By Founder and President of Covisum, Joe Elsasser, CFP®. President Biden has outlined a substantial tax plan that includes many changes that could significantly affect retirees. While an extensive congressional negotiation process would precede any tax law changes, financial advisors must be aware of the potential changes. Here is a closer look at a few of the Biden-Harris Administration’s tax proposals and how they may change how you build efficient retirement income plans.
Currently, workers pay FICA taxes on up to $142,800 of income–this is indexed yearly for inflation. The employee pays 6.2%, and the employer pays an additional 6.2% for a total of 12.4%. This tax funds the Social Security system. There is a proposal to reinstate the tax for people who earn over $400,000 a year. High wage-earners would again begin paying 6.2%, and self-employed people would pay both halves for a total of 12.4% on income over $400,000.
President Biden has proposed adjusting the current top tax rate (37%) back to the pre-Tax Cuts and Jobs Act rate of 39.6%.
The estate tax exemption has fluctuated over the past several years. Currently, you can have $11.7 million in an estate before facing any estate taxation. President Biden’s tax plan proposes reducing the exemption to $3.5 million. Reducing the exemption will significantly increase the number of people paying estate taxes. Look for different planning opportunities like gifting earlier on in retirement or using life insurance as an estate planning tool to account for this change.
The “step-up in basis at death” provision applies to inherited portfolios. Currently, inheritors only pay tax on the difference between the date of death value and the value on the day they sell the assets. They pay very little in capital gains tax. President Biden has proposed eliminating the step-up in basis. This change could result in either immediate taxation of the difference between the basis and the value as of the date of death or a carryover basis. With a carryover basis, inheritors would retain the original purchase price of inherited assets as their new basis. Inheritors wouldn’t be taxed until they sold the asset, but they wouldn’t get the “step-up in basis” that allows them to sell the asset with very low taxation. Both of these situations would create natural planning imperatives. Rather than holding assets with the expectation of an eventual “step-up in basis,” you want to make sure to align the portfolio throughout retirement, avoiding the balancing game between holding an asset you wouldn’t otherwise keep with the hope of avoiding tax altogether.
Converting funds from a traditional retirement account into a Roth IRA can be a tremendous tax-saving technique for clients who are in a low tax bracket currently. Advisors also might want to consider harvesting capital gains, not just capital losses. Sometimes it makes sense to harvest some capital gains and take advantage of a zero or a 15% tax bracket if it’s unlikely that those brackets will be available later on in retirement. The right financial technology can make planning for taxes in retirement more accessible than ever. Tax Clarity® is a financial planning software that allows you to view a client’s tax landscape throughout retirement. Use the software to quickly identify sub-optimal tax situations and show clients how to make retirement decisions in the most tax-efficient way. Calculate your client’s effective marginal tax rate and identify dangerous points where just one additional dollar of income can push clients into much higher effective marginal tax rates. Now is the time to take advantage of historically low tax rates before the laws change. Advisors need to educate clients and prospects about how these changes could impact their retirement strategy, take steps to adjust, and set a clear path forward.