There's little question the tides are moving towards a higher tax environment with multiple trillion dollar spending bills, a new administration, and deficits as far as the eye can see. Instead of feeling helpless, here is a quick look at what might be on the horizon and some thoughts on how to be prepared.
- Self-employment tax risk. Social Security and Medicare fund collections took a hit during the pandemic. This is because of high unemployment and new federal benefits allowing employers to receive a credit on these taxes to help continue paying employees to take leave due to COVID-19. Over the next few years, there will be tremendous pressure to add funds back into these programs. This might be done by increasing the taxability of benefits or dramatically increasing the income subject to Social Security taxes.
Potential action: Continue to work on a retirement plan that is not as dependent on Social Security benefits. If you are a small business owner, and your business income is subject to self-employment tax (SE tax) now is a good time to consider reorganizing your business to shield some of your business income by moving to an S corporation.
- Capital gains tax rate increases. In 2021, the highest long-term capital gains tax rate is 23.8% (20% capital gains tax rate plus a 3.8% surtax as part of the Affordable Care Act) but if planned correctly, you could pay either nothing or 15% federal tax on long-term capital gains. Congress could see the sales of long-term securities and other assets as a valuable source of tax revenue by eliminating this preferential tax rate and instead using ordinary income tax rates (currently as high as 37%).
Potential action: Actively manage investment profits, netting your gains against your losses. If you have any assets that have appreciated over time and intend to sell in the near future, consider trading in 2021 to avoid a potential increase in the capital gains tax rates.
- Tax planning problems for your estate. There are several considerations to take into account when looking at your estate’s tax plan. First, under current law, say for example your parents bought one share of stock in 1980 for $10 and you inherit the share of stock when it’s worth $100 and immediately sell it for the same $100. You would not owe any federal taxes on the $90 difference. In the future, this feature, called stepped-up cost basis, may become limited or removed to increase tax revenue. Second, the estate tax rate currently set at 40% is under pressure to be increased. This is entirely possible when you consider that this tax rate was 55% in 2001.
Potential action: Consider gifting money or securities to family, friends or a foundation during your lifetime. Individual gifts in 2021 of $15,000 or less ($30,000 for married couples) don't count against the lifetime gift-giving limit.
- Tax rate volatility. With huge federal deficits that are now beyond the scope of imagination, what will happen next? Just the latest legislation adds a whopping $1.9 trillion to what must be paid back. While interest rates are being held at historic lows to help lower the cost of this added debt, it cannot continue unabated. And the meteoric rise in home prices is just one of the costs of this low interest approach. The current proposals in Washington suggest an increase in tax rates is not too far in the distant future.
Potential action: Do a forecast of your future income and tax rates. If you think tax rates and your taxable income will be increasing in the next few years, you will want to move as much money as possible into tax-advantaged accounts like Roth IRAs. You should also understand any state tax ramifications to help with your tax planning.
While Congress is debating what to do with your tax rates, now is the time to create a strategy so that if or when tax rates do increase, you will be prepared.