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Legislative Uncertainty and Year-end Tax Planning (Yes, Again)

The “new normal” seems to be heading into the end of the year with unanswered questions around tax policy, and this year is no different. Between sweeping tax legislation signed in December 2017, the SECURE Act signed in December 2019, and the uncertainty around the Senate elections in late 2020, Congress has kept advisors on their toes with the ongoing negotiations around the future direction of tax policy.

While the financial headlines have been filled with discussions of looming increases in ordinary and capital gains rates, on November 19th we got our first real indicator of what proposed tax policy changes might become law when the House passed their version of President Biden’s Build Back Better Act (“BBBA”). Attention now turns to the Senate to see what changes might be negotiated or even if a final bill makes it to President Biden for signature this year.

Individual Tax Provisions of the Build Back Better Act passed by the House

As you work with your tax professional on year-end planning, it is worth noting what did not make it into the House bill. Since the release of the Biden Green Book proposals in early 2021 with the now infamous “date of announcement” plan for an increase in capital gains rates, taxpayers and advisors have been anticipating dramatic increases in all tax rates. Estate planners have also been worried about a significant decrease in the available estate tax exemption and the removal of certain popular planning techniques. However, none of these proposals had enough political support to become part of the final House bill.

Key Individual Income Tax Changes:

Increase in State and Local Tax Deduction (SALT) The Tax Cuts and Jobs Act of December 2017 reduced the SALT deduction allowed as an itemized deduction on Form 1040 to a maximum annual limit of $10,000. After this change, many taxpayers had a large share of their state income and property tax payments become nondeductible. The House bill would increase the limitation from $10,000 to $80,000, beginning in 2021, but does also extend a limitation through 2031. The $10,000 limitation from 2017 was set to expire December 31, 2025.

High-Income Surcharge While the BBBA does not include the much-anticipated increase in ordinary or capital gains rates, the bill would create a new 5% surcharge on a taxpayer’s modified adjusted gross income (MAGI) over $10 million, with an additional 3% surcharge on MAGI over $25 million. These surcharges would also apply to estates and trusts with MAGI over $200,000 and $500,000, respectively.

Expansion of the 3.8% Net Investment Income Tax (NIIT) Originally part of the Affordable Care Act of 2010, the 3.8% NIIT is commonly referred to as a Medicare surtax. This tax currently applies to “passive” income that is not subject to Medicare withholding, such as interest, dividends, capital gains, and passive business income, for taxpayers with MAGI in excess of certain thresholds. The BBBA would expand the types of income subject to NIIT to all trade or business income (i.e., not just “passive”) that isn’t subject to self-employment tax, including partnership income for limited partners, as well as S Corporation shareholder business income.

Expansion of the Wash Sale Rules A wash-sale transaction occurs when a taxpayer sells a security at a loss and then buys back a substantially identical security within thirty days. The IRS’ longstanding rule to disallow this loss for income tax purposes was enacted to prevent a taxpayer from selling a security to generate a tax loss without truly suffering an economic loss. As is often the case, the tax code must evolve to keep up with technology and investments. The current wash sale code section specifically refers to shares of stock or securities. The BBBA House bill would expand the assets subject to the wash sale rules to include commodities, foreign currencies, and digital assets such as cryptocurrencies, effective in 2022. The BBBA would also expand the wash sale rules to prevent “related parties” from buying back the identical asset on behalf of the taxpayer.

Changes to Retirement Accounts Large IRAs and Roth conversions are also a focus of the House BBBA. The most imminent change would take effect for tax years beginning after December 31, 2021, and impact all taxpayers, regardless of their taxable income. The change would eliminate the ability to complete what has become known as a “back door” Roth. This is when after-tax contributions to an IRA or 401(k) are then immediately converted to a Roth account. For tax years after December 31, 2028, high-income taxpayers, defined as having taxable income over $450,000 for Married Filing Jointly, would also face new restrictions on contributions, as well as new mandatory annual distributions, regardless of age, if their combined IRA/defined contribution plans have balances that exceed $10 million. Finally, Roth Conversions would be disallowed after December 31, 2031 for the same high-income taxpayers.

2021 Year End Income Tax Reminders

Unfortunately, we do not yet know what tax provisions will make it into the final version of The BBBA or what new tax legislation might be introduced during 2022. However, it does appear, for now, that some of the drastic increases in rates for 2022 are not likely. With that in mind, year-end tax planning can take a more personal approach, with a focus on your specific tax picture over the next two or three tax years. The best planning starts with a good income tax projection and a discussion of any material upcoming changes to your income, expenses, or balance sheet. Taking that into account, some general year-end reminders include:
  • For those with earned income from wages or self-employed business income, consider fully funding your available retirement deferrals. While some retirement accounts allow contributions up to the date you file your tax return, other accounts require funding by December 31st.
  • Be sure to take your required minimum distribution (RMD) from your retirement accounts. The IRS penalty for a distribution that does not meet the required minimum is one of the most onerous in the tax code at 50% for every dollar not withdrawn.
  • For taxpayers over age 70 ½ that are charitably inclined, consider utilizing your IRA to make charitable donations, up to $100,000, directly to a charity. This distribution, known as a Qualified Charitable Distribution (QCD), can count towards satisfying your RMD, if applicable, while not being included in your gross income on Form 1040. A QCD also allows a taxpayer that is taking the standard deduction to still receive a tax benefit from their charitable contributions. A QCD should always be coordinated with your tax advisor and your IRA custodian to ensure requirements are met for proper tax reporting.
  • For those not eligible for a QCD, consider the timing and type of asset used when making your charitable contributions:
    • Carefully planning the timing of your contributions could create the opportunity to itemize and deduct charitable contributions in certain years, while using the standard deduction in other years when no contributions are made.
    • While donating cash is an easy way to contribute to a charity, consider the tax benefits of donating appreciated stock you held for more than one year directly to a public charity. While the deduction you receive is generally equal to the fair market value of the stock, you are not required to pay capital gains tax on the unrealized gain at the time of the donation. For taxpayers with a large concentration of appreciated stock, this technique can be particularly useful.
  • The repeal of the SALT cap may not come to fruition this year, however, if you have already reached your limit of $10,000 in state and local taxes paid during 2021, coordinate closely with your tax and financial advisors to monitor the ongoing BBBA negotiations to determine proper timing of your 4th quarter state estimated income tax payment, as well as any property taxes that are due in early 2022.
  • While the potential for dramatic increases in capital gains rates for 2022 appears to be off the table, it is still important to be proactive in managing your capital gains and losses for the year. This includes communicating any gains or losses from assets outside of your investment portfolio with your wealth advisor so that a comprehensive plan can be put in place. Also, let your advisor know of any material capital loss carryovers or any expected taxable income variations between 2021 and 2022. This information could impact any decisions regarding tax-loss harvesting or rebalancing of your portfolio prior to year-end.

Your SouthState Wealth Advisor would be happy to work with you and your tax advisor to fully explore any of the topics mentioned above.

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