Tax impact of the Inflation Reduction Act of 2022
The deal is done. It took a while for it to cross the finish line on Capitol Hill. But the Inflation Reduction Act of 2022 (formerly known as the Build Back Better bill) was signed into law earlier this week.
Even though this bill has been greatly discussed for almost two years, there is still confusion about what is in it, how it may impact investors and what got left on the chopping-room floor. In short, most of the proposed tax increases and tax policy changes did not make it into this new bill.(However, stay tuned on those because many of the originally proposed items are likely to come up again.) What did make it in is summarized below.
The bill and its expenditures
The Inflation Reduction Act of 2022 is estimated to generate $739 billion in revenue while spending a total of $433 billion. Part of the revenue raised is expected to go toward deficit reduction, to the tune of $102 billion. The bill also contains a provision allowing the federal government, through Medicare, to negotiate the prices of a handful of prescription drugs, which is expected to generate savings of $266 billion. In addition, the bill provides the Internal Revenue Service (IRS) additional funding of more than $100 billion over 10 years, which is expected to be covered by the revenue raised through additional enforcement and tax audits.
Outside of deficit reduction and IRS funding, the bill’s expenditures fall into two broad categories. The first is the extension of expanded Affordable Care Act (ACA) subsidies for an additional three years at a cost of approximately $64 billion. The second major expenditure and the largest in the bill, at $369 billion, is for climate and energy provisions in broad terms.
In summary, based on Congressional Budget Office (CBO) estimates, the bill will generate net revenue and reduce the budget deficit. The jury is still out on whether it will actually help reduce worrisome inflation, as analyses by both Penn-Wharton and the Tax Foundation estimate it will have a net neutral to slightly inflationary overall impact, while also reducing gross domestic product (GDP) by a small amount over 10 years.
The bill and its tax impacts
While the focus over the last two years has been on the multitude of tax increases and tax policy changes proposed, at the end of the day only a handful of tax increases and tax policy changes made it into the final bill. While almost none of the changes have a direct impact on investors, there are indirect effects that investors should be aware of.
- Corporate taxes: The bill includes a new 15% minimum tax rate on the profits of companies with at least $1 billion in income. Taxes on corporations largely get passed through. Some of that tax expense passthrough could come in the form of reduced earnings. This could have some impact on investors. Share prices are largely dictated by the earnings and earnings growth of companies, so this new tax could affect the stock prices of the specific companies impacted. More details will surface over time.
- Share buybacks: A change of some consequence to investors is the new 1% excise tax on stock buybacks. Simply put, a 1% tax on stock buybacks reduces the benefit investors receive from the buybacks. It also could be a disincentive for companies to do them. Not all companies do buybacks, however, so only a select pool of companies and investors will be affected. On the other hand, companies may divert this type of shareholder payout activity to increased dividend payments. (Both buybacks and dividends are ways corporations distribute excess income back to shareholders). The impact of this may take time to study and analyze.
- IRS: The bill substantially increases funding for the IRS, mainly to improve and increase its revenue collection and enforcement, as well as allow it to expand audits. The change is geared toward businesses as well as individual taxpayers earning more than $400,000 per year. The funding is largely expected to be paid for through increased revenue collection and in the end be a net revenue generator. Investors should be aware of the increased potential for audits.
- Changes and increases to individual tax rates and brackets
- Increasing the top marginal income tax rate to 39.6%
- Capital gains tax on unrealized capital gains
- Increased tax on dividends
- Reduction of estate tax limits
- Reduction of gift tax limits
- Taxing carried interest as ordinary income
- Expansion of the Affordable Care Act's 3.8% tax surcharge to passive income businesses
It’s worth highlighting the list of tax items that didn’t make it into the final bill as investors should stay focused on these for retirement and tax planning purposes. Below is a summary of some of the most discussed proposals from the last two years:
What didn't make it in
The important thing to remember here is that it’s likely some of the proposed items that didn’t make it into the current bill could resurface in the future. In addition, there are other tax changes coming up in a few years that are already embedded in law that investors need to be preparing for.
Future tax changes
The Tax Cuts and Jobs Act of 2017 is largely set to expire in 2025. It might be hard to remember now, because so much has happened in the last few years, but that bill reduced taxes on individuals and investors across a broad spectrum. The taxes that will increase in 2025 include income taxes due to changing tax brackets and tax rates on short-term capital gains, interest income and certain dividends. In addition, estates and estate planning will need to be revisited as the estate tax exemption is expected to decline by around half. These could have notable effect on investors and could come as a large negative surprise for those who aren’t prepared.
The bottom line
As investors, we should always hope for the best but prepare for the worst. It’s not a stretch to assume these recent tax changes will not be the last we’ll see. With the bill from the huge stimulus packages that helped the economy get through the COVID pandemic coming due, the government will likely be searching for any and all ways to increase tax revenues. As with all things in life, it’s better to be prepared.
While you can’t control which taxes will increase now or later, you can control the impact of taxes on your client portfolios. By minimizing tax drag from distributions, for example, you can help your clients keep more of their money working for them in the future.
Helping your clients benefit from techniques like tax-loss harvesting or transitioning to a tax-managed solution can help set you apart from your peers and demonstrate your value as an advisor. Seizing these opportunities during this period of uncertainty and volatility can help your clients and you feel confident that you are doing what you can to help them grow their after-tax wealth.