Tax Bill Targeting Millions Of Affluent Investors Not As Aggressive as Anticipated

As tax increases make their way through Congress, a surprising takeaway has emerged for financial advisors with clients who are affluent but may not be “Jeff Bezos-rich.” Nearly 4.8 million individuals making between $369,300 and $884,900 would pay $4,340 less in federal tax starting next year under the tax and spending bill approved with last minute changes by the House of Representatives the week before Thanksgiving. Americans that fall just below the 1% highest income earners typically have a net worth that exceeds earnings once homes and retirement accounts are added in. So far, many high net-worth individuals are off the hook from the tax hikes embedded in the Biden administration’s $1.8 trillion Build Back Better Act.

For months, investors had been on high alert amid early proposals from Democrats that took aim at the wealthy. However, the bill that House Democrats approved omitted many of the most feared measures that had been in the legislative works for months. Investors will still be able to use a longstanding loophole to pass on wealth to heirs, who won’t have to pay taxes on gains in assets that accumulated before they inherited them. With the top ordinary federal rate of 37% remaining unchanged, so is the 23.8% capital gains rate. The long-standing tax benefits of grantor trusts remain in place as well.

For all their talk earlier this year about taxing the rich, House Democrats landed on a bill in which the average federal tax rate of those making between $500,000 and $1 million would nudge down to 27.2% next year from the current 28.1%.

Changes for the richest

Ultra high net-worth individuals don’t get off as easily in the reworked bill. The bill places a $10 million cap on individual retirement accounts. The so-called mega backdoor Roth conversions, in which an investor can put as much as $58,000 a year into a 401(k) account and convert much of the money to a tax-free Roth account, would be banned after the first of January. However, investors can still do regular Roth conversions but would be banned from the strategy come 2032, if they’re high earners. Those conversions involve taking money out of a taxable retirement account like an IRA or 401(k), paying income tax on the gains, then putting the proceeds into a Roth, where it can grow free of tax.

Individuals making more than $10 million a year would pay a 5% surtax on their incomes, including wages, capital gains and dividends. Those making more than $25 million would pay an 8% levy. The “millionaires’ surtax” is still considerably less painful than earlier proposals. Some 22 million American adults had a net worth over $1 million in 2020. Many affluent investors will be happy with the tax bill, but there’s a subset of who may not be pleased. These folks are a niche group of people who own small businesses or participate in partnerships and receive a chunk of their profits. Investors with interests in those so-called pass-through entities who make more than $400,000 ($500,000 for couples) would pay the existing 3.8% net investment income tax if they don’t already. The levy, which falls on capital gains, dividends, rental income, and passive income, has an identical counterpart for people who earn wages. Tax writers expanded the levy due to data showing that some affluent business owners avoid both forms of the tax by improperly casting income as profits rather than wages.

An even smaller subset of investors who have stock in start-ups will be upset, as the bill cuts the tax benefits of qualified small business stock. That perk lets founders and employees at small companies who receive stock as part of their compensation rake in $10 million, and often giant multiples of that, free of federal tax. The tax bill now before the Senate would slice that tax benefit to 50% for individuals earning more than $400,000 and for trusts and estates. The bill would hit investors who sell their founders stock after Sept. 13, 2021, unless there is a binding contract for a sale before then and it’s completed by the end of the year.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

Archives