Tax Planning In 2021 – Avoiding Potential Tax Storms

We all know, as Benjamin Franklin famously said, there are only 2 guarantees in life: death and taxes.¹ But it turns out, while taxes are indeed a certainty, they aren’t entirely out of our control. We actually have a lot more control over our individual tax outlook than many of us give ourselves credit for.

In this article, we’ll be taking a look at three things:

• Will Taxes Be Lower or Higher For You In Retirement?
• America’s Tax Landscape Today: The current tax outlook — where we stand as a nation and how we got here
• What the future may hold — and whether we’re facing a potential tax storm, including increased taxes for individuals like you — especially with a new administration
• And tax planning strategies to consider: what YOU can do right now to help protect yourself no matter what the future holds.

We’ll also talk about three action steps you can take, starting today, to help ensure that more of your hard-earned money stays with you and your family, versus going to the government. So, you can feel confident about your financial future no matter which way the political winds are blowing.

Will Taxes Be Lower or Higher For You In Retirement?

Many of us have been operating for a long time under what can be believed as a popular myth – that our tax rates will be lower in the future, and particularly in retirement, than they are today. And therefore, we often choose savings vehicles that DEFER our tax bill until a later date — things like traditional IRAs and 401(k)s for example.

Past generations of retirees probably did fall into a lower tax bracket in retirement. They stopped taking vacations, they spent less than when they were working, they “tightened their belts” and accepted their “fixed” income in retirement.

For recent retirees, it’s been a different story. They’re going to every new restaurant, traveling the world and spending time at the lake house with the kids and grandkids. Their retirement spending may actually outpace that of their working years. And for baby boomers and Generation X’ers, often the same is true. Retirement is seen as the reward for years of hard work and savings – they’re looking to maintain their income in retirement to meet their goals and dreams. ²

They often DON’T fall into a lower tax bracket in retirement for a couple of reasons:

• They have fewer tax deductions (generally by retirement, homes are paid off and children are out of the house)
• They want to travel and enjoy the hobbies they didn’t have time for while they were working (and those all mean more spending)
• And future tax rates are actually likely to be higher than during their working years. Historically speaking, we’re currently at some of the lowest tax rates we’ve seen in our nation’s history.

So, the answer: Is it true or false that your taxes will be lower in retirement? Most likely false, for the majority of us. But everyone’s situation is different.

Some of our most popular savings vehicles, such as IRAs and 401(k)s, are based on this premise that taxes will be lower in retirement. These tax-deferred vehicles allow us to “defer” paying taxes on our contributions, and we then pay taxes both on what we put in AND on the growth when we go to withdraw those funds.

In effect, the government is our “silent partner” … and that partner will want those taxes repaid in the future. But the rub here is that there’s no guarantee what those tax rates will be when your “silent partner” – the government – is ready to collect.

America’s Tax Landscape in 2021

So where are we right now, financially speaking, and how did we get here?

Since shutdowns grounded the economy to a near-halt last spring, Congress and the Federal Reserve have pumped trillions of dollars into programs aimed at fighting the coronavirus and bailing out industry and small business — in essence, to save the economy.

On March 27, 2020, the historic CARES Act was signed by President Trump, putting $2.2 trillion of stimulus money into the economy. And while there’s been some debate on exactly how those funds were doled out, here’s what’s not up for debate: Those funds were essentially an emergency loan from the government. But that wasn’t the end. Just before the calendar page turned to 2021, President Trump signed into law an additional $900 billion stimulus package — representing the second-largest federal stimulus package in history (after the CARES Act).

The Federal Reserve has committed to potentially more than $4 trillion in relief efforts on its balance sheet.

And on March 11, 2021, President Joe Biden signed a $1.9 trillion plan to combat the coronavirus and stimulate the economy, called the American Rescue Plan. It’s the first of two major spending bills expected from his administration. Those are some big bills we’re racking up as a nation. All of which MUST be repaid at some point, virtually assuring higher taxes in the future. ³

Where could we go from here? Could your taxes be on the way up?

There’s a good chance we will see higher tax rates in the future, compared to today’s tax rates.

Beyond the massive stimulus spending recently, let’s look at a couple more reasons why …

First, we have a new administration in Washington, D.C. — and with that comes lots of big plans. These will be important to watch going forward because they could affect your pocketbook in a number of ways if they are signed into law.

