As I write this, the Senate and House of Representatives have almost come to an agreement on the third stimulus package. The main component being discussed is a $1400 payment to eligible individuals. Also being debated as part of this package are the continuance of higher unemployment payments, potential monthly payments to taxpayers with children, and payments to municipalities, schools, and hospitals to help with COVID-related costs.
Before the current pandemic, there were discussions about the funding problems with the Social Security and Medicare systems. These concerns have only been magnified because of individuals electing to collect earlier than anticipated and the added health costs on the Medicare system. Pre-pandemic, the estimates had these systems being unfunded beginning in 2034. Now, there is a discussion that these systems may experience this as early as 2029.
Many are asking – how are we going to pay for all this? Or, more accurately, many are asking, who is going to pay for all of this? We all agree someone has to, and most would say they want it to be someone other than me. Following are some of the proposals that the current Biden administration is considering. This post aims to make you aware of these proposals, have you consider the impact it could have on your situation, and provide some suggestions on minimizing that future tax impact.
In 2018 tax rates were cut for both individuals and corporations. Those in the 15% bracket were now in the 12% tax bracket. The 25% tax bracket became 22%, and the 28% became 24%. The highest tax rates dropped from 39% to 35%. The SALT (state and local taxes) limitation came into existence, limiting the deduction for taxes to $10,000. Mortgage interest became more limited, the deduction for employee business expenses disappeared, and the medical expense limits saw an increase from 7% to 10%. The standard deductions increased, and many individuals moved from claiming itemized deductions to taking the standard deduction. There was an expansion of the child tax credit and the elimination of dependency exemptions.
Many have forgotten that when these changes went into effect in 2018, they were put into place for only eight years. These tax changes were meant to be temporary. When these laws were enacted, it was known that government debt would increase. The hope was that the tax cuts would stimulate the economy, and tax revenue would increase to offset the shortfall the tax cuts were creating. This was meant to be a short-term solution. The tax rates have always been scheduled to go back to the 2017 tax rates beginning with the 2026 tax year.
Will that return to 2017 tax laws happen? Not sure. If it does, it will raise taxes for most. For some, even though tax rates will increase, if the $10,000 limitation for taxes goes away, they will have a lower tax liability. There is a discussion about delaying that return to the higher tax rates until 2029. There is a discussion about raising corporate tax rates back to pre-2018 rates now, but not individual rates. There is talk about limiting itemized deductions to a maximum of 28%.
Lots of discussions are going on. We do not know which of the components will pass yet and become law. The result of most of what is being discussed is an increase in future taxes. You may see that increase directly on your tax return. You may experience that increase by paying more for products and services because the business owners increase prices to pay for their taxes.
There is now a window of opportunity. Maybe until 2026, maybe until 2029 – or laws may change to pull these changes back to start earlier. We cannot know how short or long this current window exists.
The current administration is discussing changes beyond reverting to pre-2018 tax rates that may impact your situation. The tax rates on the income from non-retirement investments may be increasing. Currently, there are special capital gain tax rates. Depending on your ordinary tax rate, your capital gains tax rate could be 0%, 15%, or 20%. If your ordinary income tax rate is a maximum of 12%, your capital gains tax rate is 0%. If your ordinary income tax rate is a maximum of 24%, your capital gains tax rate is 15%. For those above the 24% tax bracket, capital gains are taxed at a maximum of 20%. There are discussions about eliminating capital gains tax rates.
Capital gain tax rates apply to qualified dividends and to profits made on the sales of stocks, mutual funds, and other investments. If you are receiving tax documents for dividends and stock sales, you would be impacted if there was a change to the capital gain tax rates.
There are currently discussions within this administration to increase the child tax credit, increase the education credit, and increase student loan interest deductibility. All these will have a favorable impact on your tax liability if you qualify for these credits. Your income would be taxed at higher tax rates, but your overall liability may decrease if the credits exceed the tax increase.
There is a discussion about eliminating the SALT limitation and allowing individuals to claim the full amount of taxes paid. This is set to already revert as part of the pre-2018 changes. There is a discussion about having it happen in an earlier tax year. For many, the higher standard deduction means not itemizing, and this would have no impact. For those with incomes even in the $100,000 range, this could reduce overall taxes if you are in a higher tax state like New York.
While we cannot know when or exactly what will happen, there is likely an increase in taxes for most individuals coming. One of your current financial goals should be to pay what taxes you can at the current lower tax rates if you can avoid paying higher taxes later. How? Consider:
- If you contribute to a 401(k), 403(b), or 457 plan at work and you have an option to make contributions either in a Roth plan or a pre-tax plan, choose the Roth plan. If you do not have a Roth option at work, have a discussion with your employer about adding it as an option.
- If you cannot contribute to a Roth option through your work plan, consider making Roth IRA contributions outside of work for any amounts over the employer match amount.
- If you are contributing to a Traditional IRA, consider making Roth contributions instead. You will lose the tax deduction today, but you will avoid the taxes on the higher value later.
- If you are eligible to fund a health savings account (HSA), fully fund it. If you do not have the medical expenses today to use the dollars, it will be growing tax-free until you need to use it. If you withdraw for medical expenses later, you will not have to pay taxes on the earnings.
- Consider allowing your HSA account to grow and not using it for current medical expenses. It can grow tax-free and be available for use during retirement to pay Medicare premiums, supplemental insurance premiums, or medical expenses.
- If you have Traditional IRAs or employer plans with old employers, consider Roth conversions. Pay those taxes now at these tax rates to avoid higher taxes on the current balance and any future growth.
- Consider life insurance as an investment instead of for its death benefit if you still have excess cash to invest and are looking to avoid future taxation on an income source.
- If you own stock with a low-cost basis and a high current market value, you might consider cashing it in and pay the taxes at those lower capital gain rates now. If you like the stock, nothing prevents you from purchasing it again with a now higher cost and less future tax liability attached to it.
- If you are holding non-qualified annuities, it may be time to start taking distributions from those annuities and begin getting the taxes paid on that deferred income.
It is tax time, and you may be thinking about taxes. For many, this simply means filing a tax return and either getting your refund or paying your tax bill. We want to suggest, now is the time to consider your future tax burden and take steps to minimize it. We certainly advocate that you pay the taxes that you legitimately are required to pay. We also advocate that you do not pay a dollar more than necessary. Tax planning is what can make that happen.
