Top questions from advisors about taxes

Bill Cass, CFP®, CPWA®

Bill Cass, CFP®, CPWA®, 03/03/21


As a new administration and Congress settle in, many financial professionals and investors are asking what type of policy changes may be in store for 2021.

While the near-term focus on Capitol Hill has been on vaccine distribution and passage of another Covid-19 relief bill, policy discussions will soon shift to other priorities, including infrastructure spending and potential tax increases.

In fact, earlier this week Senator Elizabeth Warren (D-MA) introduced legislation — the Ultra Millionaire Tax Act of 2021 — which would impose a 2% wealth tax on households and trusts exceeding $50 million in net worth. A higher rate of 3% would be imposed once net assets exceed $1 billion.

While the chances of this proposal eventually becoming law may be slim due to a number of political, legal, and enforcement challenges, it signals a desire among some lawmakers to increase taxes on higher-income households.

During the 2020 election season, the Biden campaign also outlined a number of tax increases.

Budget reconciliation creates a path for potential tax increases

Since broad tax increases would not likely be supported by Republicans in Congress, legislative changes would have to be pursued through the budget reconciliation process. This process requires only a simple majority vote in the Senate but means that the Democrats could not afford to lose one vote within their caucus. Moderate Democrats in the Senate may not support certain tax policy changes.

Questions on potential tax policy this year

Since the beginning of the year, our wealth management team at Putnam has engaged with many financial advisors on a series of virtual events, webcasts, and conference calls. Here are some common questions that we have received on the tax policy outlook for 2021, and responses based on our current views.

1. During the campaign, the Biden team called for a number of tax increases. Which tax proposals may be more likely to emerge later in 2021?

While forecasting future tax policy with any degree of accuracy is challenging, we believe that Democrats in Congress, for the most part, are aligned with raising the corporate tax rate from its current level of 21%. That’s not to say we think a corporate tax rate increase is more likely than not to be signed into law later this year. But if we do see tax legislation emerge, a corporate tax rate increase may be the highest priority. The Biden plan called for an increase to 28%, but we could see the rate level off somewhere between 21% and 28%.

After corporate tax increases, the next most likely area may be a return to a 39.6% tax rate (from the current 37% rate) on ordinary income at the highest income tax brackets. The Biden campaign called for restoring the 39.6% tax rate for higher-income taxpayers, as defined by those exceeding $400,000. But the proposal did not clearly define whether the threshold applied to individuals, married couples, or both. We believe there is a greater chance the 39.6% rate would be applied for those at the highest current tax brackets ($523,600 in taxable income for individuals, $628,300 for married couples filing a joint return).

2. What are the chances that capital gains could be taxed as ordinary income for certain taxpayers?

The Biden campaign called for taxing long-term capital gains and qualified dividends as ordinary income (39.6% not including the 3.8% surtax on net investment income) once income exceeds $1 million. While it’s unclear whether an increase in investment income taxation will receive consideration as part of legislation this year, we think a more likely scenario would be increasing the tax rate on long-term capital gains and qualified dividends from the current 20% tax rate (again, not including the 3.8% surtax), but not as high as 39.6%.

Assuming that one of the primary goals for raising tax rates is to generate revenue to offset other spending priorities (infrastructure for example), challenges can emerge if the tax rate on capital gains increases too much. At a certain level of capital gains taxation, historical research suggests the incremental revenue generated decreases, since investors will alter their behavior to avoid a higher tax cost.* For this reason, it may be more likely that we see the 20% maximum tax rate increased to 23% or 25%,† instead of applying a 39.6% tax rate on those reporting more than $1 million in income. Additionally, the more that tax rates on long-term capital gains are increased, the greater chance that investors will hold those assets until death to benefit from stepped-up cost basis. Of course, lawmakers could pair an increase in long-term capital gains tax with a scale-back in allowing stepped-up cost basis treatment at death to mitigate this response.

3. What are the chances that the SALT deduction limit (currently $10,000) will be increased or restored to the level prior to the TCJA?

We are skeptical about any proposal that would expand the SALT (state and local tax) deduction beyond its current limit since prevailing estimates suggest that a high proportion of the tax benefits would flow to higher-income taxpayers. It’s likely that Senate Democrats from lower-taxed states would not support increasing the SALT deduction. For more insight, see our recent post, “Lawmakers call for SALT revival.”

Plan in advance

While tax increases will garner attention from lawmakers, we are not convinced that there will be meaningful tax law changes signed into law this year. However, it’s likely that taxes will increase at some point in the near future given rising federal budget deficits. With the likelihood that tax rates could increase, it may be time to review current financial plans and consider tax-smart strategies. With any tax strategy, it is important to consult with a financial professional or tax expert with knowledge of your personal financial situation. Making changes to tax strategies may have an impact on your overall tax plan. Read Putnam’s “10 income and estate planning strategies” for more information about tax-smart strategies for 2021.

*While research on this topic can vary widely, analysis from the Tax Policy Center and Tax Foundation has suggested that the revenue-maximizing tax rate on long-term capital gains is roughly 30%. Additionally, the U.S. Treasury Department and the Joint Committee on Taxation generally apply an elasticity factor of roughly -0.7 on capital gains taxation estimates. This means that a 10% increase in the tax rate results in a 7% decrease in capital gain realization.

†For 2021, the 20% tax rate on investment income applies to individuals once taxable income exceeds $445,850 and for married couples filing a joint return once income exceeds $501,600. The 3.8% net investment income surtax applies to individuals with more than $200,000 in modified adjusted gross income, and $250,000 for married couples filing a joint return.

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