Will Taxes Rise for the Wealthy?

by Michael Townsend, Hayden Adams of Charles Schwab, 9/17/21

The U.S. House Ways & Means Committee recently approved a package of tax increases on the wealthy to help fund a $3.5 trillion “Build Back Better Act,” an economic package that includes expanded Medicare, free community college, universal prekindergarten, and more.

Among other things, the House proposal would:

Raise the top individual tax rate to 39.6% after it was reduced to 37% in the 2017 Tax Cuts and Jobs Act;
Apply a 3% surtax on incomes higher than $5 million;
Raise the long-term capital gains tax rate¹ to 25% for individuals earning more than $400,000 (couples more than $450,000).

The points below represent the House Ways & Means Committee’s starting point with regard to tax increases. Importantly, the entire bill, including the proposed tax increases, is very early in the legislative process and is therefore almost certainly going to change significantly. The Senate could take a different approach. Provisions could be dropped or altered.

For one thing, if the $3.5 trillion package has to be significantly reduced in size and scope in order to pass the 50-50 Senate—a strong possibility—then less revenue would need to be raised by the tax increases, which would mean some provisions outlined below could be eliminated or revised.

Possible strategies for investors to consider

A wait-and-see approach is best right now. However, if you’re concerned about the potential ramifications of the proposed changes, know that there are strategies that can be used to deal with tax changes, if they occur. Here are some to keep in mind:

1. Proposed: Higher individual income tax rates. From 2022 onward, the top rate would increase to 39.6% from 37% for individuals with more than $400,000 in income (couples over $450,000).

Possible strategies to consider

Maximize contributions to tax-deferred retirement and savings accounts, such as 401(k)s, individual retirement accounts (IRAs), or health savings accounts (HSAs). You will not pay taxes on income from tax-deferred accounts until you withdraw the money, at which point your tax rate may be lower (or the income may not be taxed at all, such as HSA withdrawals for qualified health-care expenditures).
Consider municipal bonds, which are generally exempt from federal and potentially state income taxes.
If you are charitably inclined, you may want to consider making donations, as the tax benefit of those gifts would increase and could reduce taxable income.
Some self-employed individuals may be able to accelerate income recognition into 2021, if they can collect revenue or meet income recognition requirements this year.

2. Proposed: Surtax on wealthy individuals. From 2022 onward, a 3% surtax would apply to individual modified adjusted gross income over $5 million. (This is separate from the existing 3.8% net investment income tax, or NIIT, which applies only to investment income.)

Possible strategies to consider

This change would effectively make the highest federal income tax bracket 42.6% (39.6% plus 3%). The strategies mentioned above could also help here: maximize contributions to tax-deferred accounts, consider adding municipal bonds to your portfolio, make charitable donations, and in certain circumstances consider accelerating income recognition.

3. Proposed: Long-term capital gains tax increase. Any capital gain realized on or after September 13, 2021, would have a top tax rate of 25%, while gains realized before that date would be taxed at the current top rate of 20%. This would apply to individuals with income over $400,000 (couples over $450,000).

Possible strategies to consider

The potential benefits of tax loss harvesting would increase, because the losses that are recognized could be used to offset other capital gains. Just don’t run afoul of the IRS’ wash-sale rule, which disallows the loss if you purchase the same or a “substantially identical” security within 30 days before or after the sale date.
In addition, you could simply hold your assets longer and continue to defer gains into the future, potentially at a lower tax rate down the road.

4. Proposed: Gift and estate tax exemption reduction. From 2022 onward, the estate tax exemption amount would drop to about $5.8 million to $6 million, from current level of $11.7 million. (Note: President Joe Biden’s proposal to end the step-up in basis for inherited assets was not included in the House proposal.) The $15,000 annual exclusion on gifts would remain in place.

Possible strategies to consider

Those with large estates and the ability to gift assets today should consider maxing out the full $11.7 million estate/gift tax exception before it is potentially reduced. This can be done in many ways, through a direct gift to an individual or by gifting the assets to certain irrevocable trusts.

5. Proposed: Changes to grantor trust rules. Grantor trusts created on or after January 1, 2022 would be included in the gross estate. Existing grantor trusts would be grandfathered into the old rules. However, any new contributions would result in the trust being included under the new rules.

Possible strategies to consider

We recommend meeting with an estate planning attorney to ensure that your current estate plan won’t be negatively affected if these changes become law.

