In her bestselling book Thinking in Bets, world-renowned poker player Annie Duke explains how she makes decisions when the outcomes are uncertain: “Improving decision quality is about increasing our chances of good outcomes, not guaranteeing them.”
We can’t guarantee taxes will change, for better or worse. We can only improve the odds of getting some of this right. In my opinion, tax rates will soon go up: Blink, and today’s tax benefits may be gone.
President Biden and House Democrats are pushing for higher taxes to fund the administration’s multi-trillion-dollar agenda. Even if tax rates remain unchanged by the Biden administration, you can still expect the current favorable tax rates to expire in 2026.
Given this gloomy backdrop, it’s no wonder that in my 21 years of advising executives, I’ve never seen so many clients interested in tax planning. From changing their state residency to using cash-value life insurance to shelter investment gains, everyone is looking for an angle. Proper tax planning starts with controlling what you can control. Here are four conversations I am having with high-net-worth clients right now to cut tax bills for the 2021 tax year and decades to come.
1. Accelerate Income Into 2021
In September, the House Ways and Means Committee, as part of the “Build Back Better” initiative, proposed increasing the top income tax rate (see table below). The committee also proposed a 3% additional tax on income over $5 million.
Higher taxes are likely, especially for those in the highest tax bracket, even if they’ll only be temporary. (Democrats may pass tax changes via the budget reconciliation process, which requires an expiration date on any new legislation.)
Proposed New Tax Rates and Tax Brackets
| Current (2021 Tax Year) | Proposal (2022 Tax Year and Beyond) | ||
| 35% | $418,851-$628,300 | 35% | $430,751-$450,000 |
| 37% | $628,301+ | 39.6% | $450,000+ |
Especially for taxpayers in the top bracket, in some cases it may make sense to accelerate income into this year, affirms Sara Laufer, a CPA for high-income professionals in Weehawken, N.J. However, she cautions not to act on assumptions: “We never know what the changes are until they are signed into law.”
Indeed, much can change, so we do need to be careful. Lately, I have been advising clients to consider taking some — not all — of their chips off the table. Collect some cash, and pay taxes on it now before rates potentially go up. Here are two ways to do it:
- Exercise stock-options. Once you exercise a non-qualified stock option, the difference between the stock price and the strike price is taxed as ordinary income. Now may be a good time to exercise some options to take advantage of the low rates while they last.
- Rethink deferring a bonus. Deferring a bonus — say, from December to January — is usually a good idea, because it kicks the tax bill a full year into the future. However, deferring a bonus to a year such as 2022 when your tax rate will likely be higher makes little sense.
For a high-net-worth executive already in the top bracket (above $628,301), but below $5 million, the difference in tax between accelerating income into 2021 or collecting it instead in early 2022 will be 2.6% of the amount recognized (37% vs. 39.6%).
Executives who would benefit most from accelerating income into 2021 are those in the 35% bracket. Let’s say you have $450,001 of income, with an opportunity for $100,000 more in late 2021 if you exercise stock options or elect not to defer a $100,000 bonus. In 2021, you would be taxed on that $100,000 at a rate of 35%. In 2022, the same taxpayer could be in the top tax bracket, taxed at 39.6% on the extra income. Easy math — you’d save nearly $5,000 in federal taxes by accelerating that income this year.
The other taxpayers who may want to consider accelerating income are those who expect to make more than $5 million in any future year. The proposed higher tax rates and a proposed 3% surtax on income above $5 million mean that every $1 million in taxable income above that amount could trigger $56,000 more in federal taxes every year.
2. Harvest Investment Losses to Offset Capital-Gains Taxes
Investment losses are not the goal, but every investor experiences them. Now is the time to bank them and use them to your advantage. Tax-loss harvesting — using stock losses to offset gains — is something executives should routinely do every year if possible, but becomes more important now that the House wants to increase the top capital gains rate from 20% to 25%, retroactive to September 2021. Aggressively harvesting losses will help. Here’s how:
- Let’s say an executive sells $50,000 of Apple stock, triggering a tax bill on a long-term taxable gain of $20,000.
- If he or she is in the top tax bracket, the tax under current law would be $4,000 — 20% of $20,000 — excluding the Net Investment Income Tax. Under the House proposal, the tax on that gain would jump to $5,000 (25% of $20,000).
- Fortunately, this executive has unused investment losses from the sale of stock at the recent market bottom in March 2020 — and is able to use them on his or her 2021 tax return to offset the Apple gains.
- Lesson learned: Banking your unused investment losses from year-to-year (there’s no limit to how far back you can look to harvest losses) to use in the future when you sell winning stocks is a smart strategy — especially if the capital gains rate jumps up.
3. Score a Bigger Tax Deduction With Smart Charitable Giving
Here’s a tax-smart move for high-net-worth executives who now claim the standard deduction, which was nearly doubled as part of the Tax Cuts and Jobs Act of 2017: “Bunch several years’ worth of charity contributions into one year using a donor-advised fund,” recommends Scott Therrien, a tax accountant, CPA and head of Therrien & Associates in Wilton, Conn. Here’s how it works:
- Married taxpayers filing jointly enjoy a standard deduction of $25,100 for the 2021 tax year.
- Let’s say you and your spouse typically make $10,000 in charitable donations each year. And you have another $12,000 in itemizable deductions. Your total itemized deductions in 2021 would fall below $25,100 — in other words, no sense in itemizing, and no additional tax savings.
- By lumping five years’ worth of charitable donations (5 x $10,000 = $50,000) into a 2021 contribution to your donor-advised fund, you will now exceed the standard deduction by $36,900 by itemizing — and could save as much as nearly $10,000 in taxes if that deduction bumps you out of the top tax bracket.
- The donated amount can grow in value in investments within the DAF, and you can direct the funds to selected charities over the years ahead.
Make it a win-win by donating appreciated securities to your donor-advised fund instead of cash when you rebalance your portfolio heading into 2022. You’ll avoid the capital-gains tax bill on the proceeds from the sale of your winning stock, and you’ll cut your tax bill on all your other taxable income if that big DAF donation leads to a larger itemized deduction (and a lower tax bracket).
For executives who’ve had a really good year — say, in excess of $10 million of income — Therrien recommends setting up a private foundation.
But get the timing right on these moves. Charitable giving may be more valuable next year if tax rates indeed are higher. For the remainder of 2021, I would take a wait-and-see approach. If tax rates do go up, hold off on bunching multiple years’ worth of donations until 2022.
4. Transfer After-Tax 401(k) Contributions to Your Roth IRA — Now
The House stunned many tax professionals by proposing to eliminate after-tax 401(k) conversions to Roth, regardless of income level. Currently, after-tax contributions to your 401(k) can be converted tax-free to a Roth IRA. (Earnings on those after-tax contributions are still taxable and should be transferred to a regular IRA.) Most executives earn too much to contribute to a Roth IRA directly, so this back door to a Roth IRA is the way to go.
Withdrawals from Roth IRAs in retirement are tax-free, making it advantageous to fund them now if you expect tax rates to be higher in the future. If your 401(k) allows, consider making after-tax contributions before the end of the year and then moving those contributions to a Roth. Be sure to check with your 401(k) administrator or qualified professional beforehand.
Seniorexecutive.com is not affiliated with Summit Financial LLC and its affiliates (“Summit”). Investment advisory and financial planning services offered through Summit, an SEC Registered Investment Advisor. The views and opinions expressed on this page are solely those of the author and should not be attributed to Summit. None of the statements on this page is intended to recommend any security, service, or product or to provide investment, tax, or any other advice.
