Eyes on the Horizon
Despite the fears of many, the transfer of power from President Trump to President Biden on January 20 was peaceful. However, there is a true split in the country. Half the country is relieved that we actually survived the last four years, and half the country is terrified of what’s to come. Of course, those positions were reversed 4 years ago (which was a reversal from 8 years ago).
The reality is that America voted for gridlock, which is a positive. While there is technically Democrat control, Republicans gained ground in the House, which was an unexpected outcome. Similarly, Democrats control the Senate (with Vice President Harris being the deciding vote); however, with a 50-50 split between the parties, more extreme actions that require a 60-person vote are unlikely to occur. As we have repeated often, the markets like gridlock – there is less opportunity for the politicians to screw things up for the rest of us.
Given that life – and the markets – will go on regardless of whether you are currently optimistic or pessimistic, let’s focus on what the new administration might mean for your money. At this point, we are simply speculating based on comments that have been made by those in the new administration, but it will be important to understand the implications of proposed policies should the talk become reality.
Higher Corporate Tax Rate: As currently contemplated, the corporate tax rate would increase from 21% to 28%. I know – it doesn’t impact you; it is just the corporations that pay more. Well, that’s not actually the case. There are a couple potential implications. First, companies may increase prices to make up for the lost earnings. If that’s the case, it will hit you directly in the wallet. Next, to the extent that the full impact of increased taxes cannot be made up by increasing prices, corporate earnings will decrease. Since corporate earnings have a direct correlation to stock prices, all else being equal, you can assume that stock prices will decrease. That will have an impact on investors across the board.
Higher Taxes on High Earners: The top federal tax rate on those earning over $400,000 is expected to increase to 39.6%, a significant increase for some of that group currently in the 35% tax bracket. Additionally, there has been talk of subjecting any earnings over $400,000 to the Social Security payroll tax, which is currently taken on the first $137,700 in earnings (under the proposal, earnings between $137,700 and $400,000 would not be subject to the Social Security payroll tax). Between both provisions, higher earners can expect to see a significant reduction in after tax earnings – an average reduction of 15.9% for the top 1% of earners according to the Urban-Brookings Tax Policy Center (source: CNN 10/20/2020). This has a direct impact on many of you. Some of you may be breathing a sigh of relief because you are being spared. Keep in mind that the $400,000 limit may not be indexed for inflation – at least for the Social Security payroll tax - so over time, it will impact more and more people. Additionally, there is no magic to $400,000 – it can easily become $250,000 or $100,000 with the stroke of a pen.
Higher Capital Gains Rates: Currently, the top tax rate for long-term capital gains is 23.8%. If you are in a household making over $1 million per year, you may be in store for another shock. There is a proposal that for you, long-term capital gains will be taxed the same as ordinary income. To make it worse, the “Obamacare” tax may still be in place, which would result in the effective tax on long-term capital gains being around 43.4%. And that’s before state taxes! Again, for those of you who are not currently in this earnings bracket, once the change is made, the threshold can easily be lowered in the future.
Estate Taxes/Step-Ups: This is an area where there may be significant changes that can impact most of you. This year, if you were to die, you would be able to pass $11.7 million to your heirs without any estate tax issues. If you are married, you and your spouse can pass $23.4 million to your heirs without any estate tax issues. There are serious discussions about reducing this amount significantly. Depending on how “significantly” is defined, this can have an impact on many estate plans.
There is also talk about eliminating the “step-up” which will affect virtually all of you. An example will help. Let’s say you buy a stock for $1 and it is worth $10 when you die. Under current law, when you die, the stock will pass to your heirs and the cost basis will be the value on the day you died, or $10 in this example. So, your heirs could sell the stock immediately and pay no capital gains tax (assuming no change in price) or could hold the stock and sell it in the future but only pay taxes on gains above $10. There is serious talk about changing this in two very significant ways. The first change would be the removal of the step-up. In other words, your heirs would retain your basis ($1 in our example) and would owe taxes on gains above that amount. The second, and even scarier, change would be that the taxes might be due at death, regardless of whether or not the position is sold. That would likely force your heirs to sell something to pay taxes (and these taxes are separate and distinct from the actual estate tax).
If we are simply dealing with stocks, it might be easy to raise the funds needed to pay the tax. However, imagine that you have a business worth $10 million with a very low basis or perhaps a building worth the same amount that is fully depreciated. Think about what your heirs might need to go through to raise sufficient funds to pay capital gains taxes in that situation. Again, this does not even take the actual estate tax into account.
Needless to say, this ends up being a very complicated issue and one that can significantly impact the value of estates going forward. Fortunately, it is simply an idea at this point. Nonetheless, it is something that we need to watch closely and may need to take action on at some point during the year.
Deductions: Finally, some good news for many of you. It is likely that the deduction limitations on state and local taxes may be removed. If that happens, many of you will have larger deductions and may be able to itemize once again. If this doesn’t happen until 2022, delaying certain payments for 2021 until 2022 may prove to be a smart move. Of course, there is some potential bad news as well. There has also been talk of capping the benefit of deductions to 28%. In English, if you are in the 35% tax rate, one dollar of deduction provides a benefit of 35 cents to you. If this change goes through, your benefit would be limited to 28 cents.
Bringing it Together
There are other changes that have been discussed, but these represent some of the proposals with the broadest impact. With luck, we’ll have enough warning before any of this becomes reality to be proactive so we can minimize the impact to the extent possible.
Fortunately, we are here to keep an eye on these issues so you can do what’s really important – spend time with family, friends and engaging in activities that bring you happiness and fulfillment. If there is anything we can do to ensure you are spending more time on these things, just let us know.