Is Joe Biden coming for your Money?

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US politics has been admittedly kind of boring lately, with the current US president just “going to work” and “doing his job” rather than “threatening to nuke a hurricane” on a daily basis, but I thought it was time to check in with what good ol’ J to the B was up to these days. Turns out, quite a bit!

After passing a COVID stimulus bill back in March worth $1.9 trillion, Biden and the Democrats have been rolling out proposal after proposal, each with equally eye-popping price tags. The American Jobs Plan & the American Family Plan unveiled last week in his State of the Union address promise new highways, broadband for all Americans, two years of free community college, two years of free pre-school, expanded access to Obamacare, subsidized daycare, and a choice of one free rainbow OR unicorn per family [citation needed].

Choose wisely, my friends.

Sounds great, right? Who wouldn’t want all that? Until you look at the price tag. The American Jobs Plan has a projected price tag of $2.3 trillion dollars! And the American Family Plan? $1.8 trillion. For a total spend of $4.1 trillion.

A trillion is a difficult thing to envision, but that is $1,000,000,000,000, or a million million dollars. To put that into perspective, if you were to convert that into $100 Benjamins and stack them up in a tower, a trillion dollars would be almost 3 times the height of the Empire State building. And to put that into another perspective, the total price that America spent on the Iraq war was about $2 trillion dollars. So the Democrats are proposing to spend the equivalent of 2 Iraq wars, all in one go.

Yikes.

So how are the Democrats planning to pay it? By raising money on the wealthy of course! Ah, classic big-spending-soak-the-rich Democrats. Left-wing politics at its finest.

I guess it shouldn’t be a surprise. During the election, the Democrats campaigned on going after millionaires, and this is just a fulfillment of that promise. So I thought I’d do a deep dive into what exactly Joe Biden’s plan is to go after millionaires, and more importantly, how those proposals might affect the FIRE community.

Income Tax

The first and most obvious way to raise taxes on the wealthy is a good old fashioned income tax hike. Income taxes (especially for employed people earning salaries) is one the most reliable ways of taxing individuals because there are relatively few ways of evading it. I mean sure, there are some self-employed people who can monkey around with how their income is classified but for most people, there’s very little else they can do to affect how much income is reported aside from maxing out your 401(k).

The current Democratic proposal is to increase the top federal tax bracket from 37% to 39.6%. This is actually where this tax bracket was in 2016, so what this proposal really does is roll the Trump tax cut on that specific tax bracket back to Obama levels.

Specifically, this is what the new proposed US Federal tax brackets would look like.

Tax rateTaxable income bracket
10%$0 to $9,875
12%$9,876 to $40,125
22%$40,126 to $85,525
24%$85,526 to $163,300
32%$163,301 to $207,350
35%$207,351 to $518,400
37% 39.6%$518,401 or more
2021 US Federal Tax Brackets for Single Filers

A few things to note here. First, none of the other tax brackets are changed by this proposal. During the 2020 US presidential campaign, Joe Biden promised that people earning less than $400,000 wouldn’t see any tax increases at all, so by only targeting the top earning tax bracket of $518,401+, he’s holding himself to that promise.

A single person earning over $500k a year is relatively rare, even in the FIRE community. While there are quite a few millionaires in this space, the vast majority of them became millionaires by saving a high percentage of their working salary rather than earning an insane amount each year from stock options as a C-suite executive or Wall Street finance guy. With less than 5% of Americans in his category, this is a very narrow minority of our readers that would be affected by this change. Or at least, among the single filers anyway. The picture changes a bit when we look at married couples filing jointly…

Tax rateTaxable income bracket
10%$0 to $19,750
12%$19,751 to $80,250
22%$80,251 to $171,050
24%$171,051 to $326,600
32%$326,601 to $414,700
35%$414,701 to $622,050
37% 39.6%$622,051 or more
2021 US Federal Tax Brackets for Married Filing Jointly

Again, the last tax bracket is the only one that changes, but look at how the tax brackets are organized versus the single filers. In every other tax bracket, the income level where you get bumped into a higher bracket is simply double the number for single filer. However, the one exception is the 35% to 37% boundary, where the number for the married couple is only slightly higher than for the single person ($622,050 vs. $518,400). This means that for married couples filing jointly, it’s actually easier to hit this top tax bracket than for a single filer.

A single filer earning over $500k is going to be limited to highly paid executives. A couple earning $622k is equivalent to both people earning $311k, and while still quite a high bar, can be done if both spouses are highly paid professionals (2 doctors, 2 lawyers, etc.). With $538,926 as the cut off for top 1% household income in the US, this is incredibly rare.

In both cases, regardless of the marital status, the proposed change in the top federal tax bracket is unlikely to affect the vast majority of people working towards FIRE.

Capital Gains Tax

Here’s where things get interesting. Changes in the federal long-term capital gains tax rates are relatively rare. The last major change was all the way back in 2008, which created the lower two levels of 0% that we base a lot of our FIRE tax planning on.

SingleMarried filing jointly or qualified widow(er)Tax Rate
$0–$38,600$0–$77,2000%
$38,601–$425,800$77,201–$479,00015%
Over $425,800Over $479,00020%
US Long Term Capital Gains Tax Rates for 2021

The Democrats proposal is to create a new capital gains tax rate of 39.6%, which by the way is the same proposed rate as ordinary income at the top tax bracket. Historically, LT capital gains have been taxed at a far lower rate than salaried income, and this is what has fuelled all this anti-fat-cat sentiment because people like Warren Buffet who derive most of their income from capital gains are able to pay a lower tax rate than his secretary, who gets paid in the form of a salary. So effectively, this change would stop the preferential treatment of long term capital gains vs. ordinary income.

