If President Biden's Green Book tax proposal makes it into law this year, how will it directly affect you as a taxpayer? My focus here will be on income – ordinary and capital gains – and won’t touch on recognition of income for gifts and estates. We’ll also ignore annual bracket adjustments based on C-CPI-U, the 3.8% net investment income tax (NIIT), the 0.9% additional Medicare tax, alternative minimum tax, and other additional taxes.
If you make less than $452,700 (or $509,300 if you’re married filing jointly)… it won’t.
While the Green Book doesn’t specify any tax brackets aside from the reinstatement of the 39.6% bracket from pre-TCJA, the lack of specificity also indicates that the other brackets wouldn’t be affected, and we’d just return to pre-TCJA income tax brackets. Your capital gains taxes will also stay at preferential rates: 0%, 15%, and/or 20%, depending on your income.
What if you make more than that? Say $609,300 as a married couple?
In this case, you’ll be pushed into the 39.6% tax bracket. But remember, that’s only for the $100,000 of income above $509,300. Below that your tax brackets are the same as before. At worst, if all of your income is taxed at ordinary rates, your last $100,000 would be taxed at 39.6% instead of the 35% it would be taxed at now. In other words, an additional $4,600. If a significant portion of your income is long-term capital gains, the impact of the higher bracket will be mitigated since your gains will still be treated preferentially (as long as your income is less than $1 million).
What if you make $800,000 in earned income and have $300,000 of long-term capital gains?
You’ll end up in the same 39.6% marginal bracket based on $1.1 million of income. However, because your capital gains push you past $1 million of income, the elimination of preferential capital rates will affect you. It's still a marginal effect though, so the 20% rate still applies for capital gains up to $1 million of total income. Therefore, $200,000 of your gains will be taxed at the same 20% rate as before, and only the $100,000 above that is taxed at 39.6%.
In the case where capital gains pushes your income above $1 million, the 2021 tax year is important to consider as well. The elimination of the preferential capital gains tax rate for $1 million earners is proposed to be retroactive to April 28, 2021. While April is seen as unlikely and very aggressive, sometime later this year seems to be the consensus (assuming Congress wraps things up this year). If being in the $1 million income range with capital transactions is unavoidable, you need to be working with tax planners right now.
What if your income fluctuates because of stock option exercises and capital sales?
For most people, the same prudent tax planning as before will work, while keeping in mind the 39.6% marginal rate.
In particular, keep a closer eye on NSO exercises and disqualifying dispositions of ISOs. This year, the 35% tax bracket applies until $628,300 for married couples. If the 39.6% bracket is reinstated at $509,300 (MFJ), it will be a lot easier to accidentally push yourself into the highest bracket. Any other short-term capital gains or ordinary income that could push you into the 39.6% bracket should be considered as well. RSU vesting and selling ESPP stock are two other events that can increase your ordinary income. If Roth conversions are your thing, keeping an eye on the 39.6% bracket is important too.
Long-term capital gains that push your income above $1 million in a tax year might be the most painful. The elimination of the preferential capital tax rate above that means $100,000 of excess capital gains income results in nearly $20,000 in additional taxes. And don't forget that the change to the preferential capital gains rate might be effective this year.
The vast majority of taxpayers won't be affected at all, and a small portion will just need to be aware of the 39.6% bracket. In some cases, managing around the top bracket is possible, but in others, there's nothing you can do to avoid it (except by making less money). As for the elimination of the preferential capital gains rate for $1 million earners, there's a big incentive to avoid that tax.
Remember that nothing is certain. We don't even know if Congress will come to an agreement on the budget, and negotiations on tax rates are ongoing, with changes seen (mostly on the corporate tax side) since the Green Book was released.