State of the Union Tax Reform

In his State of the Union address last night, President Obama laid out grand plans for reforming the tax code and eliminating loopholes. Most of this was done in the name of providing relief to the middle class and putting a stop to special interest tax breaks. Politics aside, essentially the president’s budget calls for $320 billion in new taxes primarily targeted at high-income earners and banks.

A call for new taxes should not be overlooked when it comes to financial planning; however, I think there is some important perspective we need to consider in light of the president’s proposals. With that in mind, let’s look at a couple of the reforms the president put on the table which could have the greatest impact on you:

529 Plans

– Under current law (in place since 2001), contributions to a 529 savings plan grow tax-free. As long as the withdrawals are used to pay for qualified college expenses, no taxes are paid on distributions either.

– That’s why 529 plans are probably the single best vehicle for most families to save for their children’s college. In addition to the federal tax benefits noted above, some states (including Colorado) also offer a state income tax deduction on contributions.

– The president’s plan would revert us back to pre-2001 tax law by taxing withdrawals from 529 plans, even if they are used for college expenses.

– This is really an odd proposal since it would have the most significant impact on the very demographic the president said he was focused on helping: the middle class. That said, it’s pretty unlikely that this change would ever make it through Congress. More importantly, the current proposal only calls for changes on future contributions, not money that has already been contributed. Thus, there is no reason to abandon 529 plans at the current moment.

Increase to the Capital Gains Tax Rate

– As part of the ironically named American Taxypayer Relief Act (ATRA) which went into affect on January 1, 2013, the top marginal tax rate for long-term capital gains was raised from 15% to 20%. In addition, a 3.8% “net investment income” surtax also went into effect. The resulting rate amounts to 23.8% for those taxpayers in the 39.6% marginal income tax bracket.

– Obama’s proposed budget would see the top capital gains tax rise from 23.8% to 28%, the highest since 1997. This would amount to a nearly doubling of the highest applicable long-term capital gains under the Obama administration (from 15% to 28%).

– While this change would only impact those taxpayers in the highest tax bracket, it’s important to remember that this group often includes small business owners. That’s because most small businesses are structured as pass-through entities (e.g. limited liability corporations or S-corporations), meaning that the business income flows through to the owner’s return. The owner then pays taxes on that income, even if they reinvest it into the business.

– Similar to the proposed change on 529 plans, the spike in capital gains taxes is also a long-shot to see the light of day with a Republican-controlled Congress. Although future changes are always possible, the same strategies to maximize after-tax returns generally apply in all tax environments. This is a good reminder to focus on what we can control and ignore what we can’t.

Other Proposed Tax Reforms

– Eliminating the Step-Up in Basis: Current tax law provides that inherited assets benefit from a step-up in tax basis to the extent the fair market value of the asset at the time of death is higher than the decedent’s basis. Obama’s State of the Union tax reform proposal would do away with this basis adjustment, meaning an inherited asset would keep the decedent’s original basis (with certain exceptions). The step-up in basis is a significant tax benefit for many Americans and a critical consideration when it comes to investment and financial planning.

– Cap on Retirement Plan Accruals: For many American’s, the most powerful tool to save for retirement is through an IRA and 401k plan. The president’s State of the Union tax reform plan intends to cap the total amount an individual can accrue in such retirement plans at $3.4 million. While this may seem like a lot of money, as we live longer and see fewer benefits from other sources of retirement income, it could have a significant impact on some retirees.

Ultimately, this is likely much ado about nothing, as they say. Although the president delivered a long list of talking points on tax reform, there simply isn’t much bite to the bark since Republicans are unlikely to pass most of the proposals. It’s important to keep a close eye on any changes in legislation, but for now, it’s business as usual.

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