Regardless of the outcome of the elections, there are profound tax law changes coming which are already built in to the “system” and that will become effective on January 1. While it is possible that Congress could modify or repeal some of these changes, it seems very unlikely that all of these changes will be undone given the current fiscal state of the country. Therefore, advance planning with your accountant or tax advisor is more essential now than at any other time in recent memory because these extensive changes will greatly affect virtually every taxpayer and in differently.
Income taxes for individuals will, of course, see very significant increases. Prior trade-offs that were used to sponsor various tax incentives (or loopholes, depending on one’s perspective) that were added in recent years will expire at the end of this year. Most often discussed are the changes in the effective income tax brackets where virtually every tax bracket will see an increase in rates. In addition, wage earners will see an increase in their social security taxes go back up from the current 4.2% to 6.2%, and “rich” people ($200,000 single and $250,000 married taxpayers) will see their medicare tax rate go from 1.45% to 2.35% on all wages over these amounts.
Deductions will also be restricted. Standard deductions for married taxpayers will be decreased, while itemized deductions and personal exemptions will see the old phase-out rules come roaring back. Sales tax will no longer be deductible in lieu of state and local income taxes and the floor for medical expenses will increase from 7.5% to 10% for those under age 65. Employer paid tuition will no longer be excludable from income, teachers will lose deductions and the deduction for student loan interest will be gone. Education credits, dependent care credits, child tax credits, energy credits, earned income credits and a whole host of other miscellaneous credits will either be reduced, modified or eliminated entirely. Investment income will be hit particularly hard. The tax rate on an individual’s dividend income will increase from the present rate of 15% and will now be taxed as ordinary income up to the new maximum individual tax rate of 39.6%. Worse yet, the law imposes a brand new sleeper provision that calls for a 3.8% Medicare tax on investment income. Combined, this will bring the effective tax rate to as much as 43.4%, representing an increase of more than 189%. Investment income, you might note, will include not only dividends and interest, but also income derived from a passive activity and gains from the sale of property not used in a business. This new tax can even apply to the sale of one’s principal residence if the gain happens to be more than the exclusion that is allowed.
Individuals need to consider whether to sell investment property before December 31 in order to avoid the 3.8% tax. They might put off selling loss securities in order to shelter investment gains next year or they might harvest losses this year in order to offset current year gains. Tax exempt municipal bond interest will not be subject to this new tax, so changes in your investment strategy and asset mix may be warranted. The Medicare tax will also be imposed on a trust’s undistributed net investment income in excess of certain amounts, so additional planning might be necessary.
Estate, Gift and Generation Skipping taxes will increase substantially and have been the subject of a great deal of discussion. The two changes that have the biggest impact involve the increase in the tax rate and the decrease in the lifetime exemption. The tax rate is now capped at 35%, but will go to 55% together with a reinstatement of the 5% surcharge for estate and gifts in excess of $10 million. Also, the lifetime exemption that is presently $5.12 million will go back down to the former $1 million.
Less exposure has been given to other very meaningful changes, however. These include the elimination of the “portability” rules that presently allows a surviving spouse to use a decedent’s unused lifetime exemption. In addition, state death taxes will no longer be deductible and instead, the old state death tax credit is reinstated. Complex rules have also been added that deal with the generation skipping exemption allocation. The ability to pay estate taxes in installments has been restricted. Numerous other changes will also be made, but which are too technical to detail here.
Given the likely expiration of the many favorable benefits that presently exist, a great deal of effort is even now being given by better informed taxpayers to take full advantage of these benefits before they go away. There are a large number of different long sanctioned tools and approaches that can be selected and implemented now that are carefully and purposefully designed to try and “have your cake and eat it too”, depending on your own unique situation. Exploration of the many differing benefits and detriments of these various alternative approaches takes both time and careful thought, so if you haven’t yet begun to develop a good strategy, now is the time to begin.
You would be well advised to proactively seek the counsel of a good high quality tax advisor who can work with you and your situation to project the impact of these many changes and who can offer sound advice as to negotiating your path through this new minefield. How can you best achieve your financial and family planning objectives by adjusting your circumstances to maximize your wealth on an after-tax basis? Should you alter your investment mix or perhaps pay off your mortgage early? Should you be setting up trusts for the benefit of your family members that transfer wealth yet don’t damage their incentive to go out and conquer life? Should you be creating family limited partnerships that can transfer wealth while keeping all of the strings to the accession to that wealth? The knowledgeable and wise counsel of a good advisor is now more important than ever!