Biden's Tax Plan, Part I: Impacts on Federal Income Tax and Estate Tax
- How a federal income tax rate increase affects you
- Impact of capital gains tax rate on your assets
- Three situations university professionals might find themselves in
The inauguration of President Joe Biden has allowed for more clarity on the evolving U.S. tax landscape. With record government debt levels and more deficit-spending on the horizon, taxes are all but certain to head north. While many of the specifics of future tax laws are unknown, below are a few changes the Biden administration has already put on the table that could impact most university professionals, including an increase in federal income tax rates for high earners and an increase in capital gains taxes.
How the Federal Income Tax Rate Increase Affects You
The proposed tax changes call for increasing federal income tax rates for those making more than $400,000, raising the highest marginal rate from 37% back to 39.6%, and capping deductions for higher earners. If your income is less than $400,000 annually and your income in retirement is likely to be even lower, why should you be aware of and planning for these changes? University professionals encounter unique situations where their taxable income in a given year can be much higher than it normally is, which can have unintended negative consequences. Professors routinely experience three scenarios:
- Retirement Incentives: Universities may offer incentives for faculty to retire within a certain timeframe, which is often paid out in the form of a lump sum. If your regular annual salary is $225,000 and you take a two-year lump sum payment from your university to retire early, you could end up having $675,000 of gross taxable income in one calendar year. A professor who would normally never have to think about potentially crossing the $400k income threshold could easily find themselves in this group after accepting a buyout package. Your $450,000 retirement bonus could end up being more like $300,000 after being taxed at the 39.6% marginal tax rate.
The Impact of a Capital Gains Tax Rate Increase on Your Assets
The proposed changes also call for increasing or eliminating the currently favorable capital gains tax rates and taxing gains as ordinary income for those with income in excess of $1 million. An area this might affect you is the buying or selling of your home or assets.
- Selling Assets: Many university professionals have business interests and investments in companies related to their research and areas of expertise. Many more own a second home. In the past, selling these types of capital assets meant paying only up to 20% in capital gains taxes. In comparison, the current highest income tax rate is 37%; that 17% difference means more money in your pocket. If capital gains rates are eliminated or raised in the future, these tax savings vanish.
Additionally, you may have savings in after-tax brokerage accounts. These accounts are very attractive during retirement because you can sell appreciated stock in a brokerage account if you need more income and pay a much lower capital gains rate, as mentioned above. If this changes, professors will lose out on a valuable planning tool to help reduce tax liability during retirement. Along with after-tax accounts, the proposed changes will also affect your relationship with tax-deferred accounts, including funding for medical expenses.
- Distributions for Medical Expenses and Other Purchases: Oftentimes professors do not carry long-term care insurance, instead choosing to self-insure for medical expenses with their tax-deferred retirement savings accounts. The problem with this is every dollar you take out of your tax-deferred retirement plan is subject to income taxes. This is true for all distributions; it is important to keep increasing tax rates in mind for all future spending like traveling, gifting to children, or purchasing real estate. Whether you or your spouse need long-term care, or you plan on using your retirement account to purchase a vacation home, these could lead to an inadvertent invitation into the $400,000+ club.
Review and Diversify
How do you begin to navigate these changes? The first proactive step you can take is to start planning for your future today. Review your retirement savings and their respective taxable accounts: brokerage accounts, cash, real estate, Roth, or tax-deferred. Then compare your available retirement income assets to your goals and needs. Are there any likely events that could trigger a highly taxable outcome? The second step is to diversify. As tax law evolves, it is good to spread out your savings across different “tax buckets.” A balance of tax-deferred and after-tax savings is best.
This comprehensive approach must be coordinated with your current income and future goals and needs. If you are unsure where to start, consult with your tax professional or a Certified Financial Planner™ to start planning today. Watch for Part II of this report on proposed tax changes under the new administration.
- To learn more about the importance of seeking guidance from an independent fiduciary, read this report: Who Can You Really Trust With Your Financial Future?
- To learn more about investing during unusual times and the effect on your retirement portfolio, read this report: Investing in a Low-Yield Environment: Unusual Strategies for Unusual Times.