Ready or not, higher tax rates are coming!
October 26, 2023|
The 2024 upcoming presidential election season will be here before we know it, and most candidates will emphatically proclaim they will not raise taxes. While this may put taxpayers at ease, come January 1, 2026, and once we all emerge from our New Year’s Eve celebration haze, just about everyone’s personal taxes are scheduled to automatically increase.
The Tax Cut and Jobs Act (TCJA), signed into law by President Trump, went into effect January 1, 2018. The TCJA lowered taxes for most individuals and businesses, and while many of the business provisions are permanent, most of the individual taxpayer provisions are temporary and set to expire, or “sunset,” on December 31, 2025. Is it possible that Congress intervenes prior to sunset to extend these lower rates? Yes, it’s certainly possible. However, given the rising federal debt, the need for additional tax revenues, the inability of Congress to work together and compromise, and the more immediate concerns needing attention (shoring up Social Security and Medicare among some of the most pressing), we believe it is highly unlikely Congress will act to fully extend a fiscally unpopular tax cut act.
The importance of the TCJA sunset cannot be overstated. If your goal is to work within the tax code and minimize the amount of taxes paid over your lifetime, the impending TCJA sunset should weigh heavily into how you approach your overall financial strategy. In fact, every financial plan should evaluate opportunities to take advantage of the current advantageous TCJA rates prior to sunset.
I suppose you could bury your head in the sand and ‘hope’ the TCJA is permanently passed into law, in which case favorable current tax rates remain in place for the foreseeable future. Although true, as General Gordon Sullivan, former Army Chief of Staff, wisely noted in his book title, “Hope is not a Method.” Rather than solely relying on ‘hope,’ it is prudent to plan for aspects of the TCJA to expire and enact strategies to take advantage of some of the lowest tax rates in history. As many coaches in sports settings stress to their players, “Control the controllables.” Opportunities exist given what we know now, and failure to plan and “control the controllables” now may result in you, and your family, paying considerably more taxes over your lifetime.
To illustrate the impact of TCJA sunset, there are four main points every taxpayer and advisor should consider.* These are:
- Income Tax Rates
- Standard Deduction
- Long Term Capital Gains Rates
- The Lifetime Estate and Gift Tax Exemption.
I will cover each of these points and address some considerations and planning opportunities should TCJA sunset as planned.
Income Tax Rates
Higher income tax rates will likely impact most taxpayers. All but two of the current seven marginal tax rates are set to increase. Marginal tax rates are important, as they represent the income tax rate you pay for each additional dollar of taxable income.
Coupled with higher marginal rates, the threshold to reach the next higher marginal bracket will generally be lower, thus making it easier for you to reach a higher tax rate sooner. To put the impact into perspective, here is an example using the chart below, with William and Kate, a Married Filing Jointly (MFJ) couple earning $375,000 of taxable income in 2026.
Under TCJA (right side of chart), this couple’s marginal bracket would be 24% and they would pay just over $69k in taxes. Under previous law (left side of chart), which rates are scheduled to revert back to in 2026, they will be in the 33% marginal tax bracket and pay just over $86k in taxes resulting in an estimated $17k increase from TCJA rates. To see how a TCJA sunset may affect your particular situation, a chart depicting projected rates for all tax brackets can be referenced at the end of this document**.
An Impending Income Tax Bomb
As legendary pitchman Ron Popeil says, “But Wait, There’s More!” Not only should you consider the impacts of current years, it’s also prudent to project future taxes paid throughout your lifetime. This particularly comes into play when evaluating traditional IRA and 401(k) distributions, which are taxed as ordinary income. Many pundits have led the public to believe it is a wise strategy to defer taxes into retirement when you will be in a “lower tax bracket”; however, after personally evaluating hundreds of retirement plans, I can emphatically conclude more often than not, this assumption has proved to be false. One of the primary reasons is large IRA and 401(k) balances requiring significant Required Minimum Distributions (RMDs) annually from those accounts. This results in individuals being pushed into high, marginal rates, in many cases higher than their working years. Renowned CPA and IRA expert Ed Slott refers to these large IRA and 401(k) distributions as, “The New Retirement Savings Time Bomb.”
How can you avoid this tax bomb? One way is to contribute to Roth accounts, especially when you are young (under 40) and in a lower tax bracket (24% or lower marginal rate). Next, for those with Traditional 401(k) and IRA assets, consider a strategy of Roth conversions and timing them to opportunistically (and legally) manipulate the current historically low tax rates to your advantage. You choose to pay taxes now on the conversions, possibly spreading conversions over multiple years to stay within lower/favorable marginal rates. This allows the principal and future gains to become tax-free to you throughout your lifetime, and tax-free to your beneficiaries as well. While it’s sometimes hard come to grips with paying more taxes now for something you can defer into the future, it’s worth careful analysis to see if it makes sense in your situation, especially while we know TCJA rates will be in effect through December 31, 2025.
