As impending tax code changes in 2022 could change the landscape of your financial planning, now more than ever, you should consult with a wealth management advisor about high-income tax strategies you can leverage.
After a long, winding path on the Hill over much of the second half of 2021, President Biden’s roughly $1.75 trillion social investment ‘Build Back Better’ (BBB) bill seems on-track to clear the halls of Congress by the end of the year. The House of Representatives passed its iteration of the bill shortly before Thanksgiving, and the consensus among experts and legislators alike suggests the bill will pass the Senate late December or early January. Containing a bevy of social and environmental program investments funded in large part by corporate and individual taxation adjustments, high-income individuals everywhere are of course curious to know how this legislation might impact their 2022 tax strategies.
The legislation, as it stands right now, appears to adhere to the president’s election promise that no American making under $400,000/year would see a tax increase. However, those making more than $400,000 (after deductions) may see an increase in income and capital gains tax, along with surcharges as high as 8% on income between $10-$25 million. Will the same tax strategies that worked in the past for these high-income earners still apply in the future?
New Proposed Tax Changes
While still subject to change in the Senate, the biggest change to the tax code in the House-passed version of BBB appears to be a surcharge between 5% and 8% on modified adjusted gross income (MAGI) between $10 million and $25 million. MAGI that exceeds $10 million is subject to a 5% surcharge, while MAGI exceeding $25 million is subject to an additional 3% surcharge.
Other than these surcharges, several other changes currently remain in the bill that may impact your tax strategies as a high-income individual. For starters, the House bill proposes a limit on individual retirement account (IRA) contributions once the balance exceeds $10 million. Single taxpayers with aggregate balances exceeding $10 million, who earn more than $400,000 ($450,000 married and filing jointly), would also be barred from making further contributions to their IRA/Roth IRA accounts under House BBB stipulations.
Furthermore, IRAs exceeding $10 million will have required minimum distributions (RMDs) of 50%, beginning after December 31, 2028. However, this rule only applies to individuals making over $400,000 annually. Therefore, someone below that threshold who has saved over $10 million in their IRA would continue operating on traditional RMD rules.
Early BBB drafts called for increasing the top long-term capital gains tax rate to 25%. However, those increases were removed, and the long-term capital gains tax remains at 20%.
Taking a Look at Exchange Funds
Exchange funds are one of several tax strategies high-income individuals can use to plan for tax changes under BBB.
Exchange funds involve several investors with concentrated stock positions looking to diversify their portfolios. These investors pool their shares into a partnership, each receiving a pro rata share of the newly formed exchange fund. Now, instead of owning many shares of a single company, each investor is invested in a fund containing a portfolio of various stocks. Exchange funds effectively accomplish two things: portfolio diversification and tax deferrals.
So how do exchange funds allow for tax deferrals on capital gains? Since investors effectively ‘swapped’ shares within the fund, no sale ever occurred. Investors can defer capital gains taxes until the fund units are sold. Exchange funds exist in both the private and public markets. Investors can diversify their private equity holdings in the private market, or broaden their portfolios with publicly traded firms.
Federal requirements, however, dictate a seven-year holding period on exchange funds. Withdrawing before those seven years lapse could lead to early-withdrawal penalties. If you’re considering an exchange fund, do so only if you’re comfortable leaving your contribution in for the long term. The two largest exchange funds also require participants to have a minimum liquidity of $500,ooo to join.
Exchange Funds vs. Exchange-Traded Funds
Be sure not to confuse exchange funds with exchange-traded funds (ETFs)! ETFs are a conglomerate of different stocks, bonds, and securities that trade like any other stock. The SPDR S&P 500 ETF (SPY) used to track the S&P 500 Index is a well-known example. So, how will new tax laws affect the tax benefits of exchange funds and ETFs?
Senate Finance Committee Chair Ron Wyden (D-Ore.) has proposed a new tax on ETFs as a means of funding the investments in the Senate version of the bill. Wyden’s plan targets in-kind trades within ETFs, which allow financial institutions to swap underlying assets to defer capital gains taxes. The proposal would end tax breaks for in-kind transactions. In short, gains on appreciated assets would be recognized as such instead of being recognized only after sale. While the architecture of the Senate bill is still in flux, Wyden’s proposal retains a distinct possibility of inclusion.
Tax Benefits of Private Placement Insurance
Two options to consider as a high-income individual when planning your tax strategies are private placement life insurance (PPLI) and private placement variable annuities (PPVAs). Both are insurance policies where the purchaser can invest their premiums into a multitude of investment options. PPLIs and PPVAs allow investors to take on different types of risk and seek alternative investment options.
PPLIs and PPVAs allow individuals to opt into alternative investments like hedge funds, real estate, and private credit as well as traditional investments, such as stocks, bonds, ETFs and mutual funds. In contrast, traditional variable life policies only allow the purchase of mutual funds, which are then invested in stocks, bonds, real estate, etc. The cash value inside your policy can grow tax-deferred based on your chosen structure. Furthermore, as with traditional life insurance policies, the beneficiary receives a tax-free death benefit upon the policy holder’s death. Death benefits grow over time as the policy’s cash value appreciates.
You can withdraw from your PPLI tax-free, as long as you’re withdrawing the cost basis (the aggregate amount of premiums paid thus far). The IRS considers any withdrawals over cost basis as standard income. You can also consider borrowing against the cash value of said policy tax-free, only paying the interest set by the carrier. Just remember: the goal of a PPLI is to leave your underlying investments in place to grow tax-deferred over time. The more money you withdraw or borrow against your policy, the less money is available for growth.
Annuities often get a bad rap, but they can be a robust wealth management tool if used properly. Remember, when you withdraw gains from an annuity, it counts as ordinary income. That’s to say if you invest $1 million into an annuity, and it grows to $10 million, 90% would be subject to income tax. However, most companies require commissions to get started (resulting in longer wait periods for your investment to come back to you) or hit you with back-end charges (which results in a costly exit). Additionally, internal costs can rise upwards of 3.5%-4%, eating up profits. At Polaris Wealth Advisory Group, most clients using the private placement annuity that we sub-advise pay less than half of what most investors pay using traditional annuities. There’s also no restrictions to get in or out, and we embed all our costs within the annuity to avoid client withdrawal taxes when withdrawing management fees from the account.
Preparing for ‘Build Back Better’ in 2022
‘Build Back Better’ will likely increase taxes for high-net-worth individuals in one way or another. The impending tax code changes in 2022 could also change the landscape of your financial planning. Now more than ever, you should consult with a wealth management advisor about high-income tax strategies you can leverage.
There are myriad ways to diversify a portfolio full of highly concentrated stock without paying taxes. Reach out to Polaris Wealth Advisory Group to learn more about the investments you should make to secure your future.
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