Again, this is a tough item to predict but certainly something we are watching closely.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

There’s Still Time to Contribute to an IRA for 2020

Even though tax filing season is well underway, there’s still time to make a regular IRA contribution for 2020. You have until your tax return due date (not including extensions) to contribute up to $6,000 for 2020 ($7,000 if you were age 50 or older on or before December 31, 2020). The Internal Revenue Service (IRS) delayed the April 15th tax-filing deadline to May 17th, giving taxpayers an additional month to contribute for 2020. This postponement applies to individual taxpayers, including individuals who pay self-employment tax. This relief does not apply to estimated tax payments that are due on April 15, 2021.

The extension will also provide taxpayers additional time to contribute to an Individual Retirement Account (IRA). You can contribute to a traditional IRA, a Roth IRA, or both, as long as your total contributions don’t exceed the annual limit (or, if less, 100% of your earned income). You may also be able to contribute to an IRA for your spouse for 2020, even if your spouse didn’t have any 2020 income.

Traditional IRA

You can contribute to a traditional IRA for 2020 if you had taxable compensation. However, if you or your spouse were covered by an employer-sponsored retirement plan in 2020, then your ability to deduct your contributions may be limited or eliminated, depending on your filing status and modified adjusted gross income (MAGI). (See table below.) Even if you can’t make a deductible contribution to a traditional IRA, you can always make a nondeductible (after-tax) contribution, regardless of your income level. However, if you’re eligible to contribute to a Roth IRA, in most cases you’ll be better off making nondeductible contributions to a Roth, rather than making them to a traditional IRA.

IF YOU ARE COVERED BY AN EMPLOYER SPONSORED PLAN:

2020 income phaseout ranges for determining deductibility of traditional IRA contributions:
1. Covered by an employer-sponsored plan and filing as:Your IRA deduction is reduced if your MAGI is:Your IRA deduction is eliminated if your MAGI is:
Single/Head of household$65,000 to $75,000$75,000 or more
Married filing jointly$104,000 to $124,000$124,000 or more
Married filing separately$0 to $10,000$10,000 or more

IF YOU ARE NOT COVERED BY AN EMPLOYER SPONSORED PLAN BUT A SPOUSE IS & FILE JOINTLY

2020 income phaseout ranges for determining deductibility of traditional IRA contributions:
2. Not covered by an employer-sponsored retirement plan, but filing a joint return with a spouse who is covered by a planYour IRA deduction is reduced if your MAGI is:Your IRA deduction is eliminated if your MAGI is:
All Filing Status (i.e., Single or Married)$196,000 to $206,000$206,000 or more

IF YOU ARE NOT COVERED BY EMPLOYER SPONSORED PLAN & FILE SINGLE THERE ARE NO INCOME LIMITS

Roth IRA

You can contribute to a Roth IRA if your MAGI is within certain limits. For 2020, if you file your federal tax return as single or head of household, you can make a full Roth contribution if your income is less than $124,000. Your maximum contribution is phased out if your income is between $124,000 and $139,000, and you can’t contribute at all if your income is $139,000 or more. Similarly, if you’re married and file a joint federal tax return, you can make a full Roth contribution if your income is less than $196,000. Your contribution is phased out if your income is between $196,000 and $206,000, and you can’t contribute at all if your income is $206,000 or more. If you’re married filing separately, your contribution phases out with any income over $0, and you can’t contribute at all if your income is $10,000 or more.

2020 income phaseout ranges for determining eligibility to contribute to a Roth IRA:
Your ability to contribute to a Roth IRA is reduced if your MAGI is:Your ability to contribute to a Roth IRA is eliminated if your MAGI is:
Single/Head of household$124,000 to $139,000$139,000 or more
Married filing jointly$196,000 to $206,000$206,000 or more
Married filing separately$0 to $10,000$10,000 or more

Even if you can’t make an annual contribution to a Roth IRA because of the income limits, there’s an easy workaround. You can make a nondeductible contribution to a traditional IRA and then immediately convert that traditional IRA to a Roth IRA. Keep in mind, however, that you’ll need to aggregate all traditional IRAs and SEP/SIMPLE IRAs you own — other than IRAs you’ve inherited — when you calculate the taxable portion of your conversion. This is sometimes called a “back-door” Roth IRA – check out our prior blog post on Mega Back Door Roth Conversions.

If you make a contribution — no matter how small — to a Roth IRA for 2020 by your tax return due date and it is your first Roth IRA contribution, your five-year holding period for taking qualified tax-free distributions from all your Roth IRAs (other than inherited accounts) will start on January 1, 2020.

Learn more about Roth in Retirement Plans by watching this short video by clicking here.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2021. Edited by BFSG.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.

Pandemic Relief Measures and Your 2020 Tax Return

The two emergency relief bills passed in 2020 and another in 2021 in response to the COVID-19 pandemic will make this an unusual tax season for many taxpayers. The Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed in March, a second relief package was attached to the Consolidated Appropriations Act, 2021, in December, and just recently the American Rescue Plan.