The president has signed a $1.9 trillion coronavirus relief and stimulus plan and we’ll likely see more of President Biden’s tax-related proposals — which he shared on the campaign trail. In addition to tax-focused policy, that plan also is expected to tackle his policy goals relating to jobs and infrastructure, climate change and racial equity. Biden has promised not to raise taxes on those making less than $400,000 per year, so many of his proposals are focused on higher earners. Some tax proposals from Biden’s campaign that could affect individual taxpayers like you include:⁴

• Returning the highest individual tax rate to 39.6% (up from the current 37% – it was lowered by the 2017 Tax Cuts and Jobs Act. And while that lower rate already was set to sunset in 2025, it’s possible a Biden plan could speed up that increase)
• Capping itemized deductions for wealthy taxpayers (Taxpayers earning more than $400,000 with tax rates over 28% would face limited itemized deductions.)
• Taxing capital gains at the ordinary income tax rate for those who earn more than $1 million a year (remember we said that rate could be going up to 39.6%) rather than the current lower rates (20% for those with more than $445,850 in income (single filer) or $501,601 in income (married filing jointly))
• Making wages above $400,000 subject to the payroll tax (currently wages above $142,800 are exempt)
• Ending the step-up in basis for inherited capital assets, which means more taxes on wealth passed to heirs
• Limiting “like-kind exchanges” (called 1031 exchanges) by real estate investors
• Phasing out the 20% deduction for qualified business income for upper-income taxpayers
• Imposing sanctions for using tax havens
• Decreasing the federal estate tax exemption to pre-Tax Cuts and Jobs Act levels — meaning more wealthy estates will be subject to that tax
• He’s also targeting corporate tax rates, proposing raising the corporate income tax rate to 28% from 21% — and he supports a 15% minimum tax on large corporations

As you can see, there are a number of areas targeted for tax increases among just these highlights. We’ll keep a close eye on these plans moving forward.

Current Tax Rates

Another reason we anticipate higher taxes in the future: We’re currently experiencing historically low tax rates.

Even before President Biden was elected, the Tax Cuts and Jobs Act, passed in 2017, made substantial changes to the tax rates for individuals, reducing tax rates at almost all levels and shifting the thresholds for several income tax brackets. And those tax cuts already were scheduled to expire Dec. 31, 2025, unless extended by Congress.⁵

As mentioned earlier, on Biden’s wish list is returning that top marginal tax rate to 39.6% – the pre-Tax Cuts and Jobs Act level – so it remains to be seen if he will let it simply sunset in 2025 or speed up that potential increase.

Either way, we’re looking at a virtually guaranteed tax hike for many of us.

What can you do to help protect yourself?

With all that in mind, let’s look at what matters most. What can you do – right now – to help protect yourself and your financial future – regardless of what the future holds? (Regardless of where tax rates land in the future, regardless of what political party controls the White House or Congress …)

In a time in which so much feels outside your control, the reality is that your finances and the retirement you’ve spent a lifetime preparing for don’t have to be.

Those things actually can be completely controlled. And you have more control than you may think over what your tax picture looks like in retirement. Protecting yourself starts with understanding the difference between a “micro” and a “macro” view of taxation.

A micro view focuses on your current year’s taxes – what your accountant or CPA does for you each year when they file your taxes. A macro view, and what we at E.A. Buck Financial Services can help you with, focuses on lifetime taxes through retirement. Our comprehensive financial planning process is designed to take your entire retirement picture, for a lifetime — including your taxes — and bring it into focus for you.

Here are several big-picture tax strategies that can help you take control and protect yourself no matter what future tax rates look like. As well as three actions you can take to make those strategies part of your comprehensive financial plan taking you to and through retirement.

Avoiding Tax Volatility

As we’ve already seen, while taxes are generally a certainty, there’s no guarantee that tax rates will stay steady over a 20- or 30-year retirement. And those changes can have a big impact on your bottom line over the course of a retirement.

You’ve probably heard about diversifying your investments — so you don’t have all your eggs in one basket — but did you know that making sure you’re diversified from a tax perspective is just as important?

When we look at diversifying assets by how they’re taxed, we generally think of three buckets.

These represent three broad categories based on how income is taxed:

• Taxable Income
• Tax-Deferred Income
• Income Tax Free

The goal is to begin moving money from left to right as you are able and if it benefits your tax situation in the long term.

