How Proposed Tax Changes Could Impact You
The Build Back Better plan was first proposed by the Biden administration in April. Since then, the bill has been modified and several of the tax provisions have been removed.
Originally, the top individual income tax rate and top capital gains tax rates were to be increased. These provisions have been eliminated but some tax provisions remain that could affect you, including additional taxes on high earners and reduced retirement savings options for those with significant income or account balances.
Build Back Better Tax Provisions – Income Tax
Several changes have been proposed to income tax rates for high-earning individuals, estates, and trusts in the proposed Build Back Better plan. These individuals could see changes to the way they calculate tax on their investment income and could also see a tax surcharge added to their income tax bill.
Net Investment Income
Currently, a 3.8% tax is imposed on any individual, estate, or trust with net investment income [NII] over certain thresholds. The current threshold is $250,000 for couples who are married filing jointly, $125,000 for a married individual who files a separate return, and $200,000 for single individuals. For estates and trusts, the tax applies to the lesser of undistributed net investment income or adjusted gross income over the amount at which the highest tax bracket for an estate or trust begins ($13,050 for 2021).
Under current law, the NII tax only applies to passive income. These types of income can include interest, dividends, capital gains, and rental income. Net investment income also includes passive business income, like income received from a business involved in trading financial instruments or commodities. Types of income that are not considered net investment income include wages, unemployment benefits, Social Security benefits, alimony, and self-employment income.
Under the new proposal, the definition of NII is expanded for certain high-income individuals to include net income or net gain from all investment activities, regardless of active participation. The new definition will be called “specified net income.” The definition will continue to exclude income that is taken into account when determining self-employment income.
The income thresholds for the new tax proposal are $500,000 for married filing jointly, $250,000 for married filing separately, and $200,000 in any other case. These thresholds would be used to calculate specified net income. The 3.8% tax would apply to individuals whose applicable income exceeds the existing NII thresholds or the new specified net income thresholds. For estates and trusts, the 3.8% tax is applied to the lesser of either undistributed NII or undistributed specified income or adjusted gross income over the amount at which the highest tax bracket for estates and trusts begins.
If the bill is passed in its current state, this provision would be applicable in tax years beginning in 2022.
Additional Tax on High Income Individuals, Estates, and Trusts
If passed, the new legislation would impose a 5% income tax surcharge on individuals with income over $10 million ($5 million for married filing separately). The tax surcharge would also be applied to estates and non-grantor trusts with income over $200,000.
Additionally, a 3% tax surcharge would be applied to individuals with income over $25 million or estates and trusts with income over $500,000. If passed, this provision would also begin in tax year 2022.
Build Back Better Tax Provisions for Retirement Plans
The Build Back Better legislation would also impose new rules for retirement plans. Some of these rules will impact those with high incomes or those with significant balances in their retirement savings accounts, while others will impact all investors.
Contribution Limits for Retirement Plans
Additional contributions to certain retirement plans including IRAs, 401(k)s, and 403(b)s would be prohibited for those whose balances exceed $10 million and income exceeds certain thresholds. The income thresholds would be $400,000 for individuals, $425,000 for head of household, and $450,000 for joint taxpayers.
The legislation also imposes required distributions for taxpayers whose retirement account balances exceed the same thresholds. These distributions would not replace current required minimum distribution [RMD] rules but would be in addition to those RMD rules. Participants with account values over $10 million would have to distribute a portion of their account each year. Additionally, those who maintain more than $20 million in Roth accounts would be required to distribute any Roth amount which exceeds the $20 million threshold—referred to as the “excess Roth amount.” Under the new legislation, annual required distributions would be calculated as any applicable RMD under the old rules plus the “applicable Roth excess amount” and 50% of the vested retirement account balance that exceeds $10 million, reduced by any applicable Roth excess amount.
SEP and SIMPLE plans, rollovers, and accounts acquired through death or divorce are excluded. This provision would apply to plan years 2029 and forward.
Eliminate Roth Conversions for High Earners
Taxpayers with adjusted income exceeding $400,000 for individuals, $425,000 for head of household, or $450,000 for joint returns would not be able to convert from a pre-tax IRA to a Roth IRA. Additionally, these individuals would not be able to convert from certain pre-tax employer sponsored plans, including 401(k)s and 403(b)s, to a Roth IRA or designated Roth account. If passed in its current state, this would be effective for tax years beginning in 2032.
Eliminate Back Door Roth Contributions
The House bill would eliminate after-tax contributions in a traditional (non-Roth) retirement plan from being converted to Roth – often called backdoor Roth contributions. This provision would disallow conversions of after-tax funds in a traditional IRA, 401(k), 403(b), or other pre-tax retirement plan from being converted to a Roth IRA or a designated Roth account. Unlike the other provisions, this rule is not subject to an income limit and would eliminate back-door Roth contributions for all individuals, regardless of income. If passed in its current state, this would apply beginning in 2022.
How these changes could impact you
Your tax rate could increase if you have significant income. If you make over $10 million a year, you could have to pay a 5% tax surcharge and could pay additional taxes on your investment income. If your income exceeds $25 million, you could pay an additional 3% surcharge on your income over that amount.
If you maintain an estate or trust account, you could pay additional taxes. For those that maintain an estate or non-grantor trust which generates more than $200,000 in income, an additional 5% income tax surcharge would be applicable. If the estate or trust has more than $500,000 in income, an additional 3% surcharge would apply. Additionally, the new definition for specified net income could increase the amount of tax your estate or trust owes from investing activities.
The changes to retirement plans are most applicable to individual investors. Those who maintain retirement plans with balances exceeding $10 million and who have significant income, would not be able to contribute to a Roth IRA or a designated Roth account. These individuals could also have required distributions from their retirement plan each year.
The new legislation would also prohibit backdoor Roth contributions for all investors, regardless of income. If you are currently saving for retirement, this could have a significant impact on your retirement plan.
Get Help with Tax and Retirement Planning
To learn more about how these proposed tax changes could affect your financial plan, speak with an experienced financial advisor at Brookstone Wealth Management. At Brookstone, we offer a complete suite of wealth management services, supported by a team of financial, legal, and tax professionals.
Our team can work with you to develop your Financial Fingerprint™ – a custom financial plan that is quick to assemble, easy to understand, and simple to modify as your circumstances change. If you are ready for help finding your True North, reach out to a member of our team to start your voyage to a comfortable retirement today.