Under the TCJA, about 90% of taxpayers utilize the standard deduction; thus, reducing the need to track and itemize deductions. The standard deduction is a set amount you subtract from your income, thus lowering the amount of income which is taxed. Below is a chart depicting what the standard deduction may look like (left side of chart) vs the standard deduction under TCJA (right side of chart), and a married couple filing a joint return may see a reduction of over $13k in the standard deduction.
Since the standard deduction is subtracted from your adjusted income, the higher the standard deduction, the less taxable income you have. Accordingly, lowering the standard deduction allows you to subtract less from income, resulting in more taxable income. A lower standard deduction may result in a significant number of filers to itemize deductions to increase their standard deduction and reduce taxable income. Without question, itemizing will require deliberate recordkeeping and tracking of allowable expenses. This may be one area where Congress may look to extend this portion of TCJA to simplify deductions for most taxpayers.
Long Term Capital Gains Rates
The TCJA sunset appears to have minimal impact to long-term capital gains rates, which offer preferential tax treatment on capital gains on the sale of assets (stocks, mutual funds, investments, etc.) held for more than one year, as well as taxation of qualified dividends. Of note, capital gains on the sale of an asset held one year or less are typically taxed your ordinary income tax rate. Although capital gains rates appear to have minimal changes with the TCJA sunset, given the need for the federal government to increase tax revenue, it’s important to remain informed and consider potential legislation which could change or limit the preferential capital gains treatment. Should long term capital gains rates increase, careful consideration should be given to determine if selling appreciated long term assets (stocks, highly appreciated home) should be accelerated to take advantage of the preferential lower long term capital gains rates.
The Lifetime Estate and Gift Tax Exemption
Finally, one of the aspects causing concern among those with sizeable estates (estates in excess of $7M), is the Federal Lifetime Estate and Gift Tax Exemption. Under TCJA, this exemption nearly doubled, enabling most individuals to avoid paying federal taxes on an estate upon death.***
One of the opportunities to mitigate the lower lifetime estate and gift tax exemption is to utilize the Gift Tax Annual Exclusion, which permits each individual to gift up to $17,000 in 2023 to any child, grandchild, friend or other person (amount is adjusted each year for inflation). This is beneficial because it allows you to remove assets from your estate without it affecting your Lifetime Estate and Gift Tax exemption. This can be done each year and may be an effective technique to minimize your estate tax burden.
If your estate is valued over $7M ($14M for a married couple), it may be wise to consult with a tax and estate planning attorney now, before the mass rush in 2025 (prior the TCJA sunset). An estate planning attorney can help formulate a charitable gifting strategy and identify possible ways to form an estate plan using trusts or other means to mitigate the negative impact of tax law changes. It is important to consider that while your estate may fall below the $7M threshold now, it woujld be prudent to consider potential future investment returns, business appreciation, inheritances, etc. to determine if your estate may exceed the $7M threshold ($14M for married couples) in the next few years.
The scheduled sunset of the Tax Cut and Jobs Act on January 1, 2026 will have an unquestionable effect on most individual’s disposable income. If Congress does not act to extend all, or a portion of the provisions, more of your hard-earned money may go to taxes. Will Congress act? The ever-mounting debt and continued reliance on deficit spending by our elected leaders reinforce the need for additional tax revenue. Combined with the inability of our leaders to come together and tackle a contentious issue such as taxation, we believe many of the Tax Cut and Jobs Act will expire as planned, thus resorting to the previous law rates, adjusted for inflation, in 2026. This is especially more likely for higher earners, who traditionally bear the brunt of most tax legislation.
Through careful analysis and thoughtful planning, it’s likely you can take advantage of lower tax rates over the next couple years. There are a variety of strategies and methods to do so, and we highly suggest you explore them now.
*For a detailed list of how the TCJA changed personal taxes, visit Tax Policy Center at taxpolicycenter.org.
**Comparing estimated tax rates and brackets for 2026 under previous law, which represents the rates taxes are scheduled to revert back to ‘Tax Brackets 2026 (Previous Law)’, compared to what forecasted rates would look like should TCJA be extended into 2026 ‘Tax Brackets 2026 (Under TCJA)’.
***States differ on state taxation of estates, and one should consult with their tax advisor to evaluate your particular situation in your state.
Counterweight Private Wealth is a Registered Investment Advisor (RIA) with the Securities and Exchange Commission (SEC) with its principal offices in Raleigh, NC and Wilmington, NC. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Counterweight Private Wealth only transacts business in states in which it is properly registered or is excluded or exempted from registration. A copy of Counterweight Private Wealth’s current written disclosure brochure filed with the SEC which discusses among other things, its business practices, services, and fees, is available through the SEC’s website at: www.adviserinfo.sec.gov.
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