Strategies to Defer Income
This time around, I want to focus specifically upon strategies for tax deferral, including:
- Traditional IRAs,
- Employer-sponsored retirement plans,
- Participating in nonqualified deferred compensation plans,
- Purchasing life insurance,
- Purchasing annuities,
- Receiving compensation in the form of employer stock options,
- Investing in Series EE savings bonds (which may also be called Patriot bonds),
- Selling assets using the installment sale method,
- Investing in appreciating assets (stocks, bonds, real estate), and
- Using like-kind exchanges
It can often make sense to defer taxable income from one year to a later year in order to postpone payment of tax, thereby allowing you the use of more money for a longer period of time. Postponing receipt of taxable income may also be useful because when you eventually realize the income at a future time it's possible that you'll be in a lower tax bracket.
As you read through this keep in mind that a comprehensive financial plan can often incorporate some, or many, of these strategies to help you optimize your tax deferral. And of course, if you have any questions about your specific situation, please reach out to me.
For this first post in this series, the focus will be on retirement vehicles. In addition to helping you save for retirement, there are retirement vehicles that can be especially effective in deferring the payment of taxes on your income such as:
- Individual retirement accounts (IRAs),
- Employer-sponsored retirement plans, and
- Nonqualified deferred compensation plans
If you qualify for a tax deduction for your contribution to a traditional IRA (the maximum contribution is $5,500 for 2014 and 2015; individuals age 50 or older can contribute even more), your IRA contribution will lower your adjusted gross income for the year of the contribution (or, in certain instances, the prior year). Thus, you may be able to defer paying income taxes on your IRA contribution (and on the earnings in your IRA) until you withdraw money from your IRA.
Even if your IRA contributions will not be tax deductible, the earnings that accrue on your contributions will grow tax deferred until you take an IRA distribution. If you leave your money in the IRA until you retire, you may enjoy an added tax benefit if you are in a lower tax bracket when you start taking distributions.
However, don’t forget to consider that if you withdraw funds from your IRA prior to age 59½, you'll be subject to an additional 10% premature distribution penalty tax unless an exception applies.
If you meet certain income requirements, you can contribute to a Roth IRA. With a Roth IRA, contributions are not deductible, but qualified distributions are free from federal income tax.
Employer-sponsored retirement plans
Employer-sponsored retirement plans represent a particularly effective method of deferring the payment of taxes on your earned income. There are numerous varieties of such plans (one of which is the 401(k) plan), and numerous methods of contributing to such plans.
Typically, a portion of your salary is deposited (by your employer) into the plan; you pay taxes on this portion (plus the earnings) only when you take a distribution from the plan. Thus, you are able to defer the taxation of part of your salary, and are able to take advantage of the tax-free build-up of any investment earnings.
Certain Roth variations of qualified plans may be available where contributions are not deductible, but qualified distributions are free from federal income tax.
If you withdraw funds from your employer-sponsored retirement plan prior to age 59½, you'll be subject to an additional 10 percent premature distribution penalty tax unless an exception applies.
Nonqualified deferred compensation plans
Nonqualified deferred compensation plans are contractual commitments by an employer to an employee to pay compensation in a future year.
If properly structured, the employee typically does not recognize taxable income currently; rather, he or she pays taxes when the money is received.
As mentioned previously, one advantage of deferring the recognition of income is that you may be in a lower tax bracket at the time the deferred compensation is paid.
Although premiums are paid with after-tax dollars, insurance-related vehicles can effectively defer taxes on accumulated earnings. Life insurance cash values grow tax-deferred until withdrawn or distributed and certain life insurance benefits may also be received tax free by your beneficiaries.
A modified endowment contract (MEC) is a class of life insurance contract that is treated differently than standard life insurance contracts for federal income tax purposes. In contrast to the tax treatment of a standard life insurance contract, you cannot withdraw your basis or investment in a MEC tax free until after taxable income is withdrawn.
When a distribution from a MEC occurs, it is first treated as taxable income (to the extent that the cash surrender value of the policy exceeds your investment in the contract), then as a recovery of capital or basis.
Annuities are arrangements in which you pay one or more premiums to an insurance company (or other financial institution) in exchange for the promise of a stream of payments representing a return of your premiums plus interest over some future period. You may be able to defer the payment of taxes on interest earnings until the money is withdrawn.
Presumably, you will not begin to receive annuity distributions until the future, when you are in a lower tax bracket. When distributions occur, the interest component of your annuity payments will be taxed at ordinary income rates.
Distributions before age 59½ may also be subject to a 10 percent federal penalty tax unless an exception applies.
Employment-related stock options
Employer stock options and certain other forms of equity-based compensation can be excellent tools for income tax deferral. There are several forms of equity-based compensation, including incentive stock options, nonqualified stock options, and employee stock ownership plans (ESOPs). Of these three, incentive stock options (ISOs) perhaps offer the most favorable tax treatment from the standpoint of an employee.
An employer stock option is a right or option granted by an employer to its employees to purchase shares of the employer's stock at a certain price, for a specified period of time. If an employer stock option qualifies as an ISO, the employee does not recognize any taxable income when he or she exercises the option. Instead, the employee recognizes taxable income or gain only when a disposition occurs (generally, this means when the stock is sold). The tax treatment of this disposition depends on whether he or she satisfies certain holding period requirements.
If you must sell capital property (other than stock or securities) in one year, you may be able to arrange with the purchaser to delay payment of part of the proceeds by having the payments made to you in installments over the next few years. This may be useful if you expect to have a substantial capital gain from the sale of a capital asset.
Under the installment method, you may be able to spread your gain from the sale over the taxable years in which you receive the installment payments (assuming that you report your income on the cash basis).
In addition to allowing you to defer the payment of tax on a portion of the gain on the sale, the installment method may allow you to reduce your total tax liability resulting from the sale and minimize the chance that the sale will push you into a higher tax bracket in the year of sale. However, be aware that you may be required to impute interest income on the unpaid balance.
Appreciating assets (stocks, bonds, real estate)
If you're in a high tax bracket and you purchase low-yielding investments with capital gain potential, such as growth stocks, the current income tax liability generated by your investments will be minimized. You may then be able to hold these investments until after you've retired, when your marginal tax rate may be much lower.
For a quick refresher on appreciating assets combined with Charitable Planning, click here.
Generally, if you trade business or tangible investment property for other business or investment property of a "like-kind," you will be able to defer recognition of gain or loss.
While your gain will eventually be subject to income tax (when you sell or dispose of the like-kind property), you may be able to defer taxation for a number of years. A number of requirements must be met in order to qualify for like-kind exchange treatment.
Working with a CFP® can be especially helpful as you implement your comprehensive financial plan. A CFP® can help you to coordinate with other professionals (CPA's, Attorney's etc.) to design and implement your plan.