Looking at tax proposals for the American Families Plan
House Democrats released their tax proposals for the American Families Plan and there are significant changes to the current tax law that could significantly impact taxpayers. Bigger ticket items are increasing the tax rate for "high income earners", lowering the income level for "high income earners" as well as sweeping changes for IRAs, who can contribute and rules for large balances accrued within IRAs. Let's dive right in!
Changes to Income Taxes
As anticipated, the tax rate for the top income bracket was increased from 37% to 39.6%. Doesn't seem like a big deal, right? Not so fast my friend! One significant change was the income level that would tip you from the 35% marginal rate to the 39.6% marginal rate. Under current law, for Married Filing Jointly (MFJ) filers, the income range for the 35% marginal rate is $418,851 - $628,300. Any income above $628,300 is taxed at the top rate of 37%. Under the new law, the top income range for MFJ filers is $418,851 - $450,000. Any income above $450,000 would now be taxed at the top rate of 39.6%! This would result in a tax increase of about $5,000 per year for MFJ filers. For single filers, the top income level drops from $523,601 to $400,000. A chart highlighting the changes is below.
Long-Term Capital Gains Rate Changes
In addition to increases in income tax rates, an increase in the long-term capital gains rate is also on the table. While the 0% and 15% long-term capital gains (LTCG) rates stay in place, the top long-term capital gains rate increases from 20% to 25% and the income threshold is lowered as well. For MFJ filers, the income threshold for the 15% LTCG rate is currently at $501,600 and would be lowered to $450,000. For single filers, the income threshold is lowered from $445,850 to $400,000. One important caveat is that for 2021, any gains locked in prior as of 9/13/2021 would be taxed at the previous rate of 20% for the higher income earners. Any gains realized starting on 9/14/2021 would be taxed at the higher rate of 25% for high income earners. A table of the new LTCG rates is below.
Elimination of "Backdoor Roth IRA"
One of the most popular strategies that we execute for clients, and the one under the most scrutiny as of late, is the "Backdoor Roth IRA". This is executed by making an after-tax contribution to your IRA and then converting this to a Roth IRA after waiting one statement cycle. Because the taxpayer doesn't receive a deduction for making the contribution to your IRA, there is no tax consequence for making the conversion to a Roth IRA. One may be thinking, "why make the conversion to Roth IRA and just keep an after-tax IRA?" The answer is in Roth IRAs, gains grow tax-free and distributions are made from the Roth IRA tax-free. In an after-tax IRA, contributions are made after-tax so the contribution amounts would come out of the IRA tax-free, however, gains within the IRA are tax-deferred, meaning that you don't have to pay taxes on the gains as they are realized, but the portion of your IRA that is attributed to gains would be taxed as ordinary income when you begin taking distributions. That is why Roth IRAs are the more preferred vehicle to after-tax IRAs and have been a powerful wealth builder for clients who have elected to do so.
One important thing to note is that the elimination of the Backdoor Roth IRA would take place effective 1/1/2022. In previous years, clients have executed their Backdoor Roth IRA strategy in the following year before they file their tax returns for the previous year, which is completely fine to do. However, the proposed regulations require that any Backdoor Roth IRA conversions be executed by 12/31/2021. Be forewarned!
In closing, while there are many other proposed regulation changes to the American Families Plan, these were some of the changes that would most impact the broader public. If you have a tax professional that you work with, you may want to confirm how these changes might impact your situation if these proposals become law.
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