Where are taxes headed and how can you prepare?
Unprecedented situations call for unparalleled solutions and the Coronavirus pandemic has marshalled the full resources of our government to blunt the blow of the virus on the economy. Several phases of fiscal stimulus – government spending – have increased the budget deficit and will certainly help balloon the national debt even further to levels not seen since World War II (as % of GDP). The debt, which will never actually be paid off in full, will need to be managed – and higher debt service costs in the years ahead will either be funded by budget cuts or tax increases. This begs an interesting question, where do taxes go from here? A trip through history may help provide some insight.
First, it is important to remember that the US income tax system is just over 100 years old, having been implemented prior to World War I. The top bracket was initially just 7%, but that didn’t last long. The need to pay for the war caused it to skyrocket to over 70% in 1918. Post-war reductions in the roaring 1920’s saw a swift decline in rates, but they eventually shot back up coming out of the Depression and into the second World War.
Something interesting happened in the 1940’s, however. Not only did rates shoot up – they also significantly lowered the income threshold for being in the top tax bracket. So, while top earners were paying more, so were many others. Top rates remained high through the next decades and didn’t drop below 70% until Reagan took office in 1981.
The 1990’s saw rates stabilize a bit, and the past three decades have seen the top tax bracket bounce between 35% and 40%. Most recently the Tax Cuts and Jobs Act reduced the top bracket to 37%, from 39.6% starting in 2018.
Today, the national debt is sitting at 106% of GDP, and will continue to climb with recent stimulus measures, while the top tax bracket sits at 37%. Historically, periods of such high debt have corresponded with significantly higher tax brackets than we currently have.
This leads us back to our initial question – where do taxes go from here?
First, let’s deal with the law as written. Even if Congress takes the next few years off, taxes are set to rise in 2026 when the Tax Cuts and Jobs Act expires. Top rates return to 39.6%, and all other brackets will also increase as well.
But the expiration of the recent tax cuts will likely not be enough – more revenue may be needed and there are many ideas on how to get it. Common targets include eliminating the step-up in basis at death, lowering the estate tax threshold, adding new taxes for high earners – like a millionaires surtax, cutting back on deductions, bumping up tax brackets, implementing a national sales tax and/or increasing the Social Security wage base. And with many states in financial distress due to the pandemic, state income taxes could rise as well.
Now it’s difficult to tell when exactly this will happen, and what it might actually look like, but it’s reasonable to assume the tax landscape will progressively get less favorable in the years ahead. So, what can we do to prepare for that? It helps to have a strategic approach to tax planning decisions.
Tax planning decisions should start out with an understanding of your goals. Common goals include minimizing your long-term tax burden, avoiding tax surprises for your heirs, ensuring charities and noteworthy causes are taken care-of, and providing flexibility in withdrawing from your retirement accounts.
After establishing goals, it is important to understand your tax planning in two buckets – current year tax planning and long-term tax planning. In order to achieve your long-term tax goal, you’ll need to adjust your current year tax plan. That can mean intentionally paying more in tax now, to pay less later. It can result in deferring income now to pay taxes later at a lower rate. It can also mean understanding how beneficiaries on accounts are structured and how you gift to charity.
Those goals, built into a comprehensive plan, can help mitigate the impact of future tax hikes and inform the decisions you need to make today – and the actions you need to take to ensure the appropriate strategies are implemented.
At Vintage, our tax experts help clients with this every day. Feel free to reach out to one of our Senior Financial Planners to learn more about how we can help navigate this ever-changing tax landscape.