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Tax Reform: A Biannual Tradition Unlike Any Other

Candace Varner

Ben Hake

In this episode, Tax Directors Candace Varner and Ben Hake break down the recent tax proposals, propose an idea for an updated Schoolhouse Rock song and let you know what, if anything, you need to do now.

To read more about the tax proposals:

To hear more about Roth conversions:

To see a Schoolhouse Rock flashback about the legislative process:

To reach out to us with podcast questions and feedback: [email protected]

The Standard Deduction podcast is hosted by Tax Directors Candace Varner and Ben Hake. This podcast is a thoughtful, informed discussion about ideas, trends and developments in taxes related to personal wealth management.

Our mission is to educate and inspire people to make better financial choices through knowledge, tools and strategies. We believe that education and planning are key components of financial success. Come explore relevant financial topics with our team.


Candace Varner: Hello, welcome to The Standard Deduction. I’m Candace Varner.

Ben Hake: And I am Ben Hake, and we are excited for our, what is apparently a biannual tradition, which is talking about tax reform.

Candace: If not more often, Ben.

Ben: Although one of the questions, before we kind of get into the details is, we get a lot of clients who are asking us, “Why is tax reform something that used to be you’d see meaningful reform every 10 to 15 years. And now it seems like every 18 to 24 months, we’re seeing something large come through?” A big part of that is because at times, Congress is very much voting along party lines. So it can be difficult to pass laws with a 60 person vote in the Senate.

What a lot of the parties are using is, the reconciliation process, which Congress said, “Hey, if we want to pass a bill that’s going to impact spending or the revenue generation process, that there’s the ability to pass it with a 50 person approval.” So basically, if one party has 50 senators, they’re able to pass legislation without having to cross the aisle for that.

And with the makeup of Congress these past few years, that process has been used, generally speaking, tax reform as part of the budget, and that’s how that’s going. Which is why, you can’t use the reconciliation process to change regulations over an industry or to create new laws, but you can use it to increase revenue or decrease the spending of the government.

Enough about why we’re talking about it. Let’s get into the details.

Candace: Thank you for that summary. I feel like we could make that into a “How a Bill Becomes a Law” song, if we really wanted to, but maybe next time.

Okay. So where we’re at right now is the latest proposal from the House Ways and Means Committee as part of this Budget Reconciliation Process that he was talking about. It came out mid-September and again, is still just a proposal, which is fun that we’re always talking about just proposals and nothing’s real yet.

The headline of all of this is, of course, the tax rate changes. Currently, the highest individual income tax rate is 37%. The proposal wants to move that to 39.6%, which is what it was before the Tax Cuts and Jobs Act at the end of 2017. But it would actually start at $450,000 of income for a married filing-jointly couple. So, 2.6% change. Not nothing, but not really the biggest thing.

The other one that people are talking about all the time is the capital gains rate. Now, this is one that previously, the Democrats and Biden’s proposal was looking at making the same as the ordinary rate. So, going up all the way to 39.6%. As the law stands right now, the top capital gains rate is 20%, so that would be essentially doubling it.

But what they were proposing before, was the 39.6% on income over a million. We’ve already backed that off. So forget everything you learned about that 39.6% capital gain rate and $1 million dollar threshold, no longer on the table. Now they’re proposing that the top capital gains rate goes from 20% to 25%, but it no longer starts at $1 million dollars. Now it’s going to start around $500,000 of taxable income. So the rate is a lot less, but it will apply to more people and at lower income thresholds.

The other rate change that’s in this proposal is for corporations. Currently, they have a 21% flat rate, and the proposal is moving up to 26.5%, but it’ll be a graduated rate then, so that would only apply to income over $5 million.

Those are the big headline rate changes that we get the most questions about, of how those would affect people. But, you got to keep in mind the rate changes, but also where they apply the brackets, the income phase out thresholds, those kind of things. Those are also moving. So you could have a scenario where your rate appears higher, but you’re actually being taxed on lower income. Could go either way, depending on your situation. Ben, what are some of the other changes in there?

Ben: As Candace has kind of pointed out, those are wholesale bracket changes. So those would kind of apply to everyone. Historically, there’s been one surtax of 3.8% that’s applied to investment earnings. One big caveat for that was that, if you have a business that you’re active in and it’s not a C corporation, so this income shows up on your individual return, that if you’re active in it, that 3.8% surtax you wouldn’t be charged on, which could be a big number. So, if you make a million dollars and you don’t pay that, there’s $38,000.

One of the changes would be that, once your income goes over $400,000 for single filers or $500,000 for joint filers, that NIIT, or the Net Investment Income Tax, would start to apply. So again, as your income goes up, it opens up the sources of income that would be subject to the tax. That’s one where it’s kind of a change of the current law.

One of the other proposals would be a brand new surtax, which is going to be on people with extremely, high income. So, in this case, once your income hits $5 million or greater, in addition to just paying the 39.6%, plus possibly the 3.8% on your investment or other earnings, you’d also be subject to a 3% surtax, so it would be on top of that.

So, between all of those, you could be looking at roughly a 46% or 47% effective federal rate for those taxpayers who have incomes that are exceeding $5 million.

