Tax and Estate Changes to Watch For

A Legislative Outlook

The results of the 2020 elections have left the federal government in the hands of the Democratic Party, albeit by very slim margins. That means Americans should expect some of the Democrats' core financial proposals to be enacted, but the party's more ambitious plans will likely be tabled for the time being.

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Given what new president Joe Biden and Democratic congressional leaders have proposed, here are some changes you might expect in 2021 that could affect your tax and estate planning:

Tax Planning

Income Tax Rates: There are now seven tax brackets: 10, 12, 22, 24, 32, 35, and 37 percent. The Democrats have proposed increasing the top marginal bracket to 39.6 percent for taxpayers earning more than $400,000 per year.

Capital Gains and Dividends: Democrats have proposed to increase the top capital rate for individuals, currently at 20%, to 39.6% for taxpayers with total income of more than $1 million. In other words, the capital gains for these taxpayers would be treated as ordinary income.

Payroll Taxes: FICA or Social Security taxes are levied on the first $142,800 of an employee's wages, and any additional income is not subject to Social Security taxes. Biden has proposed levying additional payroll taxes on earnings of more than $400,000, thus creating a "donut hole" between $142,800 and $400,000, where that income would not be subject to Social Security taxes.

Limits to Itemized Deductions: Biden has proposed a 28% cap on itemized deductions and to restore the Pease limitation on itemized deductions for taxpayers with taxable income over $400,000.

Expiring Tax Deductions: There are also over 30 tax provisions that automatically expired at the end of 2020, such as the tuition and fees deduction, the mortgage insurance premium deduction, the exclusion for mortgage debt forgiveness, and other deductions and credits. These are generally expected to be rubber-stamped into renewal by Congress, but they are worth keeping an eye on.

Your Move: Keep in mind that tax hikes can be made retroactive to the first of the year. With those increases in the offing, consider converting a traditional IRA to a Roth. Paying the taxes now may be more beneficial than having the IRA be subject to income taxes later.

Estate Planning

Estate Tax Rates: Biden's plan would reduce the gift and estate tax exemption to $3.5 million from the current $11.58 million level. This limit applies to generation-skipping trusts (GST) as well, so if you have included one of those as part of your estate planning, you should consult with your estate attorney on how to proceed. In addition, Biden has proposed increasing the top tax rate from 40% to 45% for estate, gift and GST taxes.

Step-Up Basis: Biden has also proposed eliminating the step-up basis at the taxpayer's date of death, which values assets at the time they get passed on to the heirs rather than at the time the decedent acquired them. Under current law, the tax basis of property transferred to an heir is its current market value, and if the heir sells the asset, any gain would be assessed on the new basis. The appreciation of the asset during the decedent's lifetime goes untaxed. If this rule is repealed, it could leave some heirs owing significant capital gains taxes on inherited property.

Business Transfer Regulations: The Obama administration had proposed several regulations that would have restricted the ability to take valuation discounts on intrafamily transfers of business interests, such as a discount for lack of marketability. This would increase the tax burden for family businesses in the midst of a succession plan. The Trump administration withdrew these proposed regulations, but a Biden administration may be interested in bringing them back to life.

Your Move: Wherever you are in your estate planning, it's not too early to consider whether the reduction in the estate tax exemption will affect you in the long term. If you're worried that a change in step-up basis might result in a sizable tax bill for your heirs, talk to your Baird Financial Advisor team about ways to get in front of that.

All of these items remain just proposals, but there is generally a flurry of activity when control of the government switches parties. All of these could take effect in 2021, alongside even further legislation. To keep on top of how all this affects your tax and estate planning, reach out to your team of Baird Financial Advisors.