One step closer to tax law changes

From Retirement Now Newsletter October 7th 2021

As of writing this the new tax legislation is still be debated. There are factions (progressives and centrists) in the Democratic party that are not fully onboard with how the bill is proposed right now. And they disagree with each other. Which means there’s a pretty good chance that there will be some changes to the current proposals before anything is passed in an effort to get enough representatives to vote on the bill.

Which can be tough when the bill goes to the Senate since only one Democrat Senator can be against it and wreck the whole thing.

Or it may not pass at all.

I don’t know, and Miss Cleo is no longer in business taking calls to tell us the future.

But there’s probably a good chance that something like what is proposed right now may become law.

So let’s look at some of the highlights of the proposed tax changes and how they may or may not impact retirees and those that are still working and planning for their retirement.

Right now the top ordinary tax rate is 37%. The proposed legislation is to raise it to 39.6%.

On the surface, not much of an increase. However, the deeper truth is that the income brackets used to reach that higher tax rate have been lowered.

Currently, if you make over $628,300 as a married filing jointly couple your next income is taxed at the current top are of 37%.

Under the proposed legislation that income threshold is dropped to $450,000 for married filing jointly. Which means more people will experience that increase than before.

And for people that are in the 32% tax bracket, which tops out at $418,850, it doesn’t take much additional earnings for you to enter that proposed 39.6% bracket, which as I said earlier starts at $450k.

Also, the penalty for being married is back.

The top tax bracket for a single filer is $400k. But the top bracket for a married filing jointly is $450k, instead of being the double amount of $800k.

The top capital gains tax rate is also set to increase from a top rate of 20% up to 25%.

This higher rate will only impact people that have income over $400K (single) or $450k (married filing jointly).

Currently the highest capital gain of 20% only affects people with income over $501,600 (married). So the threshold is being lowered to catch more people and the rate going up.

As you can see these proposed changes are primarily affecting people that have high incomes, north of $400k or $450k.

Here’s another that affects people in the top tax bracket but not for another 10 years. That is the prohibition of doing Roth conversions if you are in the top tax bracket, which would be the 39.6% bracket.

However, this won’t go into effect until 1-1-2032.

Who knows what will happen between now and then, or if that will even still be a law at that point.

But something that could affect people regardless of their income tax bracket is the ability to convert after-tax IRA contributions to a Roth IRA.

Most IRA contributions are made with pre-tax money. But it’s also possible to contribute after-tax money into an IRA, and sometimes that’s all you can do if you have access to a group retirement plan (i.e. 401k) and you make too much money to be able to deduct your IRA contribution that year.

A strategy called “Backdoor Roth” essentially allowed someone who didn’t qualify to make Roth contributions for the year (due to excessive income) to make a non-deductible contribution to their IRA. Then they would convert that amount to a Roth, which wouldn’t be a taxable event since that IRA contribution had already had tax paid on it.

This will go away for everyone. And it may or may not be applicable to you.

(As an aside, before you try the Backdoor Roth strategy make sure you understand what the pro-rata rule is, which I won’t go into today.)

But aside from some of these proposals, my bigger concern remains what tax rates will do further into the future.

As of now, these proposals are not significantly impacting income earners below $400K or $450K. But with federal spending obligations going up with additional people aging into programs like Social Security and Medicare, my concern is that at some point there may be legislation that will impact those that are not the highest earners.

This is simply an issue of math. How will the future federal budget be funded?

Which is why I encourage people near retirement or already retired to look at their IRA and 401k balances and calculate how much of a percentage of your overall wealth are in these pre-tax accounts. This can give you an idea of how vulnerable you may be to possible future tax increases.

We’ll soon see how things will play out with these current tax proposals. If they get passed, not passed, or altered. Regardless of what happens this is a reminder that tax laws change all the time… we are literally witnessing it happen right now.

A word to the wise.

If you need help with planning your retirement click here for a 20-minute chat with yours truly.