Let’s talk about what types of assets fit within each of these three buckets: ⁶

• The INCOME TAXABLE bucket includes such things as pension income, short-term gains and stock dividends, interest on CDs, and dividends and taxable distributions from mutual funds in non-qualified accounts. Generally, these are accounts for which you typically receive a Form 1099 each year.
• The TAX-DEFERRED bucket may include Traditional IRAs, 401(k)s, 403(b)s, 457(b)s, annuities and savings bonds.
• The INCOME TAX FREE bucket includes Roth IRAs, municipal bonds and life insurance (if properly structured).

So, the first step is knowing where among these three buckets your current assets are located.

And the next step is considering whether moving some of that money (from left to right), from taxable or tax-deferred options to tax-free options, is a possibility and would fit your tax situation.

Creating Tax Diversification

But how do you know how diversified your assets are across these three buckets? Don’t worry. We’re here to help. If you’d like to receive a completely free Tax Diversification Review from our firm, it comes with absolutely no obligation – it’s just something we think is very important for you to have done. So, if that’s something you’d like to address or simply want to explore possibilities, contact us for a complimentary consultation.

A Tax Diversification Review is a simple review of your retirement portfolio to determine how much of your assets are within each tax bucket, and based on that, how much you could be affected by taxes in retirement.

What this does is give you at-a-glance clarity around where you stand financially and what adjustments you could potentially make to reduce that tax burden and keep more of your hard-earned money in retirement.

What this ultimately means, though, is that you will have a greater sense of control over your ultimate financial future and retirement outcome. And right now? With so much feeling uncertain, that kind of certainty is invaluable.

Asset Conversion Strategy

One way we can move assets from left to right on that tax buckets continuum is to convert some of our tax-deferred assets (for example a traditional IRA or 401(k)) to tax-free assets (such as a Roth IRA or an Indexed Universal Life insurance policy).

Those conversions involve paying the taxes on the money you’re converting now, rather than waiting for taxes to go up and paying them in the future, while taking advantage of tax-free growth and distributions in the future.

We’re currently in a window of time during which taxes are essentially “on sale” and such conversions can essentially be made at a discount. As referenced earlier, the Tax Cuts and Jobs Act of 2017 reduced taxes for many of us. And those tax cuts are set to expire at the end of 2025. And if those do expire, we’re looking at higher tax rates for many of us.

Well, that gives us a window of opportunity.

If the Tax Cuts and Jobs Act was to sunset in 2025, many of those who are currently in the 22% and 24% tax brackets (for couples who are married, filing jointly) could find themselves bumped back to the 25%, 28% and, for a few, even the 33% tax bracket. Those are fairly significant increases. (President Biden has pledged not to raise taxes on those making less than $400,000, so it remains to be seen where we could end up.)

And, note that those potential 2026 tax rates are what was current as of 2017 – we know that those would also likely have some adjustments for inflation.

We’re also currently enjoying a generous standard deduction of $24,000 for those who are married, filing jointly.

Let’s take the example of a couple, let’s call them Dave and Sara, with income of $170,000 in 2017 (note, here we’re assuming no adjustments for deductions, credits, etc., for simplicity’s sake). They would have been in the 28% tax bracket in 2017.

Today, with $170,000 in income, Dave and Sara would be in the 22% tax bracket.

If the Tax Cuts and Jobs Act’s tax cuts expire in 2025, Dave and Sara have $170,000 in annual income in 2026 — and not accounting for any potential inflation adjustments to those tax brackets — they could be back in that 28% tax bracket.

If Dave and Sara are interested in converting an IRA to a tax-free account (say a Roth), there’s potentially 6 percentage points difference in the taxes they would pay today versus the future. And that’s nothing to sneeze at.

For example, let’s say Dave and Sara are considering converting $100,000 from a traditional IRA to a Roth IRA, paying the taxes now.

If they made that conversion under 2017 rules, the cost would be approximately 33% or $33,000 in taxes.

If they made that conversion under 2021 rules, the cost would be approximately 24% or $24,000 in taxes.

That’s more than a 25% savings in taxes (27% to be exact).