6. Proposed: New contribution limit to retirement accounts with large balances. From 2022 onward, individuals with an aggregate balance of more than $10 million in their retirement accounts, and who are in the highest tax bracket, wouldn’t be able to contribute more to tax-advantaged accounts.

Possible strategies to consider

If you’re affected by the contribution limit, you would have to save in a taxable brokerage account. With planning, a brokerage account can be very tax-efficient if a few basic strategies are used, including:

Tax-loss harvesting: As mentioned above, tax loss harvesting allows the losses that are recognized could be used to offset other capital gains. Just don’t forget the IRS’ wash-sale rule, which disallows the loss if you purchase the same or a “substantially identical” security within 30 days before or after the sale date.
Tax-gain harvesting: Investors often focus on selling losing investments and hanging on to winning ones. However, from a tax-planning perspective, it might be preferable to sell a winner now to lock in a lower tax rate. Realizing at least a portion of your capital gains before any new laws go into effect could help you avoid a higher tax bill and create an opportunity to rebalance your portfolio back to its target allocation.
Implement tax-efficient investment strategies. There are multiple ways to maximize tax efficiency in your portfolio, including diversifying investments by tax treatment and periodically rebalancing your portfolio.

7. Proposed: Cap on tax advantaged account balances. From 2022 onward, individuals with an aggregate balance of more than $10 million in tax-advantaged accounts would have to take required minimum distributions (RMDs), even if not currently of RMD age.

In addition, if the aggregate balance for all retirement accounts is over $20 million, the individual would have to distribute Roth assets until the account balances fell below $20 million.

Possible strategies to consider

This change would make having a strategic retirement plan that takes taxes into account more important than ever. We recommend meeting with a financial and/or tax planner to ensure you are saving in the most tax-efficient way possible.

Saving in a taxable brokerage account would one of the primary strategies to avoid distribution requirements if you have large tax-advantaged account balances. Tax-loss harvesting and tax-gain harvesting, selecting assets that don’t generate much in annual taxes, and holding investments for the long term—as mentioned above—could help, as well.

8. Proposed: Roth conversion limits. From 2022 onward, Roth IRA conversions would be prohibited for both traditional IRAs and employer-sponsored plans for taxpayers with incomes above $400,000.

Possible strategies to consider

If you believe your current tax rate is lower than your likely tax rate in retirement, you should consider doing a Roth conversion this year, before the rule potentially takes effect. We recommend meeting with a tax adviser before implementing this and other tax strategies.

9. Proposed: Corporate tax rate increase. A new tiered system would be implemented for corporations:

Income less than $400,000 = 18%
Income of $400,000 to $5 million = 21%
Income greater than $5 million = 26.5%

Possible strategies to consider

Some corporations could see their net income after taxes decrease due to this change. This could mean companies that pay dividends may have less money left over to pay out. However, the correlation of a company’s net income to its stock price is not always an indication of how an investment will perform. Don’t base your decision to purchase or sell a stock solely on its potential tax obligations.

The House proposal did not include any change to the state and local (SALT) tax deduction, which permits taxpayers to deduct certain taxes paid to state and local governments. The SALT deduction was capped at $10,000 in the 2017 Tax Cuts and Jobs Act. However, several House Democrats have said publicly that they will oppose the bill if the SALT cap is not increased, and party leaders have indicated that this remains under consideration. If a removal of SALT cap were to be proposed and enacted, taxpayers could look for ways to maximize this deduction, such as combining it with charitable gifts or medical expenses deductions.

The bottom line

Taxes affect almost every aspect of investing and planning, but they shouldn’t take priority over your broader goals and risk tolerance. Before implementing any tax-planning strategies, we recommend meeting with professionals who can help you thoroughly analyze your particular situation.

Also, we can’t emphasize enough that these tax proposals are just that—proposals. There will be considerable negotiation ahead, and taxpayers are likely to have some time to digest any tax code changes and consider what, if any, strategies are appropriate for their situation prior to any new tax rules going into effect.

¹ In 2021, capital gains tax rates are based on the following income thresholds: 0% for single filers with taxable income up to $40,400 ($80,800 for married filing jointly); 15% for single filers with taxable income of $40,401 to $445,850 ($80,801 to $501,600 for married filing jointly); and 20% for single filers with taxable income over $445,850 (over $501,600 for married filing jointly).

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The policy analysis provided by Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when a nonretirement account is rebalanced, taxable events may be created that may affect your tax liability.

Investing involves risk including loss of principal.

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