The IRS would tell you that’s not a huge segment of the United States population, but still very meaningful for those that it is impacting.

Candace: It always gets tricky when we have the one tax rate and then the additional layers on top of it. That’s when everyone gets confused.

The other big piece of what they’re proposing is change to the estate taxes. So far, we’ve been talking about income taxes this whole time. The other piece is an estate tax. Now the way that this works, just as an overview before we get to the changes they’re proposing, is that this is a tax that’s paid on any transfers of wealth from you to anyone else, during your lifetime, or when you pass away — accumulative number. So all the gifts I make during my lifetime, there’re some exclusions and all of that, but let’s just say, everything I give away during my lifetime, plus everything that’s in my name when I die.

So currently, the exemption is around $11 million per person. Meaning, if I die tomorrow and, spoiler, I’m not worth $11 million, I’m not going to pay a dime in estate tax. I’m not going to pay anything, because I’d be dead, but my heirs will not pay any estate tax. That’s what we’re talking about here.

That changed to $11 million, which is indexed for inflation, so that number kind of fluctuates. But, that was set to sunset at the end of 2025. So, even if nothing happens, at the end of 2025, that was going to go back to roughly $5 million indexed for inflation. So, let’s just say, half.

This latest proposal wants to move up that date so that it now goes back to the half amount at December 31st, 2021. So, we’re essentially going back to a previous threshold. But it still means that, anyone who’s passing away, whose estates are $5 million, give or take, or less, would not be paying any estate tax and that’s per person. So, if you are married, that would be twice that. You each get the full exemption.

Ben: The next piece that isn’t tax rate driven or the estate tax that has caused, or at least gotten a lot of attention, is going to be the change to Required Minimum Distributions (RMDs).

So, for as long as I don’t know, I can remember is, if you had a retirement account, an IRA or a 401(k) through your employer, generally speaking, the only time you’d be forced to take funds from that account would be if you hit your RMD age. It was 70 ½ for a while. Then the SECURE Act bumped that up to 72.

One of the changes here, and again, similar to that 3% on $5 million of income, this isn’t going to hit a lot of taxpayers, but for those taxpayers who have retirement accounts that start to exceed certain thresholds, there are going to be required minimum distributions regardless of age.

So, the first kind of target they’ve hit is $10 million. So if you, across all combined retirement accounts, start to exceed $10 million, the IRS says, “Hey, that next year, you have to take a required minimum distribution equal to half of the excess.” So if you have $11 million of value in those accounts, you’ve got to take a $500,000 distribution to start to whittle that down. So that’s in the case if it’s $10 million.

If it goes up to $20 million, which again is probably even a smaller sub-segment of the population, then they have to take outright distributions to get it under $20 million. The effect of this long-term is going to be that there’s an effective cap on how much you could have in pre-tax, and post-tax, because this also applies to Roth accounts, in a retirement account that’s growing tax-deferred.

Again, this is something that hadn’t been discussed on the campaign trail, or hadn’t been mentioned in that effect. So again, something that’s kind of new from the proposals that came out in September.

Candace: Everything’s on the table, apparently. The other change, which we kind of touched on in our last episode about Roth conversions, was that this proposal would eliminate the ability to do a “backdoor” Roth conversion, which essentially allows people whose income is over the thresholds to be able to contribute directly to a Roth IRA — to contribute it to a traditional IRA and then convert it.

This would stop the ability to do that, as well as any Roth conversions. Not necessarily a backdoor Roth, but just any Roth conversions at all. Currently, you can do those no matter what your income is, but this proposal would set a cap on the income threshold as far as who can actually convert money from their IRA to their Roth IRA.

Ben: All the items we’ve discussed so far are not the exclusive list of the changes that have been made. So, there are a variety of other changes, things like the Affordable Care [Act], the healthcare credit, Child Independent Care Tax credits, there’re things and changes in terms of how foreign income are reported. But those items haven’t been getting quite the publicity and likely are applying to a smaller sub-segment of taxpayers. So, we’ve kind of focused on the big items that’ll likely impact a lot of people here in the next year or so.

Candace: And, as we’ve said a couple times, this is all still being negotiated. So, already pretty material changes to what they were discussing six months ago, three months ago. So, the next couple of months until the end of the year will be, I’m going to say exciting times. I’m not sure “exciting” is the right word, but I’m going to go with it.

And to be clear, based on what we’ve talked about and what they’re proposing, we’re not advocating that anyone takes any action right now. I’m talking to clients about this. What I’m saying is, we know that this might happen. And so, it’s a part of the decision that we’re making, but because this might happen, we’re not proactively telling anyone to go do X, Y, or Z, go sell everything you own or anything like that. So instead, let’s wait and see how this plays out, because it’s likely to change several more times before this is all said and done.

Lastly, we would like to hear from you guys, our lovely listeners. So if anyone has any questions or feedback or just some really interesting tax topic that they would like to know about, please feel free to email us at the email that is in the show notes. It is [email protected].

We would love to hear from all of you, except for our mothers. Please don’t email in, Mom. I appreciate it. And that’s everything for today. Thank you for joining us.

Ben: Thanks.

Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.

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