The federal government relied on the tax system to deliver financial lifelines to struggling households, boost consumer spending, and help speed the economic recovery.

The following provisions may affect many households when they file their tax returns for 2020.

Recovery Rebate Credit

Most U.S. households received two Economic Impact Payments (EIPs) from the federal government in 2020. They are not taxable because technically they are advances on a refundable credit against 2020 income taxes.

The CARES Act provided a Recovery Rebate Credit of $1,200 ($2,400 for married joint filers) plus $500 for each qualifying child under age 17. The second bill provided another $600 per eligible family member.

Any individual who has a Social Security number and is not a dependent generally qualifies for the payments, up to certain income limits. The amounts are reduced for those with adjusted gross incomes (AGIs) exceeding $75,000 ($150,000 for joint filers and $112,500 for heads of household) and phase out completely at AGIs of $99,000 ($198,000 for joint filers and $112,500 for heads of household).

For the money to be delivered quickly, eligibility was based on 2019 income tax returns (or 2018 if a 2019 return had not been filed). Eligible taxpayers who did not receive two full payments, possibly due to errors or processing delays, may claim the money as a Recovery Rebate Credit on their 2020 tax return. Households that reported a lower AGI in 2020 (or added a dependent) might be eligible for additional funds. To calculate the credit, filers will need to know the amounts of any payments they already received. The credit amount will increase the refund or decrease the tax owed, dollar for dollar.

Taxpayers who received two full payments don’t need to fill out any additional information on their tax returns. Filing electronically usually results in a faster refund.

Coronavirus-related Distributions

Another measure in the CARES Act allowed IRA owners and employer-plan participants who were adversely affected by COVID-19 to withdraw up to $100,000 of their vested account balance in 2020 without having to pay the 10% tax penalty (25% for SIMPLE IRAs) that normally applies before age 59½.

Still, withdrawals from tax-deferred retirement accounts are typically taxed as ordinary income in the year of the distribution. To help manage the tax liability, qualified individuals can choose to spread the income from a coronavirus-related distribution (CRD) equally over three years or report it in full for the 2020 tax year, with up to three years to reinvest the money in an eligible employer plan or an IRA.

Taxpayers who elect to report income over three years and then re-contribute amounts greater than the amount reported in a given year may “carry forward” the excess contributions to next year’s tax return. Taxpayers who recontribute amounts after paying taxes on reported CRD income can file amended returns to recoup the payments.

Qualified individuals whose plans did not adopt CRD provisions may choose to categorize other types of distributions — including those normally considered required minimum distributions — as CRDs on their tax returns (up to the $100,000 limit).

Other Notable Changes

For those who itemize deductions, the limit on the charitable gift deduction increased to 100% of AGI for direct cash gifts to public charities. For nonitemizers, a new $300 charitable deduction for direct cash gifts to public charities was available.

The floor for deducting medical expenses has been permanently lowered to 7.5% of AGI (it was scheduled to increase to 10% in 2021).

Unemployment Aid is Taxable

Unemployment benefits, which sustained many families impacted by the pandemic, are considered taxable income, and many recipients may not have correctly withheld taxes from their 2020 payments. Avoiding a surprise tax bill typically requires opting into a 10% withholding rate and, in some cases, paying additional quarterly taxes during the year.

However, with the recent passage of the American Rescue Plan, the bill made the first $10,200 in benefits received to be tax free for households under $150,000. This applies to 2020 only. If you already filed, you may have to amend your return.

Looking Ahead to 2021

The special rules for charitable gift deductions enacted for 2020 as discussed above have been extended through 2021. For nonitemizers, a $300 charitable deduction for 2021 direct cash gifts to public charities is available. For joint filers, this deduction increases to $600 for 2021 cash gifts to charitable organizations.

Starting in 2021, there is no deduction for qualified tuition and related expenses. Instead, the modified adjusted gross income (MAGI) phaseout range for the Lifetime Learning credit was increased to be the same as the phaseout range for the American Opportunity credit ($80,000 to $90,000 for single filers; $160,000 to 180,000 for joint filers).

A temporary provision that allows taxpayers to exclude discharged debt for a qualified principal residence from gross income was extended through 2025, though the limit has been reduced from $2 million to $750,000. Also, through 2025, employers can pay up to $5,250 annually toward employees’ student loans as a tax-free employee benefit.

For 2021 only, the American Rescue Plan will increase the amount of the Child Tax Credit to $3,000 per child ($3,600 for children under 5) for children 17 and younger. For 2021 this credit is fully refundable even if you have no taxes due. To qualify your modified adjusted gross income (MAGI) depending on how you file must be less than $75,000 for Single, $150,000 Married or $112,500 Head of Household. After that amount, the excess credit ($1,000 or $1,600 for children under 5) is reduced by $50 for every $1,000 above the MAGI limits.

We recommend you consult a tax professional who can further explain the relevant changes and recommend strategies to help reduce your tax liability for 2021.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2021. Edited by BFSG.

Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s web site or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please see important disclosure information here.