In his first four months in office, President Joe Biden has already made some significant economic changes — including signing an extensive COVID-19 relief bill. As the Biden-Harris administration continues to execute the plans outlined during their presidential campaign, many in the financial services industry are preparing for tax changes. Several of the suggested proposals in Biden’s tax plan could significantly affect retirees and change how financial advisors build efficient retirement income plans.
Advisors can prepare for the changes ahead by taking advantage of the current historically low tax rates. Clients who are in a low tax bracket could consider converting funds from a traditional retirement account into a Roth IRA as a tax-saving option. Another option is harvesting capital gains, not just capital losses. If it’s unlikely that a zero or a 15% tax bracket will be available later on in retirement, it might be helpful to harvest some capital gains and take advantage of the low tax bracket.
Another way to prepare is by stress-testing for tax changes, the same way you might stress-test for a down market. How would raising the tax rates impact your client’s retirement strategy? If capital gains and qualified dividends are no longer afforded preferred tax treatment, is your client’s plan affected? What happens if the estate exemption is lowered? Consider adding a stress test for these possible futures into your planning.
Here are a few changes you need to prepare for:
1. Rising tax rates.
Currently, the top tax rate is 37%. President Biden has proposed adjusting the rate back to 39.6%, which was the top tax rate prior to the 2018 Tax Cuts and Jobs Act. While there will be pressure on both sides to bring down some of the other tax brackets or adjust the threshold, advisors need to be aware that taxes are unlikely to decrease for lower-affluent or affluent taxpayers — and plan accordingly.
2. Adjusting the estate tax exemption.
Over the past several years, the estate tax exemption has varied. Currently, you can have $11.7 million in an estate before facing any estate taxation. Biden’s tax plan proposes reducing the exemption to $3.5 million, which means the number of people paying estate taxes will increase significantly. Gifting earlier on in retirement or using life insurance as an estate planning tool could be good planning options for some.
3. Additional taxation to pay for Social Security.
FICA taxes are used to fund the Social Security system. Workers pay taxes on up to $142,800 of income, which is indexed yearly for inflation. An employee pays 6.2%, and the employer pays another 6.2% for a total of 12.4% under the current system. If the new proposal is adopted, the tax would be reinstated for people who earn more than $400,000 a year. High earners would again begin paying 6.2%, and self-employed people would pay both halves, for a total of 12.4% on annual income over $400,000.