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What about ‘Taxmageddon’ should you be worried about?

Financial Planning Dentist

What about ‘Taxmageddon’ should you be worried about?

For years, the common belief has been that taxes, particularly income taxes, will be lower in the future for workers. That differing tax into the future almost always meant keeping more money in your pocket. But now, maybe not. The lower individual federal income tax rates ushered in by the Tax Cuts and Jobs Act (TCJA) are already scheduled to expire at the end of 2025. But with Biden’s November victory that looks to change sooner rather than later. We think the most likely and probably the best-case scenario would be a return to the pre-TCJA deal starting in 2021. This means a reversion for most earners to pay the same rates they were in 2016 and the decade prior. For many, this means about 2-3% higher taxes in their effective tax rate.

The worst-case scenario we anticipate would include higher rates on ordinary income. And higher rates on dividends and long-term capital gains too, which are currently taxed at 0%, 15%, 18.8%, 20%, and 23.8%. These rates, often criticized as being far lower than the income rate, are likely to see some changes. Both in the top-line rates, with Bidens’ opening bid raising that to the ordinary income rate. It’s very likely to see the benefits of such a low tax threshold become a source of change. 

The next, worst-case scenario will be if Washington includes eliminating more write-offs for individual taxpayers, while simultaneously subjecting all wages and self-employment income to the dreaded Social Security tax. This would be 6.2% withheld from employee paychecks but 12.4% from self-employment income. A major change for independent contractors and the self-employed.

 

The absolute worst-case scenario that we can imagine for investors and workers, is that most or all of these changes, and more, are imposed retroactively. Meaning that the damage has already been done and that the proposed changes could be from as early as the start of 2021 (unlikely but possible) or from the proposal of the legislation which could mean the changes are in effect as early as May of 2021.

What should we be doing if ‘Taxmageddon’ is real?

First, make some assumptions for what your income is going to be over the next 3-5 years. This will help you uncover some of the tax issues for those in the highest two tax brackets. If you are individually making more than $207,000 or jointly making $414,700 you should be reworking your assets today, to be able to handle the coming changes. 

One of the oddest recommendations, as alluded to above, is that if you’re traditionally differing taxes, is to realize some gains sooner rather than later. This might be a first for many investors who have not seen a tax increase, particularly one that affects the capital gains process.

Additional Resources for 'Taxmageddon'

Tax Mitigation Playbook

Opportunity Zone
Overview

Taxmageddon

Tax-smart moves that don’t involve tax deferral

Tax-smart moves that don’t involve tax deferral There are several methods that tax planners can use that are not part of the tax deferral strategy category and that might find new and improved legs as this change happens.   Contribute to your Roth IRA Qualified withdrawals from Roth IRAs are federal-income-tax-free, so Roth accounts offer the opportunity for outright tax avoidance. This strategy looks even more impressive as you can pay income tax at today’s lower tax regime, and mitigate any future taxes that will preserve the gains. Additionally, because the account avoids all capital gains tax this vehicle becomes the most promising to see capital gains on, but avoid the tax consequences of selling those assets. Making annual contributions to a Roth IRA is an attractive option for those who expect to pay higher tax rates during retirement.  Convert to a Roth IRA Converting a traditional IRA into a Roth account effectively allows you to prepay the federal income tax bill on your current IRA account. This account also allows you to see the assets grow tax-free. This method is capable of avoiding ramifications from capital gains and provides the necessary insurance from the rising tax rates. This is the only method that straddles both of the coming complications. Determining the amount to convert (all or partial) should be worked into your financial plan.  Contribute to Roth 401(k) The Roth 401(k) is a traditional 401(k) plan with a Roth account feature added. If your employer offers a 401(k) plan with the Roth option, you can contribute after-tax dollars. If your employer doesn’t currently offer the option, run, don’t walk, to campaign for one immediately. There is likely little cost to add such a program and this might be an oversight on the needs employees should convey to the plan sponsor.  The DRA (Designated Roth Account) is a separate account from which you can eventually take federal-income-tax-free qualified withdrawals. So, making DRA contributions is another attractive alternative for those who expect to pay higher tax rates during retirement. Note that, unlike annual Roth IRA contributions, your right to make annual ‘Designated Roth Account (DRA) contributions is not phased out at higher income levels. Key point: If your employer offers the Roth 401(k) option, it’s too late to take advantage of the 2019 tax year, but 2020 is fair game. For 2020, the maximum allowable DRA contribution is $19,500. Contribute to Health Savings Account (HSA) Because withdrawals from HSAs are federal-income-tax-free when used to cover qualified medical expenses, HSAs offer the opportunity for outright tax avoidance, as opposed to tax deferral. You must have qualifying high-deductible health insurance coverage and no other general health coverage to be eligible for HSA contributions. You can claim deductions for HSA contributions even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. Even billionaires can make deductible contributions if they have qualifying high-deductible health coverage. Additional Resources for ‘Taxmageddon’ Tax Mitigation Playbook Download Opportunity ZoneOverview

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