Planning for Higher Taxes in 2021

united states capitol building
Written by eharbert on February 17, 2021

Eric A. Harbert, CPA, CFP® | Wealth Advisor

As we begin 2021 with the Democrats in control of Congress and the White House, we can begin to assess the political agenda of the left and what impact it will have for our clients. One item high on that agenda is a plan to reform our current tax system, which President Biden released late in 2020. Biden’s plan targets higher taxes on income exceeding $400,000, but also proposes significant changes to corporate and estate tax rules. Below are a few of the key provisions of Biden’s plan and how it may affect your taxes moving forward.

  • Tax Rates – The US has what is known as a progressive tax system, which means the more you make the higher percentage tax you pay on new incomeThe top tax rate today is 37% on income over $622,050 which was passed in 2017 by the Tax Cuts and Jobs Act (TCJA). Biden’s proposal raises the top rate on income over $400,000 to 39.6% (Married Filing Jointly)The proposal also suggests that all other brackets remain unchanged, so higher taxes would only be paid by those making over $400,000 (taxable income). Considering the IRS reports only 1.2% of Americans made over $500,000 in 2019, this proposal certainly targets the top 1% while leaving rates unchanged for the other 99%. Overall, this provision does not represent a major adjustment, for example, at $600,000 of income, Biden’s proposal would add $8,600 of additional tax.

  • Social Security Tax – Currently Social Security tax is 6.2% for an employee and employer (12.4% total) and applies to income up to $142,800 in 2021. Biden’s plan imposes a new 12.4% additional tax on wages/earned income over $400,000 (no wage cap). This proposal impacts both employees and employers since the tax is split 6.2% each, although those who are self-employed cover all 12.4% through self-employment taxes. Considering our first example at $600,000 income, this provision would add an additional $24,800 to your tax bill. Presumably, this tax would not apply to distributions from an S-Corporation, so most business owners are already sheltered from this tax. However, those operating as an LLC would see their tax bill grow by an additional 12.4%!  By eliminating the wage cap, this provision would result in a massive tax increase for high earners. 

  • Capital Gains – Capital gain rates have historically enjoyed a preferential tax rate vs. earned income. The current maximum rate on capital gains is 20% for income over $500,000.  Biden’s plan increases the top rate to 39.6% (equal to ordinary income) for taxpayers with total income over 1 million. Keep in mind there is also a 3.8% surtax on capital gains for income over $250,000 bringing the top rate for gains in the proposal to 43.4%! This provision could impact many of our clients planning to sell their business in 2021 and beyond. Many high-income earners may look to spread out their gains going forward through installment sales to stay under the 1 million income threshold.    

  • Equalize Retirement Plan Benefits – Likely the most controversial proposal is to change retirement plan benefits by moving from a deduction to a tax credit, which dollar for dollar is meant to benefit all taxpayers equally vs. receiving benefit equal to your tax bracket. This provision would diminish the benefits for high-earners and increase the benefit for lower earners. For example, currently taxpayer in the top tax bracket saves 37% in taxes for each dollar funded to their retirement plan. This proposal would limit that deduction to a flat amount which many believe would be around 28%. While this provision would incentivize lower income earners to save for retirement, it will likely result in fewer plans offered by employers.  

  • Estate Tax Changes  Another change targeted by Biden’s plan is a reduction in the exemption for calculation of estate taxes. The exemption is currently $11.7 million per person, which means no estate taxes are due for estates under this amount. Biden has proposed lowering the exemption to $3.5 million and raising the top tax rate from 40% to 45%. The Tax Policy Center estimates that only 1,900 estates will pay taxes in 2020 due to this higher exemptionBased on the proposed changes many individuals will need to consider if their estate planning documents are structured to prepare for a lower exemption.  

  • Corporate Tax Rates – One of the most meaningful changes of the TCJA in 2017 was reducing the corporate tax rate from 35% to 21%. This change boosted earnings for public companies and was meant to reduce the number of companies looking to reorganize outside the US. Biden’s plan would increase the corporate rate to 28%. This change will reduce corporate earnings about 9%, which could certainly have an impact on the stock market which has enjoyed high annual returns partially fueled by lower tax rates.

The current tax code went through a massive overhaul with the passing of the Tax Cuts and Jobs Act (TCJA) of 2017. This proposal was passed entirely by republicans and now looks to be in the cross hairs as Democrats frame their agenda for the next 2 years. As you can see above, the tax changes proposed mainly impact incomes over $400,000 leaving the old TCJA rules in place for most taxpayers. Although these changes are high on the Biden agenda, there is also a possibility they will be delayed due to the uncertain impact on the economy which is still recovering from the Pandemic. Time will tell if these proposals become law, but considering the political climate and mounting national debt, higher taxes seem to be a safe bet!

This information was derived from sources believed to be factual and reliable. It is being provided for informational purposes only and should not be construed as tax or legal advice. Please consult a tax or financial advisor with questions about your specific situation.