personal finance  |  october 13, 2020

2020 Election: Potential Impact of Changes in Tax Policies on Personal Finances

During every election cycle, investors compare the tax plans of each candidate with particular attention on potential tax increases.

 

Key Insights

  • While taxes are an important consideration, we believe investors should stay focused on their long-term investment strategies, regardless of what policies are in place.

  • The key for investors is to keep abreast of potential changes and how these could affect their investments while remaining committed to their own financial goals.

  • We suggest that investors include tax diversification in their financial plans.

Over the past few months, we’ve seen an uptick in client inquiries about what to do with their investment accounts should there be changes to the current tax code. Tax policy proposals differ between the two candidates in the upcoming presidential election. Democratic party presidential nominee Joseph Biden has proposed many tax changes during his campaign. Generally, his proposals would increase corporate taxes and taxes on individuals earning over $400,000 per year. President Donald Trump has suggested fewer tax policy changes for the coming years, having already signed the Tax Cuts and Jobs Act of 2017 (TCJA) into law. Because further tax cuts would require passage by both houses of Congress, we expect tax law would remain relatively stable in a second Trump term.

While taxes are an important consideration, we believe investors should stay focused on their long-term investment strategies, regardless of what policies are in place.

Given what we know, it is important to remember that many things would likely need to occur before there would be any major changes to tax laws:

  • A Biden presidential victory,

  • The Democratic party taking control of the U.S. Senate (via a net gain of three or more seats),

  • Acceptability of specific policies to all or nearly all Senate Democrats despite potential pressure from interest groups, and

  • High prioritization of specific tax changes relative to other policy goals (particularly if they are to take effect retroactively to the beginning of 2021).

There are five tax proposals made by Biden that we think are most relevant to personal financial planning:

1.  Increase tax rates and limit deductions for high earners.

Biden has proposed reinstating the 39.6% top federal income tax bracket for taxpayers earning over $400,000. In addition, those taxpayers would face limitations on the value of deductions, including a phaseout of the pass-through business deduction for taxpayers earning over $400,000. Some of these changes would just accelerate the reversion to pre-2018 law that was scheduled for 2026 under the TCJA. However, a new aspect is that earned income over $400,000 would be subject to Social Security tax (12.4% between employer and employee) for the first time.

Less than 2% of taxpayers would be directly affected by these changes. Even for those affected, the ability to shift income into a year with a lower tax rate will probably be limited. However, the proposals are a good reminder that tax laws and rates can change.

Financial planning tip: We suggest that investors include tax diversification in their financial plans. This means investing using a mix of accounts with different tax treatments. For example, having some investments in Roth accounts and taxable accounts can give you flexibility to manage taxes effectively if rates are higher when you need to use the money. The benefit of taking action—such as converting traditional retirement assets to Roth accounts—depends on your individual situation.

2.  Tax capital gains and dividends for those earning over $1 million at the same rate as ordinary income.

Currently, long-term capital gains and qualified dividends are subject to a maximum tax rate of 20% (or 23.8%, including the net investment income tax). Under the proposed changes, households earning over $1 million would pay the top marginal tax rate of 39.6% on that investment income (while the existing additional 3.8% net investment income tax may continue to apply).

This change would affect even fewer people than the marginal tax rate increase. For wealthy individuals who generate much of their income through investments, however, the impact could be much larger.

Financial planning tip: For those earning over $1 million, it could make sense to sell some assets before rates go up to realize gains at the current rate, in case this policy is implemented. However, since this change is far from a sure thing, we caution investors in these circumstances to focus more on the underlying investment decision than on the tax impact.

3.  Eliminate the “step-up” in basis of investments at death.

Under current law, if you bequeath investments in a taxable account, the value at the time of your death becomes the cost basis for the beneficiary (with some exceptions). This means that appreciation of the investment during your lifetime never faces income tax. This significant tax benefit would be eliminated—at least for some investors—under the Biden proposal.

Compared with the first two proposals discussed, it is less clear how this would be implemented to meet Biden’s goal of avoiding tax increases for the middle class. The impact would also be affected by the details of any increase in capital gains tax rates.

Financial planning tip: Until details are known, we would suggest that most investors avoid taking any significant action. Going forward, this change could affect your approach to retirement income if you have assets in different types of accounts. Again, tax diversification can help you meet your retirement and legacy goals despite policy uncertainty.

4.  Replace the deductibility of retirement contributions with a refundable credit.

Today, if you save for retirement in a traditional 401(k) plan, you probably get to exclude that contribution from your taxable income. In the short term, the benefit depends on your current marginal tax rate. (Longer term, you pay taxes when withdrawing the money, so the ultimate benefit also depends on your tax situation at that time.) Biden proposes a shift in this structure. Instead of a deduction (or exclusion) from taxable income, everyone would get the same percentage tax break via a tax credit equal to roughly 26% of the contribution. (Refundable means that you get the break even if you owe no federal income tax.)

This change would essentially flip retirement savings strategies. A low earner who benefits from Roth contributions today would probably prefer a 26% tax credit from contributing to a traditional account going forward. People in the 32% tax bracket or higher might want to switch from traditional to Roth 401(k) contributions, unless they expect much lower income in retirement. An investor’s decision could also be affected by the way their state reacts to the federal change.

Financial planning tip: This proposal doesn’t require immediate action, but be prepared to rethink your strategy if it becomes law. 

5.  Increase the corporate tax rate and establish higher minimums.

A Biden administration would look to raise the corporate tax rate from 21% to 28%. It would also seek to broaden the tax base through minimum rates on foreign income and on reported “book” earnings.

To put it in perspective, 28% is only halfway back to the 35% corporate rate in place for most of the 2009–2020 bull market. However, in terms of federal tax revenue, it is expected to have a much larger impact than the individual income tax proposals. It would have different effects across companies and industries. Our investment team is already analyzing the potential impact as it evaluates risks and opportunities.

Financial planning tip: While this policy change would not directly affect individual income taxes, the potential impact should be considered in investment decisions.

Keep in mind that taxes are only one of many topics being debated this election. Government policies and spending (funded by those taxes) in many areas could affect your financial planning. These include health insurance, economic stimulus spending, climate change, trade policies, Social Security, and more. And of course, tax and other policies are fluid. The key is to maintain a mix of accounts with different tax treatments and to keep abreast of potential changes and how they could affect your investments while remaining focused on your own long-term financial goals.

Important Information

This material is provided for general and educational purposes only and not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.

The views contained herein are those of the authors as of October 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.  

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Actual outcomes may differ materially from expectations or forward-looking statements.

202010-1360330

 

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