In last night’s State of the Union address, President Obama referenced his desire to close tax “loopholes” that are commonly used by wealthy individuals and families. Although he did not provide much detail in the speech, his proposed changes to the tax code were released last weekend in a White House “Fact Sheet.” These changes will likely be included in the Administration’s Fiscal Year 2016 budget packet, which will be released on Monday, February 2. Although the proposals are not likely to be enacted into law – most certainly not in their current form – we still thought a summary of the proposals helpful. There are three elements of the proposal that have the potential to adversely impact high net worth individuals: investments, estate planning, and retirement security.


The proposal seeks to raise taxes on capital gains and dividends to 28%. Generally speaking, this rate would apply to all income not received as compensation (salaries or wages), such as real estate transactions and securities trading.

The current capital gains and dividends rate is 20%, although most types of capital gain have an additional 3.8% “net investment income” tax imposed as well, making the effective rate 23.8% (before any additional state taxes). The Fact Sheet is not clear as to whether the proposed 28% includes the net investment income tax (though some press reports indicate that the new rate is inclusive of the net investment income tax). In other words, the proposed effective rate for capital gain and dividends could be 31.8%.

Estate Planning

The proposal seeks to limit the “step-up in basis on death” rule.

“Basis” is the value against which subsequent gain (or loss) on an asset is measured. As a simple example, if an individual buys a share of stock for $100,000 the basis equals $100,000. If the stock is later sold for $250,000, the seller has taxable gain of $150,000: value received less basis. If the stock had originally been purchased for $200,000 and later sold for $250,000, the basis would be $200,000, resulting in only $50,000 of taxable gain. Thus, basis is equally important as sale price in computing taxable gain.

Under the current rules, the basis of an asset transferred at death is adjusted to reflect the fair market value of the asset at the time of death. For example, if an individual purchased one share of Apple stock in 1995 for $100 and sold it years later when the share was worth $1,000, the individual would have taxable gain of $900: value received less basis. However, if instead of selling the stock, the individual had kept the Apple stock until his/her death, and the Apple stock was left to a beneficiary by Will, the beneficiary’s basis in the stock would be “stepped up” to $1,000. Therefore, if the beneficiary sold the stock the following day for $1,010, his/her taxable gain would be only $10 (value received less stepped up basis) as opposed to $910 (value received less original basis). This step-up in basis upon death results in capital assets being retained beyond their utility (particularly by older individuals) because of the more favorable tax treatment.

President Obama’s proposal seeks to curtail the use of basis adjustment, and thereby stimulate the flow of capital assets, by treating transfer at death as a sale triggering capital gains tax. This would essentially increase the estate tax from the current 40% to between 60% and 70% (depending on if the capital gains tax is increased as discussed above) for any assets not converted to cash before death.

The proposal includes a $100,000 general exemption plus a $250,000 exemption for residences per person. In other words, the first $100,000 worth of capital gain (the difference between the fair market value at the time of death and the basis) would not be subject to the additional 20%-30% capital gain tax. It is not yet clear how this would interact with the lifetime estate and gift tax exemption.

Retirement Security

The proposal seeks to limit the amount one can accumulate in an IRA to $3.4 million, which the White House projects would be sufficient to provide an annual income of $210,000 in retirement.

IRA accounts provide significant tax advantages. Amounts contributed to an IRA escape income tax until funds are distributed from the IRA. In most cases this distribution occurs years later, meaning that money that would have otherwise gone to the government as income tax has been allowed to grow through capital investments by the IRA. Further, the funds distributed from the IRA are subject only to income tax at the effective rate of the distributee at the time of distribution, not the time of contribution (which is usually lower) and the growth is not subject to capital gains taxes.

However, IRAs create an extremely illiquid pool of capital because of the strict rules regarding their distribution and transfer. Therefore, most high net worth individuals do not maintain vast amounts of wealth in IRAs and are unlikely to be significantly impacted by this proposal. For those who do use this method of tax deferral, in excess of the proposed $3.4 million limit, we would be happy to discuss alternative opportunities with you.