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Considering President Biden’s proposed tax rate hikes for high-earning and wealthy individuals, it is an important time to think about the interplay of Roth IRA conversions, accelerating capital gains, and dynastic wealth planning. The president’s proposed American Families Plan (AFP), which was introduced in late April, presents a number of relevant planning considerations. The AFP aims to fund additional education, paid leave, childcare, and other reforms by raising top income and capital gains tax rates for Americans who earn more than roughly $400,000 per year. For our purposes, the two key elements of the proposal are (1) taxing unrealized capital gains at death (i.e., repealing the present law’s step-up in tax basis that increases the basis for inherited assets to their fair market value at death) and (2) the near doubling of the capital gains rate for taxpayers who earn more than $1 million a year.

US President Joe Biden speaks about the US economy during a press conference

Before we dig into these proposal items, let’s review how Roth assets differ from traditional retirement assets. Roth accounts are funded with after-tax dollars and are distributed tax-free, whereas traditional IRA accounts are funded with pre-tax dollars and are taxed upon withdrawal at ordinary income rates. For those of you with traditional retirement assets, a partial or full Roth conversion should be a planning consideration, given Biden’s proposal. A Roth conversion allows you to transfer some or all of your tax-deferred assets into a Roth account. In exchange for paying income tax on the transfer, you benefit from tax-free growth and distributions, avoid required minimum distributions (RMDs) on the Roth portion of your retirement assets, and gain the ability to pass on tax-free growth to your beneficiaries. Simply put, you either pay the tax now or you pay it later. If we were only considering increases to top marginal income tax rates for high-income earners, in isolation, a Roth conversion may not seem like the most compelling technique.

However, when facing Biden’s proposed removal of the step-up in basis, at death, for any gain of more than $1 million per person — things become a little more interesting. As it stands today, in many cases, assets that appreciate within an estate are not taxable upon death. Heirs would generally receive a “step-up” in income tax basis equal to the fair market value for taxable assets using the date of death. Estates with assets exceeding $11.7 million (per person), however, would be subject to a federal estate tax of 40% on anything above the aforementioned threshold. Another consideration to keep in mind is the potential for the lifetime exemption amount of $11.7 million to be significantly reduced. It could create a scenario in which only gains of $1–$2 million are excluded from capital gains taxation, at death. In a situation where a wealthy family is over the lifetime exemption amount at the passing of the second spouse, the estate could feasibly have a capital gains and, potentially, an estate tax liability.

The other component to consider is the proposal to nearly double capital gains rates. Currently, you pay a rate of 0%, 15%, or 20% based upon your taxable income. For those with higher taxable income levels (a modified adjusted gross income above $200,000), there is an additional 3.8% net investment income tax (NIIT) — the Medicare surtax — that will likely also apply. So, under the most extreme capital gains circumstances, you would be subject to a marginal federal tax rate of 23.8%. Under Biden’s proposal, things would look different for high-income earners. If you are fortunate enough to have an annual income above $1 million, your long-term capital gains would be taxed at the top marginal rate of 39.6% + 3.8% NIIT. Doing basic math, if there were circumstances in which a wealthy individual or couple were to eclipse the $1 million income threshold and/or there were significant embedded gains within a taxable estate, there may be scenarios in which paying tax now could be extremely beneficial for your long-term tax liability.

To illustrate this potential scenario, let’s use an example of a wealthy family. John and Jane Smith, both age 75, are married with two children: Charlotte (40) and Noah (37). Their assets, income, and objectives are as follows:

  • Liquid net worth: $35 million ($20 million in a trust account and $15 million in tax-deferred accounts)
  • Cost basis: Zero basis for taxable assets (for the sake of simplicity)
  • Taxable income: $500,000 per year
  • Key objectives: Maintain their current lifestyle and pass on as much wealth as they can to their kids
  • Assumptions: The discussed elements of Biden’s proposal are passed and go into effect in 2022; the current lifetime exemption amounts remain unchanged

What happens if both John and Jane pass away next year, assuming the changes from the AFP go into effect in 2022? We will compare the base case (doing nothing) versus converting a large portion of their retirement assets ($12 million) into Roth assets.

Planning considerations:

  • Convert a portion or all of the tax-deferred assets to a Roth IRA
  • Sell assets within their trust account for the source of the tax payment, accelerating capital gains
  • Reduce the overall value of the estate (annual gifts, larger lifetime gifts, Roth conversions)
  • Have a portion of the liquid assets growing tax-free
  • Eliminate RMDs for the portion of tax-deferred assets converted to a Roth IRA
Base Case - No Roth Conversion, Year 2022
Taxable Assets (Zero Cost Basis)$20,000,000
Traditional Retirement Assets$15,000,000
Roth Retirement Assets-
$1mm Step-up in Basis Repeal Exemption, Per Person($2,000,000)
Capital Gains Taxed at Proposed Ordinary Income Rates (39.6% + 3.8% NIIT = 43.4%) 1($7,812,000)
Value of Remaining Assets in the Estate (Taxable + Retirement), Post Capital Gains$27,188,000
Current Estate Tax Exemption ($11.7mm, Per Person)($23,400,000)
Taxable Estate$3,788,000
Estate Tax Rate 40%($1,515,200)
Subtotal of Capital Gains and Estate Tax($9,327,200)
Taxes Paid if $12mm of Traditional IRA Distributed (39.6% + NIIT = 43.4%) 1($5,208,000)
Total Taxes Paid (IRA Distribution, Capital Gains & Estate Tax)($14,535,200)
$12mm Roth Conversion in 2021
Taxable Assets (Zero Cost Basis)$20,000,000
Traditional Retirement Assets$15,000,000
Roth Retirement Assets-
$12mm Roth Conversion Taxed at Current Ordinary Income Rate (37% + 3.8% NIIT = 40.8%) 2($4,896,000)
Selling $6.5mm Worth of Securities in Taxable Account Subject to Top 23.8% Long-Term Capital Gains Rates (for Roth Conversion-Related Tax Bill) 2($1,547,000)
Total Taxes Paid for Roth Conversion($6,443,000)
Post Roth Conversion, Year 2022
Taxable Assets After Roth Conversion $13,557,000
Traditional Retirement Assets$3,000,000
Roth Retirement Assets$12,000,000
$1mm Step-up in Basis Repeal Exemption, Per Person($2,000,000)
Capital Gains Taxed at Ordinary Income Rates (39.6% + 3.8% NIIT = 43.4%) 1($5,015,738)
Value of Remaining Assets in the Estate (Taxable + Retirement), Post Capital Gains$23,541,262
Current Estate Tax Exemption ($11.7mm, Per Person)($23,400,000)
Taxable Estate$141,262
Estate Tax Rate 40%($56,505)
Total Taxes Paid (Roth Conversion, Capital Gains & Estate Tax)($11,515,243)

1 Assumes Proposed American Families Plan (AFP) Tax Rates
2 Assumes Current Tax Rates

The above example and considerations come with some significant assumptions, and we don’t know with any certainty how the dust will settle. What we do know is that now is a wonderful time to create a framework for your wealth planning options. The B|O|S team will be following these proposed changes very carefully, and we will surely have additional insights to share later this year. In the interim, please don’t hesitate to reach out to your B|O|S team with any questions you may have.

Filed under: Financial Planning

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