BUT it only does this to people earning over $1,000,000. So rather than changing existing tax rates for LT capital gains, it would create a new bracket for households earning over $1M, like so…

SingleMarried filing jointly or qualified widow(er)Tax Rate
$0–$38,600$0–$77,2000%
$38,601–$425,800$77,201–$479,00015%
$425,800-$1,000,000$479,000-$1,000,00020%
$1,000,000+$1,000,000+39.6%
Proposed US Long Term Capital Gains Tax Rates for 2021

So while on the surface this may seem alarming for people trying to get to FIRE, again I don’t think this affects us. Here’s why.

The FIRE journey can be broken up into two major phases: Accumulation and Retirement. In the Accumulation phase, you’re working, saving your money, and investing it in (hopefully) low-cost Index ETFs. During this period, you generally don’t need to sell anything at all. As we demonstrated in our Investment Workshop, even if your portfolio drifts from your target allocations, you can keep your portfolio rebalanced by allocating more newly added cash towards the ETFs that are under target and less towards the ETFs that are over. No selling required. And therefore, no capital gains to report.

In Retirement, it’s a different story. Sometimes you do have to sell to rebalance (or to raise money to fund your living expenses), but during this period your household income will plummet since you’re, by definition, retired and no longer working. Under the current US tax code, as long as your total household income is less than $77,200 any capital gains you realize can be done for free!

So again, this is another tax hike that simply won’t affect most people in the FIRE community.

The BIG exception to this, however, are people who put the majority of their savings into real estate rather than ETFs and are relying on that to retire.

One of the more subtle problems (and there are many) about using real estate to retire is that you can’t strategically manage your capital gains taxes. If you own ETFs and need to sell something, you don’t have to literally liquidate your entire portfolio. You can sell just a few shares, and capital gains will only be realized only on the portion you sell. With real estate, on the other hand, you can’t sell part of a house. You can only sell the entire thing. So if you are sitting on a big capital gain on an investment property and you sell it to retire, you may find yourself pushed into that $1M+ tax bracket for the year, and if that happens you may see almost 40% of your nice fat juicy housing gain vanish into Uncle Sam’s coffers.

Just another reason to avoid real estate, as if you needed more.

Inheritance Taxes

The final tax hike that’s being proposed is to something we haven’t really written about on this blog at all: Inheritance taxes.

The US tax rate on estates is a punishing 40%, but US citizens currently have an estate exemption of $11.2 million, meaning if the total value of your net worth at the time of your death is less than $11.2 million, then no inheritance tax is due. This $11.2 million number was created by Trump, which doubled the previous exemption of $5.6 million. The Democratic proposal would roll this exemption back to its previous value of $5.6 million.

In addition, Joe Biden is also proposing to eliminate a rule in how capital gains of inherited assets are treated called the “step-up in basis” rule. Here’s how it works.

Let’s say Alice has a giant portfolio of ETFs worth $3M that she originally bought for $1M, so there’s an unrealized capital gain of $2M. At some point, Alice dies (sad trombone noise) and passes on her entire portfolio to her son Bob (happy flute noise!). Under the current rules, no capital gains taxes are paid in Alice’s hands. Bob would receive the portfolio’s full value at $3M, and the basis (or book value) would be “stepped up” to its current market value of $3M. That means that later on, if he sells this portfolio for $4M, he would only have to pay capital gains on the increase in value that occurred from the time he received the inheritance, or $4M – $3M = $1M.

So even though the “real” capital gain on this portfolio should be $4M – $1M = $3M (the price Alice originally purchased this at), $2M of that capital gain went away when Alice died.

This rule has been described by activists as a subsidy that unfairly favours inherited wealth. Capital gains is, after all, already taxed less than regular income, and by holding those assets forever until death, it’s taxed even less.

So if Democrats get their way and eliminate this loophole, Alice’s original basis will get passed down to Bob along with the shares. When Bob sells those shares, he will realize the full capital gains on those shares ($4M – $1M = $3M) as if Alice had sold them herself.

Now, there is a certain small group of people that are very, very upset about this change, but for the FIRE community this doesn’t really affect them because inheritance taxes, by definition, don’t affect your retirement because when the come due, you’re usually, you know, dead. It might affect how your money gets passed down to your kids, but that’s really an estate planning issue rather than a FIRE issue.

However, if inheriting money from your parents is a major part of your FIRE plan, this might affect you. The first change, which is the lowering of the estate exemption from $11.2M to $5.6M, will mean you receive less money out of an estate worth $5.6M, though I would argue that your “problems” at that point are pretty unrelatable even to other millionaires. And the second change, which is the elimination of the “step-up-in-basis” rule just means that you’ll be more susceptible to capital gains tax when you sell those shares, but even that can be managed by a) only selling shares after you retire and b) doing it slowly enough so that you only realize capital gains within the 0% tax rate each year.

Conclusion

While Joe Biden’s vow to go after the wealthy with tax hikes initially sent a wave of apprehension through the FIRE community, it appears that they’ve defined “wealthy” very narrowly, meaning those earning very high yearly salaries ($500k+) or those with ridiculously high net worths ($5.2M+). For the vast majority of our readers who are either on their journey to FIRE or already retired, it appears that these tax hikes aren’t targeted at us. Phew.

So what do you think? Do you think Biden’s tax proposals are structured in a fair manner, or are they unfairly punishing the ultra-rich? Let’s hear it in the comments below!


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