How Biden's Tax Proposals May Impact Financial Advisors' Clients

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Barbara Friedberg
·6 min read
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President Joe Biden has proposed tax increases on the wealthiest Americans, including changes impacting estate tax and capital gains tax.

Although most individuals earning less than $400,000 won't see much change in their federal income taxes, it's likely that some of your financial advisory firm's clients will. Get a firm grasp of the consequences of the potential tax changes now, so that when the time comes, you're prepared to explain them to your clients.

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Biden's Proposed Tax Policy Changes

The proposed tax increases would hit those individuals earning more than $400,000 per year the hardest. In a nutshell, they include reinstituting a payroll tax of 12.4% for wages above $400,000. The top marginal tax rate for those wealthy individuals will be hiked from 37% to 39.6%. Other highlights include:

-- The value of itemized deductions for those who earn more than $400,000 will be capped at 28%. Also, qualified business income deductions will phase out above that $400,000 income level.

-- The Internal Revenue Code's Section 1031 "like-kind exchange" would be eliminated for individuals earning more than $400,000. A 1031 like-kind exchange allows a swap of one real estate property for another in a way that offers tax advantages for investors.

-- For taxpayers who earn more than $1 million per year, dividends and capital gains will be taxed at an ordinary income rate of 39.6%.

-- The step-up in basis on assets left to heirs would be eliminated. This means that beneficiaries would lose the opportunity for the value of inherited assets to be set on the day of death. Instead, when the assets are sold, the beneficiaries would pay the same tax on capital gains that the deceased would have owed.

-- The deduction for contributions to 401(k) plans in retirement would cease under the Biden proposal, and a flat 26% tax credit would take its place.

-- The threshold for the estate and gift tax exemptions could be reduced to $3.5 million per person, and the top estate tax rate would rise to 45%. If this change is implemented, many more people would find themselves responsible for estate and gift taxes. For 2021, the threshold is $11.7 million per individual.

[Read: Reasons to Discuss Your Estate Plan With Your Children ]

What to Tell Clients About the Proposed Tax Changes

The Biden administration's proposals merit revisiting your clients' tax and estate plans. Regardless of how the president's tax initiatives play out, tax policy changes from the 2017 Republican tax overhaul are due to sunset in 2025.

The following are some proactive steps to discuss with your clients in light of potential tax changes.

Reduce the impact if the 1031 like-kind exchange is removed. One step that real estate investors can take is to use component depreciation methods for new properties on their taxes, says Julio Gonzalez, CEO of Engineered Tax Services in West Palm Beach, Florida. Component depreciation separates out the specific systems of a building, such as electrical, roofing and plumbing, then depreciates each element over a shorter life span. That would help minimize the tax advantages lost with the removal of the 1031 like-kind exchange, Gonzalez says. In the meantime, investors might be able to slip in a 1031 exchange this year, before the law is repealed, he adds.

Gonzalez also suggests that individuals invest in transferable tax credits to help balance increased liabilities. These are state-offered tax credits for investing in certain projects that benefit the community. The credits are meant to help spur economic growth and increase the number of jobs. Sometimes, they can be transferred and purchased by others.

Sidestep the elimination of the step-up in basis on inherited assets. If the step-up in basis on assets for beneficiaries is gone, many people's retirement plans are likely to change, says Phil Lubinski, co-founder and head of retirement income for IncomeConductor. Currently, heirs enjoy a tax basis on inherited assets equivalent to the asset's value at the decedent's time of death. Without the stepped-up basis, the asset's tax basis is carried over from the testator to the heirs, so the beneficiaries have a higher investment income tax burden.

If Biden's plan becomes law, wealthier Americans might want to consider gifting more of their assets to their children while they are still alive. The parent could sell the assets now and pay the current, lower capital gains taxes. By giving the money to their children sooner, the parent will spare them a larger tax bill later. And gifting assets before death has another tax benefit for individuals whose estates surpass $3.5 million: Since the exemption threshold is about to drop, transitioning assets out of one's estate now could significantly lower the aggregate amount paid to Uncle Sam.

[Read: Your Guide to Tax Efficiency in 2021 and Beyond]

Plan for the switch from a deduction for 401(k) retirement contributions to a tax credit. This is a simple fix, especially for high-income earners. They can contribute the maximum to their 401(k) plans until the proposal becomes law. If the 26% refundable credit for contributions to traditional and SIMPLE IRAs, 401(k)s and 403(b) accounts goes into effect, high earners might benefit from directing some of their retirement contributions to a Roth, says Jody D'Agostini, a certified financial planner with Equitable Advisors, Falcon Financial Group, in Morristown, New Jersey. This approach would enable individuals to forgo the current tax deduction and benefit from the tax-free growth and distributions of a Roth IRA.

Consider a Roth rollover. Those with a large portion of their net worth in pretax retirement accounts should also consider rolling over some of it into a Roth IRA. Having less money in traditional IRAs and pretax accounts will reduce their required minimum distributions at age 72. And lowering income in retirement also reduces the premiums for Medicare Part B and Part D.

Dodge higher capital gains taxes. You might advise those earning more than $1 million to sell some investments before Biden's tax plan goes into effect. Clients will save a bundle in long-term capital gains taxes, as the current rate is 23.8% (20% capital gains rate plus 3.8% net investment income tax, or NIIT). That's nearly half the proposed 43.4% rate (39.6% plus 3.8% NIIT).

Although there's no guarantee that the Biden tax proposals will become law, it's prudent to inform your clients about potential changes and possible strategies for long-term planning.