Taxes and Deferring Income
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Deferred income tax refers to an accounting principle where an amount of money that has been realized as income in the current year is not taxed until the following tax year.
The variation between realized income and taxes paid on the income results from timing differences in the way that gains and losses are counted for accounting purposes and tax purposes.
Using Retirement Accounts to Defer Income
Deferred income tax is available for different types of retirement accounts, allowing individuals to declare the income years later when they may be in a lower tax bracket after they retire. If they were to pay taxes on the money in the year they earned it, the tax rate may be higher (i.e. 33%) versus the tax rate after retirement, which may be much (i.e. 25%).
Variations on deferred tax retirement accounts include plans such as 401K and IRA structures which allow the earned income in the account to be deferred and taxed at a later time, but which generally require the initial tax on the investment to be paid in the year it was earned.
To gain benefits from deferring taxes on retirement accounts, individuals should make sure that they will actually be in a lower tax bracket at the time they wish to withdraw the funds.
Defer Payment Using Investment and Rental Property
Deferred income tax is available for different types of investments, including investments in real estate that are intended to be for profit (i.e. a rental property, not a primary residence). Known as 1031 Exchanges, real estate can be exchanged for different property that is of “like-kind” to the real estate formerly held.
Essentially, if a taxpayer has one duplex home used for rental income, that taxpayer can sell that unit and buy another duplex of similar size and value, and defer the associated capital gains taxes.
The theory of deferred taxation in real estate is that there is a benefit to the investor reinvesting their funds into more real estate instead of keeping the profits and realizing the gains.
How to Defer Payment using Investments
Taxpayers can utilize the benefit of deferred payments on certain types of investments. As a general matter, a taxpayer will want to research investment that will allow them to avoid paying federal income taxes on money invested until the time that they actually withdraw the money from the investment and realize the gains.
Taxpayers can defer tax payments by putting their money in qualified investments (i.e. IRA’s, qualified investment properties, etc.), and defer payment on the earnings and income that the contributions produce for the duration of the time they remain invested.
The most advantageous investments for deferred tax purposes are those which allow taxpayers to invest pre-tax dollars; thus, avoiding the income tax in the year the money was earned and avoiding the gains produced by the earned interest until the funds are later withdrawn.