Is Your Financial Plan Ready for Higher Taxes?

You can feel it in the air — tax increases are coming. And it’s not a matter of if, but a matter of when. In the last few months, there have been a number of legislative proposals targeted toward high-net worth and ultra-high-net-worth taxpayers, ranging from Sen. Bernie Sanders’s “For the 99.5% Act,” Sen. Elizabeth Warren’s “Ultra-Millionaire Tax Act” and Sen. Chris Van Hollen’s “Sensible Taxation and Equity Promotion Act.”

While each proposal focuses on a different wealth segment and type of tax, the common theme and sentiment is that higher taxes might be on the near horizon for the wealthy. If you are concerned of the possible changes to come, what can you do now to plan for them?

Income tax

The two most talked about income tax proposals are raising the highest marginal income tax rate to 39.6% (up from the current 37%) and increasing the long-term capital gains (LTCG) rate to 39.6% (up from the current 20%) for those with incomes exceeding $1 million. Combined with the net investment income tax of 3.8%, LTCG could be taxed as high as 43.4% on the federal level.

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It is unclear whether these tax increases, if passed, would be effective beginning next tax year, retroactive to the beginning of this year, or somewhere in between. Therefore, the time may be now to evaluate your portfolio, identify the assets with embedded gains, and determine whether it is advisable to sell before the rates increase. This would help lock in the current lower tax rates.

While no investment decision should ever be dictated solely by taxes, a careful analysis of net after-tax return is critical in understanding the true value and cost of holding a long-term investment versus a sale in this environment. Similarly, any tax strategies that allow for a deferral of income tax should be given an extra look. Tax-advantaged accounts, such as IRAs, 401(k)s, health savings accounts (HSAs) and 529 plans, provide enhanced benefits as the taxes on the income earned on assets in these accounts can be deferred and possibly eliminated if certain conditions are met.

Note that the IRS recently extended the federal income tax filing deadline to May 17, and with that, so did the deadline to contribute to IRAs and HSAs for tax year 2020. So there is still time to maximize these tax-advantaged vehicles. In addition, those with sizable IRAs may want to consider a Roth IRA conversion while the “conversion tax” is relatively lower with today’s income tax rate.

Estate tax

The current individual federal estate tax exemption is at an all-time high of $11.7 million. This is scheduled to sunset at the end of 2025, when it will revert back to $5 million, as indexed for inflation. Various proposals have been fairly consistent in calling for a decrease in the exemption to $3.5 million. Ultra-high-net-worth individuals should take advantage of the current exemption to make significant gifts to trusts for children and grandchildren.

While many understand the inherent benefit of gifting, many do not act because they don’t know how much to gift and what assets to gift. Generally speaking, assets with significant long-term appreciation potential but whose current valuation may be depressed due to the pandemic are the ideal assets for gifting. An experienced financial planner can help you quantify the impact of the gift against your future income needs. In particular, a sustainability analysis should be conducted to determine how a gift that’s removed from your balance sheet will impact your future cash flow and lifestyle needs. The sustainability analysis can also be stress-tested to account for any future contingencies.

Depending on your balance sheet and needs, gifting the maximum amount allowed under the current law might be too large a gift and could begin to erode your future cash flow needs. In that case, it may be wise to reverse engineer back to a more comfortable gifting amount.

Don’t forget your state of residence

While much focus has been put on potential tax increases on the federal level, do not forget any potential tax hikes at the state level. Like the federal government, states are also looking for ways to raise revenue to offset spending needs during the pandemic. For example, New York state recently increased its highest income tax rate to 10.9% (up from 8.82%). If you are a New York City resident, your combined federal, state and local tax rate could be the highest in the country, with California as a close second.

While the above strategies on mitigating income tax would apply at the state level, an additional strategy to consider is to create a trust in a tax-friendly jurisdiction, such as Delaware. For example, if structured properly, an individual living in a high-tax state may create a trust for the benefit of her children and grandchildren and locate (or situs) that trust in a low- (or zero-) tax jurisdiction. If the trust is structured as a “non-grantor trust,” the trust will be treated as a separate taxpayer, in which case it may be able to escape the home state taxation of the individual grantor and be subject only to federal tax. This would effectively eliminate any state income taxation on the sale of an asset and any future income and gains.

To put this strategy into context, applying today’s income tax rates and if properly structured, a New York City resident with a marketable securities portfolio with embedded LTCG of $1 million may save over $100,000 in New York State and City income tax using this type of strategy. There are certain restrictions and limits to this strategy, and it is very state-specific because, different states have different rules on the taxation of trusts. Therefore, working with professionals who are well-versed in trust and state taxation could be critical.

While no one has a crystal ball on what will happen with taxes, a smart investor should consider planning now for what is likely to come. The window of opportunity may be closing soon, and you need to be prepared with a plan, so that when (not if) the tax laws change, you are ready to execute on that plan with what may be very short notice.