We know there are a lot of questions about President Biden’s proposed tax bill, and people are speculating about how the changes could affect them. In this video we outline the proposed tax plan, discuss who is most likely to be impacted, and explore steps you can take today to potentially reduce your future tax bills.
What do we know now?
President Biden’s proposed tax plan could raise $1.5 trillion over the next decade. The proposal includes increases on corporate and personal income tax rates. In this article, we are focusing on potential changes to personal tax rates.
There are two revenue-raising proposals within Biden’s tax plan: restoring the top personal income tax rate to 39.6% and eliminating tax breaks related to capital gains for people who earn more than $1,000,000. The increases to personal tax rates would be used to fund the American Families Plan (AFP).
Personal Income Tax Rate
In his proposal, President Biden would raise the current top income tax rate from 37% to 39.6%. At the end of 2017, Congress and President Trump passed the Tax Cuts and Jobs Act, which reduced the top personal income tax rate from 39.6% to 37%.
Increased Capital Gains Tax
The proposal also includes an increase on capital gains tax rates for people with a taxable income exceeding $1,000,000.
Currently, long-term capital gains are taxed at a maximum rate of 23.8%, while short-term capital gains are taxed as ordinary income. Thus, many investors hold gains for at least a year before selling to qualify for long-term gain status rather than take the quick gain at ordinary income rates.
In Biden’s proposal people with a taxable income of $1,000,000 or more, including income from capital gains or stock dividends, would be subject to the proposed 39.6% rate on their capital gains.
Who would be impacted the most?
President Biden has stated that only high-income earners would be impacted. He has said that no one making under $400,000 would be affected by a tax increase; however, the $400,000 threshold applies to families, not individuals. This means that individuals who make $200,000 could be affected. In a recent report, the Institute on Taxation and Economic Policy stated that the tax increase would affect less than 1% of taxpayers and would be confined almost exclusively to the richest 1% of Americans.
What about changes to taxes at the state level?
For those of you who live in Washington, Governor Inslee is talking about putting a capital gains tax in place for 2022. We don’t know specifics, but many speculate that the change would affect high-income earners, similar to proposed changes on the federal level.
Edit: Governor Inslee signed the bill into law. It implements a 7% capital gains tax on the sale of stocks, bonds, businesses and other investments if the profits exceed $250,000 annually. Exceptions include the sale of all real estate, livestock and small family-owned businesses.
Steps you can take in 2021 to help reduce 2022 taxes
President Biden’s tax proposal and potential tax increases at the state level have a lot of high-income earners wondering about what they can do now to avoid a substantially higher tax bill in the future. There are many employee benefits available to you that can help you reduce your taxable income.
Deferred Compensation – the great equalizer to the proposed Biden tax plan
If you work for a company that provides a deferred compensation plan, we encourage you to take advantage of it. We work with many Microsoft and Intel employees who utilize this powerful benefit. You can potentially save tens of thousands on taxes annually by deferring some of the taxable income you receive now to a later date when your tax rate is likely to be lower. Deferred compensation works similarly to a pre-tax 401(k) plan. The dollars you contribute can be invested and used in your retirement.
The 401(k) and the Mega Backdoor Roth
The tax benefits associated with a 401(k) plan include being able to make deductions from your salary on a pre-tax basis. This can lower your annual taxable income. Your 401(k) earnings grow on a tax-deferred basis, meaning the dividends and capital gains accumulating within your plan are not subject to tax until they are withdrawn at retirement. Many people are in a lower tax bracket when they retire, which compounds the tax-reduction benefit of saving into a 401(k).
In 2021, the maximum amounts you can contribute to your 401(k) are:
- $19,500 if you’re under 50
- $26,000 if you’re 50 or older
Many people do not realize that there is a federal limit for total employer and employee contributions to a 401(k). In 2021, that limit is $58,000 if you are under 50 and $64,500 if you are 50 or older. This limit is important because if you work for a company that offers the after-tax Roth conversion, which is also known as the Mega Backdoor Roth 401(k). This feature won’t reduce your tax bill today, but it’ll make a big difference when you retire, because the funds grow tax free and, unlike those from a pre-tax 401k, distributions from a Roth 401(k) are tax free, too.
Companies that allow the Mega Backdoor Roth (after-tax Roth conversion) let you make an after-tax contribution into your 401(k) in addition to your pre-tax contributions to your company 401(k) account. Every company has different rules on how much can be contributed. Some will let you max out the entire difference between your contributions and the federal limit, others allow you to put in a certain percentage of your salary, while others might put a cap on the total dollar amount you can contribute.
If you are saving money above and beyond your 401(k), more than likely you’re saving into a brokerage account (individual account, joint account, etc.). Within these accounts, you hold investments that inevitably kick off interest income, dividends, and capital gains. All of these events are taxable within brokerage accounts. Over the long run, these can create a substantial tax drag on performance. Within a Roth you could hold the exact same investments, but the same interest income, dividends, and capital gains would grow tax free and even be tax free upon distribution.
We encourage anyone who has access to the Mega Backdoor Roth within their 401(k) plan to use it. This benefit is available at companies like Microsoft, Amazon, Intel, Facebook, Google, Salesforce, VMWare, Boeing, Snapchat, and others.
Health Savings Accounts
Don’t forget to take full advantage of your health savings account (HSA) and contribute the maximum amount you can. The HSA plan is a strategic way to save for future healthcare costs and reduce your annual tax bill by thousands. When it comes to their tax treatment, HSA contributions are similar to traditional 401(k) contributions, reducing your taxable income on a dollar-for-dollar basis. Unlike distributions from a traditional 401(k), however, distributions from an HSA are tax fee if used for qualified healthcare expenses.
Asset Allocation and Asset Location
Asset allocation is an investing strategy used to cushion your portfolio from market downturns. It involves dividing your investment portfolio among different asset categories, such as stocks, bonds, and cash.
Asset location is an investing strategy that can help you reduce your tax bill. Understanding what you own and where your investment is located can help maximize after-tax returns. Types of investment accounts include:
- Taxable: Traditional brokerage accounts that hold stocks, bonds, mutual funds, and ETFs are taxed when you earn dividends or interest.
- Tax-deferred: Traditional 401(k)s, 403(b)s, and IRAs delay your tax payment until the money is withdrawn, when money is withdrawn it is taxed as ordinary income.
- Tax-exempt: Roth IRAs, Roth 401(k)s, and Roth 403(b)s require tax to be paid on all contributions upfront. You can avoid paying tax on this money when it’s withdrawn, as long as all withdrawal rules/requirements are met.
Placing tax-inefficient (income earning) assets, (i.e., bonds and dividend-producing securities) in tax-deferred or tax-exempt accounts such as a 401(k)s, Roth IRAs/401(k)s, and IRAs rather than taxable accounts, can potentially improve the overall tax efficiency of your investments. Investments that generate little to no taxes such as US equities (i.e., S&P 500 index fund, passive mutual fund, or ETF) should be held in a taxable brokerage account, because they are inherently tax efficient.
What tax reducing strategies should you leverage?
Let us help you be proactive when it comes to reducing your tax bill. We don’t know whether President Biden’s tax proposal will become law; however, we do know there are things you can do today to feel better prepared for potential changes.