Part of the Democrats’ $3.5 trillion spending package — including provisions that would raise taxes on wealthy individuals and corporations to offset new spending costs — advanced this week through a House panel.
On Monday, the House Ways and Means Committee released draft legislation titled Responsibility Funding Our Priorities, which includes roughly $2 trillion of tax increases.
According to The Hill, the legislation approved would extend through 2025 much of the child tax credit expansion that Democrats enacted earlier this year while permanently making the credit fully refundable so the lowest-income families can receive the full credit amount.
It would also raise the corporate tax rate for income above $5 million from 21% to 26.5%; raise the top individual income tax rate from 37% to 39.6%; raise the top capital gains rate from 20% to 25%; and impose a 3% surtax on individuals’ income above $5 million.
This legislation is still facing debate and is subject to revision, but here are a few key provisions affecting individuals as they appear in the proposal:
Increase in the top marginal income tax rate on ordinary income from 37% to 39.6%
- The provision increases the top marginal individual income tax rate from 37% to 39.6%. This marginal rate applies to married individuals filing jointly with taxable income over $450,000, to heads of households with taxable income over $425,000, to unmarried individuals with taxable income over $400,000, to married individuals filing separate returns with taxable income over $225,000, and to estates and trusts with taxable income over $12,500. The amendments made by this section apply to taxable years beginning after DeceDec.mber 31, 2021.
Increase in the top tax rate on long-term capital gains to 25%
- The provision increases the capital gains rate from 20% to 25%. The amendments made by this section apply to taxable years ending after the date of introduction of this Act. A transition rule provides that the preexisting statutory rate of 20% continues to apply to gains and losses for the portion of the taxable year prior to the date of introduction. Gains recognized later in the same taxable year that arise from transactions entered into before the date of introduction pursuant to a written binding contract are treated as occurring prior to the date of introduction.
- This does not include the 3.8% surtax on net investment income which would bring the maximum tax rate on long-term capital gains to 28.8%.
New 3% surtax for households exceeding $5 million in income
- The provision imposes a tax equal to 3% of a taxpayer’s modified adjusted gross income in excess of $5,000,000 (or in excess of $2,500,000 for a married individual filing separately). For this purpose, modified adjusted gross income means adjusted gross income reduced by any deduction allowed for investment interest. The amendments made by this section apply to taxable years beginning after Dec. 31, 2021.
There are also major proposals for changing the corporate tax rate. It replaces a flat corporate income tax with a graduated rate structure.
The rate structure provides for a rate of 18% on the first $400,000 of income, 21% on income up to $5 million, and 26.5% on income thereafter.
Other things to consider
With so many potential changes on the horizon, in addition to the provision subject to revisions, there are still plenty of unanswered questions.
Drew Watson, a private wealth advisor with Ameriprise Financial in Owensboro, said one of those is how itemized deductions will be affected. He said the previous tax rules gave many taxpayers more of an ability to itemize their deductions, but legislation was eventually enacted to put a $10,000 cap on state and local Taxes, for example, which can make up a large portion of a taxpayer’s itemized deductions.
Watson also said it’s important to note that with the child tax credit, some individuals may end up not owing anything on their taxes. For example, parents in the 12% marginal tax bracket with one child are getting a credit of $1,800, which covers the liability of making an additional $15,000 in taxable income.
While many people simply look at their marginal tax rate, that’s not an accurate representation of a person’s overall tax liability.
The U.S. uses a graduated income-tax system, meaning income is taxed at differing rates that rise as income hits certain thresholds. The marginal tax rate refers to the highest tax bracket into which their income falls, so two people in the same upper marginal bracket could actually owe vastly different amounts.
Take this example from Investopedia:
Imagine, for example, a graduated tax system where income under $100,000 is taxed at 10%, income between $100,000 and $300,000 is taxed at 15% and income over $300,000 is taxed at 25%. Now consider two individuals who both hit the upper tax bracket of 25%, although one had a taxable income of $500,000, while the other had a taxable income of $360,000.
Both individuals would pay 10% on their first $100,000 of income, or $10,000. Both would then pay 15% percent on their income between $100,000 and $300,000, or $30,000 (15% of $200,000).
Finally, both would also pay 25% on their earnings over the $300,000 threshold. For the individual with $360,000 in taxable income, that would come to $15,000 (25% of $60,000). But for the individual with $500,000 in taxable income, the tax would be $50,000 (25% of $200,000). Their total tax obligations would be $55,000 and $90,000, respectively.
While both individuals could say they’re in the 25% bracket, the one with the higher income has an effective tax rate of 18% ($90,000 in tax divided by $500,000 in income), while the other’s effective tax rate is 15.3% ($55,000 divided by $360,000).
Even if the “Responsibility Funding Our Priorities” legislation is approved in full, Watson said to bear in mind that more tax increases could be in store given the recent announcement by the Social Security Administration. Trustees announced at the end of August that the trust fund backing the payment of SS benefits would be zero in 2033 (benefits would drop to 76% of their originally promised levels through 2095.
Watson noted the trustees report from SS released on Aug. 31 that stated the SS shortfall could be eliminated by an immediate 3.6% increase in the SS payroll rate.
So what should people do in the meantime?
Watson said to keep track of all itemized deductions, charitable deductions, medical expenses, and investments.
“It’s all still pretty fluid at the point,” Watson said of the proposals. “Probably no one is really going to know what it will look like until it’s finished.
Watson said that tax planning matters are unique to each taxpayer and require the work of a tax professional. He recommended that individuals who are concerned about these proposed changes should consult with their tax and financial professionals.