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Changes to Capital Gains Tax & Planning Strategies – American Families Plan

By: Derek Gray, CPA, Director; and Amy Sandlin, CPA, Tax Manager

The capital gains tax has long been part of the political tug-of-war, and with the release of President Biden’s FY2022 budget proposal, the change to the capital gains tax regime looks to be one of the more interesting proposals.

A quick refresher on our current capital gains tax system: the current rates are 0%, 15%, or 20% depending on income. These preferential rates apply to long-term capital gains and qualified dividends, and the application of the progressive rates is best left to tax professionals (and their trusty tax software).

Increasing the tax rate on capital gains is something we’ve seen before; however, the Biden administration’s proposal adds an additional tax bracket that would subject high-income individuals to a capital gains tax rate on par with President Biden’s proposed highest ordinary income tax rate – 39.6%. Add in the 3.8% Net Investment Income Tax (NIIT), and this rate jumps to 43.4% without taking state tax rates into consideration. This new capital gains tax bracket would apply only to individuals with adjusted gross income (AGI) in excess of $1 million. Individuals with AGI under the $1M threshold will continue to follow our current capital gains tax regime.

Under this proposal, the 39.6% capital gains rate would apply to long-term and short-term gains as well as dividends. For taxpayers over the $1M income threshold, this results in their marginal tax rate on capital gains going from 23.8% under our current system (20% highest capital gains rate + 3.8% NIIT) to 43.4%.

The Biden Administration included its reasonings for this proposal as part of its FY2022 budget release. One reason: preferential tax rates on long-term capital gains and qualified dividends disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers. We’re not here to opine on the merits of this as a policy proposal. However, the reasoning provides background for how the new capital gains tax regime will work.

For example, a taxpayer has AGI of $1,100,000 comprised of $900,000 in earned income from her W-2 and $200,000 in long-term capital gains. $100,000 of the capital gains would be taxed at the current preferential rate of 20% ($20,000 tax). However, the amount above $1M would be taxed at the new capital gains rate, so the remaining $100,000 in capital gains would be taxed at 39.6% ($39,600 tax). Therefore, the tax on just her capital gains would be $59,600. And, the entire $200,000 in capital gains would also be subject to the 3.8% NIIT. If instead the taxpayer’s AGI was $800,000, comprised of $600,000 in W-2 wages and $200,000 in long-term capital gains, the entire $200,000 in capital gains would be subject to the current 20% capital gains tax rate ($40,000 in tax). The increase in tax on $200,000 in capital gains for taxpayers with income over $1M is $19,600 under President Biden’s proposal.

This proposal is projected to raise $322 billion over the next decade. However, investment earnings, and therefore tax on those earnings, is something that can be managed over time, which makes the estimated revenue increase from this proposal an area of contention.

One aspect of the proposal that has garnered significant attention (and is causing even more sleepless nights for tax professionals around the country) is that it will be effective retroactive to the date the American Families Plan was introduced – April 28, 2021. The retroactive date is unique to the capital gains tax proposal only, and it is intended to prevent selloffs that might occur if a future effective date was announced.

Of course, this proposal has to make it through Congress, which means it may change before it goes into effect. You don’t have to be a political junkie to know that retroactive tax rate increases are going to be a hard sell in Congress. The last time a retroactive tax increase went into effect was in 1993. However, since it’s a possibility, tax planning should take it into consideration. Even if the proposal goes into effect retroactively, that doesn’t mean you can’t do any planning to minimize your tax burden if you are potentially subject to the new higher capital gains tax rate.

Tax Planning Strategies

Tax planning should revolve around getting your income under the $1M threshold if you are going to get ensnared in this new tax bracket. Since the threshold is based on adjusted gross income, you don’t have to rely solely on your investment portfolio to manage your tax liability. Instead, you can look to a variety of strategies to reduce your income, which include the following:

  • Individual Strategies:
    • Defer compensation
    • Harvest unrealized investment losses
    • Maximize retirement, HSA, and MSA contributions
    • Make a qualified charitable distribution from your retirement account instead of taking a required minimum distribution (up to $100,000)
  • Business Strategies:
    • Capital investments (especially assets eligible for immediate expensing due to bonus depreciation or Section 179)
    • Cash-basis taxpayers: delay invoicing and collection of receivables, prepay expenses
    • Pay bonuses to employees before year-end instead of waiting until the following year
    • Discretionary contribution to employee retirement plan
    • Accounting method changes that would decrease income (examples: changing from accrual basis to cash basis, accruing recurring items, deducting qualified prepaid expenses, or changing inventory methods)

The capital gains tax change is only one of the tax proposals put forward under President Biden’s plan. Your tax situation should be reviewed through a multi-year lens, taking into consideration the many factors that will impact your tax liability. Reach out to your Blue & Co advisor, or the authors, for a tax plan specific to you.

Derek Gray, CPA

Amy Sandlin, CPA
Tax Manager

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