Ep. 27 Launch Financial-Unpacking Biden's Tax Proposal And Takeaways with Shawn Donovan

Join us on a very special episode of Launch Financial, as we are joined by CPA, Shawn Donovan. On this unique episode, Brad and Shawn take a deep dive into Biden's Tax Proposal and provide the audience with the confusion surrounding this new tax plan. For more questions about Biden's tax proposal and thoughts on the episode, please reach out to us at [email protected]. 

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[Transcript]

Announcer:

Welcome to Launch Financial, your guide to important financial decisions that you should have learned about in school, but were never taught or that no one ever talked about, conversations you should be having, but never did. Together, our hosts, along with a guest speaker, will tackle topics and issues we come across and think about daily, but often don't discuss. Subscribe to the show and put yourself on the path to financial success by visiting shermanwealth.com.

Brad:

Good afternoon. And welcome to a really special edition of Launch Financial Tax Edition. We had the President yesterday unveiling tax proposals as part of the legislation around infrastructure bill. Got our special CPA guest to help unpack a lot of these changes, things to think about and things to do. We are joined by Shawn Donovan, CPA and partner at Turner, Leins & Gold. Shawn, how you doing this morning?

Shawn:

Great. How are you doing,, Brad?

Brad:

Good. Good. So you have climbed out of a cave during tax season. As everyone knows, we have seen tax season extended till at least May 17th on the federal level. Depending on where you live, the state level might be even further along. So we really appreciate you taking the time. I know you're really swamped with tax and to remind everyone, of course, that you have until that time to contribute to your traditional and Roth IRAs from 2020. So thank you for taking a small break out of your busy day. Wanted to unpack some of this tax proposal with you. If you could go through some of the highlights that you're seeing and some of the changes that folks should be thinking about.

Shawn:

Well, obviously, President Biden's been very steadfast in saying people who make over $400,000 are most likely going to be getting a tax increase. When he was running for President, he had his tax plan basically on his website. So far, it's pretty much he's following it to a T. I would expect the top rate to go back up to 39.6 from where it is currently at 37%. He's talked about increasing capital gains for people who make over a million dollars up to the 39.6% rate with an additional 3.8% net investment income tax. Meaning if you lived in New York City or California, you're all in capital gains tax rates could be upwards of 58%. It's pretty high compared to where it is currently.

Brad:

But why would you want to live there anyway? But yes, I know, we have a lot of friends of the firm that that live in New York and California, of course, so exactly right. A million dollars going to be hit. I've seen anywhere from that 53.6 to 58% in the higher tax states.

Shawn:

Sure. Yeah.

Brad:

So, go on, what are the other changes that you're seeing?

Shawn:

The other one was the 1031 exchange. Here at Turner, Leins & Gold, we deal with a lot of real estate clients that utilize this 1031 exchange. One way people have been doing it, let's say you're an older taxpayer and you have a house that you're sitting on. Once you sell it, it's going to generate a big gain. You don't want to pay the tax on that gain right now. So what you're going to do is you're going to sell your house, identify a property within 45 days and close within 180 days, which is a 1031 exchange rules. Then you're going to buy a new property. What happens is instead of paying that gain, you're going to get a reduced basis on your new property. So then what happens now is, let's say you die and you pass it on to your heirs, your heirs receive this stepped up basis, basically up to where it wasn't fair market value at the date of your death. You basically avoided paying tax on that gain altogether, passed it onto your heirs and now they have.

Shawn:

He's looking to eliminate what's going on with that, things like that. The 1031 exchange is not just used by people for that reason, though. There are a lot of people in real estate using it too, because they're continuing buying and fixing up properties and selling them for gains. They continue to utilize this 1031 exchange rule. It's helped them, to be honest with you. Eliminating it, that can cause some issues in the real estate market, potentially less buying, less inventory, less purchases. That's just a guess as to what might happen, but we don't know.

Brad:

Let's stick with the real estate market. Of course, the 1031 exchange will create even less transactions, I guess, but we should go back to this step up in basis and explain what that is. Basically, if you have accumulated gains at the time of your death, your heirs step up the basis, meaning that at the date of your death that becomes the basis of the stock or any asset. Eliminating that, which in the Biden proposal we've been reading, a million dollars for a single couple or sorry, single person, 2.5 million for a couple, would have a dramatic impact on estate and tax planning. You want to speak about that a little bit?

Shawn:

Oh, that would absolutely have a dramatic impact. It's not just the loss of that step up to fair market value. If your parents or grandparents have been holding onto this Apple stock or Google stock for a long time at this real low cost basis, we have actually clients that do that and they're looking to pass it onto their heirs at the stepped up value, that's going to really hurt. They actually know what their cost basis is, but there's a lot taxpayers out there who bought stocks and real estate so long ago that the records just don't even really exist for them anymore. Trying to go back to that original purchase price for some of these assets, that it's just really easy if someone died. You step it up to what it was at the date of death. But if you have to go back to the '70s, early '80s to buying some of these, it's going to be tough and a difficult challenge to track what the purchase price is and whatnot.

