Taxachusetts is back. In November 2022, proponents of the Massachusetts ‘millionaires’ tax (question 1) won their bid to nearly double the income tax rate on individuals with taxable income over $1M a year. Starting in 2023, a 4% surtax will be applied to taxable income and capital gains over $1M. Currently, Massachusetts taxes ordinary income and long-term capital gains at a flat 5% rate whereas short-term capital gains are taxed at 12%. As proposed, the new legislation would increase these tax rates to 9% and perhaps even 16%, respectively, starting in 2023.
Importantly, this new surtax won’t just apply to perennial high earners. The ‘millionaires’ tax will also ensnare taxpayers who exceed the $1M limit after selling a home, business, stock options, or other types of one-time events. The $1M limit will be adjusted annually (essentially by inflation).
The MA ‘millionaire’ surtax will apply to one-time sudden wealth events
Unfortunately for affected taxpayers in the Commonwealth, there may not be a lot of options to avoid triggering the surtax. And many taxpayers may not even realize the extra tax will apply to them.
Consider a few simple examples:
- A couple sells a home they purchased 20 years ago for $2.5M. They paid $300,000 for the house. The home was their primary residence so the $500,000 federal home gain exclusion applies. Excluding any improvements they made to the home, realtor fees, etc., the taxable gain is $1.7M. The surtax will increase the Massachusetts tax liability by $68,000 on the sale of their home.
- A tech employee at a startup has stock options. The company is acquired, and the taxpayer receives cash in exchange for his stock options, putting him over the $1M annual limit. (It’s worth noting that the surtax will also apply to vesting restricted stock units and exercises of non-qualified stock options if income is above the $1M limit for the year).
The simple examples above only illustrate the state tax impact, but federal tax implications will also apply. Further, both examples ignore other sources of income, such as wages, pre-tax retirement account distributions, dividends, etc., that could increase the tax due from the surtax.
Considering tax planning strategies to reduce the impact of the new MA surtax
Depending on the situation, the 4% surtax may be unavoidable. But for others, there might be some strategies to consider. Here are a few to discuss with your tax and financial advisor:
- Rethink your MA residency. Changing your state of residency isn’t as simple as buying a second home in New Hampshire or Florida. But in certain situations, when done properly, it’s possible, and can be accomplished without giving up all ties to the state. Be aware of the complexities here, including when income could be sourced to MA even if no longer a resident. Business owners can also consider possible net savings of relocating outside of the Commonwealth. Taxpayers considering this approach are strongly advised to consult a CPA or tax attorney.
- Recognize the gain now. With so little time until the end of the year, it may not be feasible to sell a home, business, or other assets unless it was already in the works. Further, if you weren’t planning to sell the asset, it’s usually not advisable to do so for tax reasons alone. But if a sale is in process, wrapping it up before 12/31 would be advantageous (all else equal).
- Consider an installment sale. If you’re selling a business and can’t close before the end of the year, consider the pros and cons of an installment sale, to spread out the taxable capital gain over a number of years (potentially staying under the surtax limit). Some downsides of this approach include: borrower’s ability to pay, time value of money, and lack of full liquidity for lifestyle needs.
- Plan your income. For taxpayers with equity compensation or high-income individuals, consider working with your advisory team annually to discuss a strategy. Some examples include: timing stock option exercises and sales (particularly around year-end), an 83(b) election, increasing pre-tax contributions to a retirement plan, evaluating a non-qualified deferred compensation plan, charitable endeavors, timing of withdrawals from an inherited IRA, alternate tax filing status, and so on.
- Married couples, consider filing separately. The $1M income limit is the same for married and individual taxpayers. Therefore it may be advantageous for some married taxpayers to file separately to double the current $1M threshold. Taxpayers who elect to file separate MA tax returns may still be able to file jointly for federal tax purposes.
Unfortunately, Massachusetts is already one of the most unfriendly states from an estate tax perspective. Massachusetts and Oregon have the lowest estate tax exemptions in the country at $1M (though couples can double this with proper planning). Starting in 2023, when triggered, the ‘millionaires’ tax will put the state among the highest tax states in the country.
Though tax planning is important, it’s equally important not to let the tax-tail wag the dog. Financial decisions should be tax-conscious vs tax-driven. The ink is hardly dry, so new details will likely emerge about the practical application of the surtax and potential planning opportunities.
About Darrow Wealth Management
Darrow Wealth Management is a financial fiduciary and fee-only registered investment advisor in Boston and Needham, MA. We specialize in financial planning for an IPO, acquisition, or sale of a private business. Although we don’t provide legal or tax advice, through ongoing financial advice and asset management, we aim to help our clients make the most of a sudden wealth event.