Broker Check

Changes Gonna Come

By Michael Lynch CFP® 

Investments, retirement plans, taxes and estate and gift taxes make a confusing stew in the more stable of times.  These times, as you know, aren’t stable.  The pandemic, a party-changing election, and resulting massive government spending provide the catalyst for investable change.  The proposals are coming out almost weekly, with mind boggling numbers and strategies to raise the revenues to pay for them.  With this, a slew of nearly inscrutable jargon flow from the lips of television commentators and keypads of pontificators of the written word. A day doesn’t pass when I don’t field a great question from a confused person on how a proposed tax code change will affect them. 

The answer, of course, is no one knows until legislation is passed, singed into law, and implemented by the IRS.  Still, the factors at play are long term-features of the U.S. tax code. Consider this a handy primer to help you make sense of our new unfolding reality.

Ordinary Income, Capital Gains and the Cost of Dying

Last week, a client arrived in my office and promptly asked how much the proposed changes is capital gains taxes would cost him and his wife.  I examined the accounts, looked him in the eye, and replied confidently, “nothing.” 

How could I be so confident?

His accounts are all retirement accounts, taxed at ordinary income rates when money in withdrawn. 

This brings me to my first point of clarification.  Your investments and the proceeds that will hopefully flow from them can be thought of as either capital assets or ordinary income assets. 

Capital assets are things such as your house or investments purchased with after-tax money for which there is a “cost basis.” When you sell, the cost basis comes back without tax.  The incremental gain is taxed as a “capital gain,” either short or long term depending on how long the investment was held.

Retirement plans, whether pre-tax, Roth, or non-qualified annuities, are ordinary income assets.  Here the untaxed portion is taxed as ordinary income when withdrawn. 

In the case of pre-tax retirement plans, this means all of it. In the case of Roth assets, this should mean none of it. And for income assets with a basis, such as after-tax IRAs or non-qualified annuities, this means the portion of payments that is counted as earnings.

Since this gentleman’s accounts were all IRAs, changes in capital gains tax rates and cost basis structures have no effect.  What he and his wife need to focus on is ordinary income tax rates and the terms on which the accounts must be emptied while alive through RMDs and after death for the beneficiaries.

The Cost of Stepping Up

Proposed changes to the treatment of “cost basis” at death is the source of most confusion I’m confronting. Longtime rules follow a logical and easy to administer path. Your cost basis is what you paid for an investment plus any future monies invested. In a stock account, this is typically reinvested dividends and additional purchases.  In real estate, it’s material improvements.  Under current rules, if a person gives a capital asset away, the cost basis follows the asset and the recipient will pay taxes on the gains when sold.  If a person dies and passes the asset only when they are no longer able to use it, it receives a step-up or step-down in basis to the value on the date of death. 

Happy Surprises

One of the biggest—and best received-- surprises I deliver to clients is the answer to the question of how much tax they will owe on an inheritance of stock or a house.  I look at them squarely in the eye and deliver the news: “Nothing.”

“If you sell it,” I quickly add, “very little.”

I can say this because I know that the basis of the asset has reset to recent market prices at the date of death.  A stock purchased by your grandparents for $1 and inherited by you when it was selling at $200 a share, has a new basis of $200.  The ability for $199 a share in gain to be taxed is gone, at least for the moment.

The President has proposed a change in these rules for some people, reportedly those with more than $1 million in income. Again, the particulars will change, so it’s the principle that’s important here.  The desire is to tax capital gains of more than $1.25 million at a person’s death, regardless of whether the asset is sold or retained by a beneficiary. 

This elimination of the step-up in basis is a major change to the current tax and planning structure. It’s worth keeping an eye on as any change may require an adjustment to your personal financial planning. 

Tax Rates

At present, there are two sets of tax rate tables applied in America. The first is that for ordinary income, which includes earned income, pensions, the taxable portion of social security, and interest income.

These rates tax income starting at zero for the portion in standard deduction. 10, 12, 22, 24, 32, 35 and 37 percent. 

Here it’s important to distinguish between your marginal tax and effective tax rates.  The former is your actual tax bracket, the rate at which your last dollar of income is taxed.  The latter is the blend of all the rates applied to your income. The math is simple: take your tax and divide it by your income.

The feds apply a lower set of rates to long-term capital gains and dividends.  These rates are zero, for those in the 10 and 12 percent brackets, 15 percent for those up into the 35 percent bracket and 20 for people whose income takes them to the top rate.

In addition to this, the health care reform in the Obama years tacked on additional 3.8 percent for individuals who earn more than $200,000 and couples who top $250,000.

At present, the top earner’s income will be taxed at 37 percent.  Capital gains and dividends at 23.8 percent. 

The Biden administration proposes two adjustments.  First, increase the top income tax rate to 39.6 percent, where it was when Trump arrived in office.

Second, apply the ordinary income rate—plus the Net Investment Income Tax surtax—to capital gains for Americans earning more than $1 million. 

This nearly doubles the current top federal capital gains tax rate from 23.8 percent to 43.4 percent.  Throw in state taxes and for some taxpayers the top rate breaches 50 percent.

At present, the proposed increases are reserved for top earners.  You’ll want to keep an eye on this and apply it to your personal situation. 

Death and Taxes

Both are inevitable and if President Biden gets his way they will be combined more often.  Here we are talking about the U.S. Federal Government’s gift and estate tax structure.  At present, a person can give $15,000 to anyone she wants annually.  In addition, she can give $11.7 million over a lifetime or at death.  For married couples, the numbers are doubled, and the tax is only due after the second to die. Amounts over this are taxed at rates that top out at 40 percent. 

This affects a mere 4,100 households a year.

The President has not formally proposed changing these limits. Killing stepped up in basis, however, would create an effective death tax at far lower levels of wealth than the current estate tax thresholds.

Consider Mary, who inherits a house and stock portfolio from her father valued at $2,500,000. At present, if she sells it shortly after inheriting it, she will owe little to no tax. If she keeps it to use and perhaps sell later, she’d only pay tax on growth over $2.5 million when she ultimately sold the assets.

The proposal would kill the long-standing provision and replace it with a $1 million exemption per individual plus $250,000 for a primary residence.  It will also likely assess the tax at death, regardless of whether the assets are sold. Thus, in this example, Mary’s father’s estate would owe tax on the $1,250,000 gain.  Like a gameshow winner of a car, she vehicle may get sold just to pay the tax on the winnings.

Stay Tuned

Keep in mind what we all learned Saturday mornings from School House Rock.  A proposal is not a bill and a bill is not a law until passed by both houses of Congress and signed by the President. I’ve outlined a few of the proposed changes.  There are of course many more proposed on the table.  It’s early in the process.  Please contact us with any questions on how the unfolding changes will apply to your situation.  Unfortunately, there is not likely to be much that’s simple with the big changes to the income tax code that is coming our way.

Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at or 203-513-6032. His writings and videos can be enjoyed at

Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. Any discussion of taxes is for general informational purposes only, does not purport to complete or cover every situation, and should not be construed as legal, tax or accounting advise. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. CRN202412-1384458