Shawn:

That's not even the hard part. The hard part is going to be the tax bill once the heirs receive it and actually end up selling it, they're going to get hit with a tax bill at that point. It would definitely impact more than just wealthy Americans. It would impact a lot of people, for sure.

Brad:

Right. What we're seeing, we had Elizabeth Goldstein from the Jewish Federation of Greater Washington speak about donor advised funds. I think that we're going to see a lot more of that as it relates to tax sheltering. Some of these were very charitable at the firm, of course. So looking for other clients who are looking for strategies to shelter this potential loss of a step up in basis, donor advised funds, direct-to-charity transfers. What else are you seeing and some strategies that folks can look at to donate stock without it being subject to excess tax?

Shawn:

Donor advised funds is a great one. The required minimum distribution for 2020 was waived. So far in 2021 it hasn't been waived. So we're going to go ahead and assume that you're going to need to take it for 2021, with the caveat of rules have been changing mid year a lot lately, in the last couple of years. You always want to have that little bit of a caveat. But as of right now, we have to take the RMD for 2021. An easy way, if you're donating to a charity every year, is to do a qualified charitable distribution. Basically, what happens is your IRA sends a check directly to the charity organization that you choose. It comes right off the top of your income. You don't pay any tax on it. And you've satisfied your required minimum distribution for that year.

Shawn:

It's a very good tool that a lot of savvy tax payers use with the help of their CPAs and financial advisors. It's a very good tool to use. It's going to come back for 2021, not that everyone has that requirement again.

Brad:

I'd say that the only way that we're not getting requirement minimum distributions for 2021 is if we have a third wave of COVID. God forbid that that happens. I don't think that we'll have a repeat of the CARES Act or any of these. For those retirees out there, be planning on taking the requirement minimum distribution. Great tip on the QCD. There is also potential legislation of raising the requirement minimum distribution age to 75. We'll be following that along, as well. For those of you who are between 72 and 75, who just started the requirement minimum distribution and might not have had to have it last year. We also did a lot of great tax planning last year as it relates to Roth conversions, which would be huge for 2021, especially if there is an increase in tax rates, even at a 2 to 3% level, depending on each bracket. Major savings there. You want to speak about a Roth conversion and how that might be beneficial to retiree clients in filling up those tax bracket buckets?

Shawn:

Absolutely. The key with Roth conversions is people who like them, they say, "The tax rates will never be lower than what they are right now." That is going to be very true when you listen to President Biden's tax proposals. You can see it. It's coming. And it's coming soon, the tax increases. It's definitely going to be something you're going to want to utilize. You want to pay attention to see when these tax increases are going to come into effect. Will it be 2021 or 2022? If it's going to be 2022, you definitely want to try to do as much of a Roth conversion as you can afford to do for 2021. It's definitely going to be a tool you want to utilize this year.

Shawn:

It was a good tool to utilize in 2020, because you didn't have that RMD requirement. We had a lot of clients who were doing the Roth conversion, basically, in place of their RMD and keeping themselves in the same tax bracket. But then they're also lowering their future requirement minimum distribution, paying tax on the dollars now at a low rate so that when they're able to, they can pull it out at tax free, basically.

Brad:

Great, great, great advice. Shifting gears to the younger generations, hopefully some of these podcasts listeners are going to be lower in age than 72, because a lot of young clients that are going to be listening to this are going to be also looking for tax strategies. The advent of the Roth within the 401k, I think is something that we're really been seeing a lot of as plan sponsors are adopting the Roth piece. A lot of their highly-compensated employees, as we know, don't have an opportunity to do a Roth IRA, given the income limits there. Seeing Roth 401k is huge. You want to speak about that as it relates to a tax hedge?

Shawn:

Roth 401ks are a great tool, obviously. Some people still do Roth conversions or backdoor Roths is what they're called. But the one downside of a Roth is you're contributing with after-tax dollars. The upside is it's tax free down the line. Right now, we know that we're paying at this low rate, this 37% top bracket, or if you're younger, you're in the 24, 22%. Biden has said he's not planning on raising middle class taxes. We don't know that to be a fact. He's saying that $400,000 mark. If you're living in New York City, $400,000, you're probably not super wealthy with 400,000.

Shawn:

If you're living in the DMV, like we do, it's an expensive area to live. $400,000 doesn't go as far in these areas as it does in other areas of the country. It's definitely something you want to pay attention to if you're a younger taxpayer on the rise, making more money, you want to take advantage of many of these Roth ideas as you can.

Brad:

Right and then even if you're just starting your career. We had a seminar yesterday with the corporation with a lot of young staff, educating them on tax arbitrage and making sure that they're understanding the Roth 401k. I know that we've had conversations even before this tax plan. You like to take the deduction sometimes, right now in times zero, but I'd rather figure out what the future tax rates might be. And especially with these on the table, 2021 could be the last year, as you said, to take advantage of generationally low tax rates.