If Dave and Sara choose to reduce their future tax liability by paying some tax today – at the lower rates – and shifting money into a tax-free account, like a Roth IRA or an Indexed Universal Life insurance policy (IUL), some of the benefits they’ll see include:

1. Tax-free distributions
2. If they are older than 59½, they will have immediate access to funds tax-free with no penalties (in the case of a Roth IRA, while they will always have access to contributions, they must hold the IRA for at least five years to tap into investment earnings without penalties)
3. No required minimum distributions — so they will have freedom of choice, to choose when, or if, they want to take distributions from their account
4. Potential tax-free inheritance to beneficiaries
5. And they are immunized against future tax law changes — because they’ve already paid the taxes on their contribution, if taxes later go up, these accounts aren’t affected

Key Takeaways

With all this, here are the key takeaways.

• Taxes are going to increase in a variety of ways
• Most people have too little in the Tax-Free bucket
• It’s not what you earn, it’s what you keep
• You need to determine who is in control of your taxes in retirement

There are many different situations that make different types of tax planning strategies worth considering. If you have any questions or want to further explore tax planning to reduce tax liabilities or prepare for future tax changes, our financial advisors are available to help you explore your opportunities.

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Sources:

¹https://constitutioncenter.org/blog/benjamin-franklins-last-great-quote-and-the-constitution. Accessed Jan. 27, 2021

²https://www.kiplinger.com/slideshow/retirement/t055-s001-questions-retirees-get-wrong-on-retirement-taxes/index.html

³https://www.usatoday.com/in-depth/news/2020/05/08/national-debt-how-much-could-coronavirus-cost-america/3051559001/. Accessed Jan. 27, 2021.

³https://www.washingtonpost.com/business/2020/04/15/coronavirus-economy-6-trillion/. Accessed Jan. 27, 2021. NOTE: This is not behind a paywall – part of the paper’s coronavirus coverage available to all

³https://www.forbes.com/sites/leonlabrecque/2020/03/29/the-cares-act-has-passed-here-are-the-highlights/#11c2b2ac68cd. Accessed Jan. 27, 2021.

³https://www.investopedia.com/updates/usa-national-debt/. Accessed Jan. 27, 2021. (NOTE: Jan. 22, 2021 debt figure in this source)

³https://www.cnn.com/2020/12/20/politics/second-covid-stimulus-package-details/index.html. Accessed Jan. 27, 2021.

³https://www.cnbc.com/2021/01/14/biden-stimulus-package-details-checks-unemployment-minimum-wage.html. Accessed Jan. 27, 2021.

⁴https://www.cnbc.com/2021/01/14/biden-stimulus-package-details-checks-unemployment-minimum-wage.html. Accessed Jan. 27, 2021.

⁴https://taxfoundation.org/joe-biden-tax-plan-2020/. Accessed Jan. 27, 2021.

⁴https://www.kiplinger.com/taxes/capital-gains-tax/601636/2021-capital-gains-tax-rate-thresholds. Accessed Jan. 27, 2021.

⁴Ben Geier. SmartAsset. Oct. 29, 2020. “Joe Biden’s Tax Plan Explained.” https://smartasset.com/taxes/joe-bidens-tax-plan-explained. Accessed Jan. 27, 2021.

⁴JoeBiden.com. September 2020. “A tale of two tax policies: Trump rewards wealth, Biden rewards work.” https://joebiden.com/two-tax-policies/. Accessed Jan. 27, 2021.

⁴https://taxfoundation.org/joe-biden-tax-plan-2020/. Accessed Jan. 27, 2021.

⁴https://www.kiplinger.com/taxes/capital-gains-tax/601636/2021-capital-gains-tax-rate-thresholds. Accessed Jan. 27, 2021.

⁵https://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates. Accessed Jan. 27, 2021.

⁶Advisors Excel report: “Tax Strategies for Retirement: Buckets Create Tax Choices.” https://fliphtml5.com/ukrl/tfib. Accessed Jan. 27, 2021.

This content is provided for informational purposes only and is not intended to serve as the basis for financial decisions. We are an independent financial services firm helping individuals create retirement strategies using a variety of investment and insurance products to custom suit their needs and objectives.

Our firm is not permitted to offer tax or legal advice. Individuals are encouraged to consult with a qualified professional before making any decisions about their personal situation. A Roth Conversion is a taxable event and may have several tax related consequences. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA.

Securities offered only by duly registered individuals through Madison Avenue Securities, LLC (MAS), member FINRA/SIPC. Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM), a Registered Investment Adviser. MAS and E.A. Buck Financial Services are not affiliated entities. AEWM and E.A. Buck Financial Services are not affiliated entities. 1276559- 8/22.