IRA Financial’s Adam Bergman Esq. discusses presidential hopeful Joe Biden’s proposed capital gains tax hike and how wealthy individuals can manage their tax burdens easier.

If democratic hopeful, Joe Biden, wins the presidency, he’s talked about a tax hike for the wealthiest individuals in the country. Biden’s tax hike would only affect those who earn more than $400,000 annually. It’s structured so those making under that amount would not be affected by the hike. It’s welcome news for lower and middle income households for sure. However, high earners are understandably worried about such a tax hike. Of course, there are ways around such taxes, which Mr Bergman discusses in this episode of Adam Talks.

Joe Biden’s Tax Hike

Biden’s plan would revert the top individual income tax rate for taxable incomes above $400,000 from 37% under current law to the pre-Tax Cuts and Jobs Act (TCJA) level of 39.6%. Further, it taxes long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1 million and eliminates step-up in basis for capital gains taxation. In sum, for the wealthy and those investors generating over $1 million in capital gains, the old capital gains rate of 15% or 20% will be replaced with a tax rate of 39.6% This would make it the highest rate since 1977.

This will have a major impact on the wealthy who earn the majority of their income from capital assets – stocks, real estate, etc. The new tax hike will also apply to qualified dividends which will increase taxation on small business owners and investors generating over $1 million of earnings.

The ability to limit your taxes is key to any investment strategy. Thus, the biggest winner for investors and savers alike are the Roth type of retirement plans. These include the Roth IRA and Roth 401(k).

Why go Roth?

If you’ve been paying attention to our podcast, videos and blog, you know how much we love the Roth retirement plan. Roths give you the ability to save money for retirement on a tax-free basis. You never pay taxes on qualified distributions! Unlike traditional plans, there is no upfront tax-break (which is generally a good thing for high income earners). Roths are funded with after-tax money. However, once the money is in the plan, no taxes will ever be due in most instances. This includes not only your contributions, but all earnings on your investments!

Qualified distributions occur once you’ve reached age 59 1/2 and the Roth plan has been opened for at least five years. That’s it! There are taxes and penalties if you withdraw too early. Therefore, it’s important to never touch your Roth IRA or 401(k) plan until you’ve met the criteria.

As highly paid individuals know, you cannot directly contribute to a Roth if you earn over a certain amount each year. There is a way to get your money in a Roth, and that’s through the backdoor. You can simply contribute after-tax funds to a traditional plan and then convert those funds to a Roth. Those funds will now grow tax-free until you withdraw them!

What Can the Wealthy Do?

Just about any asset can be held in a Roth IRA. The IRS prohibits you from investing in life insurance, most collectibles and any transaction that violates the prohibited transaction rules. Note: there is an exception to invest in some life insurance with a 401(k) plan. The goal would be to get appreciating assets into a Roth IRA/ to shelter gains from high capital gains tax. Unless you are self-employed, a Roth 401(k) will generally not let you invest in alternative assets, such as real estate and precious metals. However, if you do have self-employed income, a Roth Solo 401(k) can be set up, which will allow you to invest in whatever you want.

Unfortunately, you cannot move assets you own personally into a Roth IRA – it’s illegal and may be referred to as shifting income. However, for new assets, it mat be a great opportunity to build wealth in a Roth IRA – especially if you will be a passive investor

We are already seeing this trend with the emergence of SPACs – Special Purpose Acquisition Companies, where founder stock is being placed in a Roth. For new ventures and businesses, there is a growing importance of having a Roth IRA invest wherever possible, without violating the IRS prohibited transaction rules.

Biden’s Tax Hike – Conclusion

When capital gains were at 15%, many real estate investors argued that it was better to hold real estate with an after-tax account then an IRA because of low capital gains tax rate. But if capital gains rate goes to 40% for over $1 million, real estate investors will have a tough time making strong after-tax returns and will have to turn their attention to a Roth IRA to shelter income.

Since the annual Roth IRA contribution limit is capped at $6,000 or $7,000 if at least age 50 for 2020, Roth conversions would also be a big part of the rothification of retirement accounts. Of course, ordinary income tax will be due on conversion. If Biden does win, we may see the most Roth IRA conversion in our history during the end of 2020.

In sum, for the wealthy, the Roth IRA may end up being the best tax strategy to protect their wealth from Biden’s capital gains tax hike.

Thanks for Listening

As always, we appreciate you taking the time to listen, watch or read about the latest podcast. This article is getting posted on Election Day, so get out there and vote if you haven’t already!

Of course, Adam will have tons of insight after the election with more episodes of how to plan your retirement, depending who is in office. Check out our SoundCloud page or our blog for all of our episodes!