Elections Have Consequences
President Biden campaigned that he would raise taxes for the ultra-wealthy. He is now rolling out his proposed changes to the tax code and three key provisions grabbed my attention. Two you have already likely heard of, and one that may be a bit more obscure but still have significant impact to some people.
The first key provision is raising the highest marginal tax rate back to 39.6% from its current 37%. As far as I can tell this has been greeted with a large, collective yawn. It’s hard to get anyone riled up about a 2.6 percentage point increase in anything tax related. Note also that right now this rate only kicks in for married couples with taxable incomes over $628,000 and single people over $523,000. If you’re paying it you’re already in the top 1% of taxpayers and you should not be expecting any sympathy from the government after the 40-year winning streak high-earners have been on.
Major Changes Affecting a Handful of Rich People
The second major change is the elimination of the preference given to capital gains over earned income on taxable income over $1 million. This is the change that caused the collective scream from Forbes magazine editors.
For more than twenty years, income from long term capital gains has been taxed at maximum rates varying from 15% to its current 23.8%. Under the initial proposal floated last week (to be clear: no legislation has been introduced) that preference would end at taxable incomes over $1 million, and capital gains above that would be subject to the new, highest marginal rate (39.6%) and the net investment income (“Obamacare”) tax of 3.8% as well. Behold, billionaires: welcome to your new 43.4% income tax bracket.
Before we go any further, understand who we are talking about. We aren’t talking about the top 1%. Not even close: we’re talking about the top 0.35% highest-income taxpayers in the U.S. The top 1 of every 285. We have data from the IRS showing exactly how many tax returns were filed in 2018 (last year for which data is available). Of the nearly 154 million returns filed, about 539,000 of them reported gross incomes over $1 million. About half of those people had incomes between $1 and $2 million.
The higher the level one reaches in income, the more likely that source of income is investment based, rather than activity based (earned income through employment, trade or business). Many lawyers now earn well over $1 million per year but it’s hard to find many earning over $5 million: there simply aren’t that many hours in the year to bill, even at $1500/hour. Overwhelmingly, at that level incomes are the result of passive holdings either in company stock or real estate. In the case of company stock, under current law no income is recognized and no tax is due until the stock is sold. At the moment of liquidation, income is determined and tax is owed.
Very Little Change For the Affluent
Also remember also that none of these changes to capital gain is applicable to money held in qualified plans like 401k’s and IRA’s. That money is always taxed as ordinary income on withdrawal. Personal use real estate also enjoys a healthy exemption from capital gains ($250k single/$500k married on the sale of your primary residence).
If you’re merely affluent in America (net worth between $1 and $5 million) the odds are excellent that the bulk of your wealth is either in qualified plans or residential real estate, to which this proposal has zero application, at least so far.
I will have a lot more to say about this once the actual proposal is introduced into Congress and we have a better idea how the administration would like it to work. Only then will we be able to start drawing useful inferences on how clients will be affected, if at all.
What is a Step Up in Basis, and Why Should I Care About It?
The last provision of the proposal (which has not been fleshed-out at all) is the elimination of stepped up basis at death. Things like stock and real estate (see above examples) that are not taxed until sale can escape that tax entirely if held until death and passed to heirs.
Grandma may own $1 million in phone company stock that was bought 50 years ago (when there actually was a “phone company”) that she paid $50,000 for over the years. If she sold it today she would owe capital gains tax on the $950,000 of internal gain. If she held it until death and passed it to her heirs, they could sell the $1 million in stock without tax at all.
The basis (what she paid) is stepped up to the stock’s value on the date of the purchaser’s death. At 23.8% tax avoided that is a considerable savings that most heirs have taken for granted for decades. By my rough estimation there are a lot more middle class families out there that benefit from the step up in basis than will ever be at risk of earning enough money that they need to concern themselves with 43% marginal tax rates.
Follow this story. It’s only getting started.
Being OK With Not Knowing
Elections Have Consequences President Biden campaigned that he would raise taxes for...