Shawn:

It really is. It does really feel like we're on the cusp of it being really the lowest rate we'll see the rest of our lives. Who knows? I remember in 2002, 3, 4, when I first started out, they were saying, "These are the lowest rates." And then they actually did go lower in 2017. But I highly doubt they're going to be any lower than this for a long time, especially with all the stimulus and everything like that with the pandemic, all the money being spent. Revenue is going to have to go up somehow. I can't imagine the tax rates are going to be any lower than they are now for a little bit of time, but I don't have the crystal ball to see that in the future.

Shawn:

As far as what you were saying with whether to take a tax break now versus in the future, it's just up to the taxpayer's appetite for that. You just have to basically explain to them the pros and cons of each, whether it be taking a set contribution, which you could get a deduction for this year or doing a Roth conversion, which is a future benefit thing. If you explain it to them, let them know what they're going to owe, what the savings will be, if you basically explain to them the different scenarios, it usually works out well for them.

Brad:

Right, right. Everything, as we talked about in financial planning, tax planning and all aspects of it, is definitely an individualized decision and making sure that you have all the facts, which is why we're getting you out of the tax season taking a small break to look at future taxes. I hope for your sake, as you said, everything changes. I hope that they're not going to make this retroactive to whenever the bill is going to, because that will make your 2021 tax season miserable. I know you have a lot going on with Maryland and S corps and other things. What advice can you give, as we have a lot of also some small business owners, what are you seeing as it relates to either the change in tax proposals or just any good tax tips for small business owners to be thinking about as you've seen a bunch of returns this year?

Shawn:

Well, here are the state of Maryland they have adopted, as you know, the new entity level tax. If you're a small business owner, S corp or partnerships, you have to actually be a pass through. If you're a Schedule C, you unfortunately can't take advantage of it. But what it is, is you're basically paying your state tax at your company level and getting a deduction for it. Only seven states adopted it for 2020. Maryland was one of them. I'm assuming for 2021, all the states will adopt it. I haven't heard anything about that yet, but I would assume they would. This is something you want to look into, see how your state's handling it. It actually is saving some business owners that I work with, tons of money by doing it this way. The reason you're saving it is because when the tax cuts and Job Act of 2017 was passed, they limited your state and local income tax deduction to $10,000.

Shawn:

This is a workaround to pay your state taxes at your entity level, so you have no limit, essentially. You're paying it at that level. You're getting a deduction for it. If you overpay, you get the refund on your state return. You're basically paying your state taxes at your business level. It's worked out to save thousands of dollars for some business owners in this area by doing it that way, that are in Maryland. Unfortunately, for our Virginia clients, you couldn't take advantage of it this year. DC clients, same thing. We're hoping for 2021 that those states adopt the IRS ruling for 2021 and those taxpayers can take advantage of it for this year.

Brad:

Great, great. So a lot of good tips there. The good SALT debate, we'll see. That impacted Maryland taxpayers a lot and some of our New York clients. And some of these higher tax states, as you're mentioning. We'll see if that changes at all. A lot of debate as to whether that's good, bad or ugly.

Shawn:

[crosstalk 00:17:14] last night. I didn't hear anything about it in President Biden's speech. From what I've heard, he's not really interested in getting rid of that $10,000 ceiling. We'll have to wait and see on that.

Brad:

Well, as we know, this is just a potential legislation, a idea, as you mentioned. I don't know. People are surprised to see it. The market had a crazy reaction for about an hour as they digested it. But I think you brought up a really good point that this has been on President Biden's website ever since the campaign trail. This is his proposal. We have a lot of folks within Congress who are going to have something to say about it, whether that's SALT, whether that's California, New York, any of these different ideas. We're going to be following this along and hopefully, Shawn, have you on as this progresses through and becomes a little bit more real. But we have a lot of folks, as I'm sure you do, calling, asking what the deal is, what should we be doing and really wanted to have you on to talk about this.

Brad:

So really appreciate your time again. Again, check out the blog. We're going to release this as a blog and a podcast. Mostly going to, as of now, just affect folks making a million dollars a year or more. But a lot to unpack, especially as it relates to charitable giving, step up in basis, potentially, 1030 exchanges. Financial planning and tax planning could be turned on its head. As you know, Shawn, never dull moment in our business. As Hyman Roth says, "This is the business that we chose." So this is what we have. And really, thank you for listening. Thank you for coming on, Shawn. I know you're so busy.

Shawn:

I appreciate you having me, Brad. It's good seeing you.

Brad:

Good to see you. It's been 15 months. The audience doesn't know that we're actually seeing each other, but audio only. But it was good to see you. Really appreciate your expertise. It was invaluable, especially at a time like this, where people are so confused as to what to do next and looking for guidance from the experts. Thanks for coming on and sharing your words of wisdom. We'd love to have you on as this becomes more real. Have a great day, everybody. We'll talk to you soon.

Shawn:

All right, take care, Brad.

Announcer:

All opinions expressed by the hosts and their guests are strictly their own and do not reflect the opinion of Sherman Wealth Management. Clients of Sherman Wealth Management may maintain securities discussed on the podcast. Sherman Wealth Management LLC is a Registered Investment Advisor. Advisory services are only offered to clients or prospective clients where Sherman Wealth and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.shermanwealth.com.