Wouldn’t it be nice to delay paying your taxes? If you are working and trying to save money, wouldn’t be nice to skip your tax for a while so you have more money in your pocket?
Well, there are a few things you can do to delay paying taxes. These deferrals do not eliminate your tax, but rather delay them until you are better able to pay the tax, or until you retire when your tax rate should be lower.
Most of these deferral schemes are attached to retirement plans. We’ll go over two of them.
The primary vehicle for deferring tax is through employer sponsored 401K plans. The money that goes into a 401K is usually “pre-tax” money. This means that your contribution comes out of your paycheck before tax is applied. This money will eventually be taxed, but not until it is withdrawn from the account after you retire. This benefit also applies to the matching contributions that come from your employer.
The second tax benefit of 401Ks is that any gains you make on the investments inside the 401K are not taxed. So, as you buy and sell investments, or earn dividends, you incur no capital gains taxes that could take a chunk out of your investments. This allows greater compounding and growth of your retirement money.
Once you start taking funds out of a 401K, the withdrawals will be taxed as ordinary income. And once you have retired, your tax rate should be lower than when you were employed. This deferral of taxes until you’re in a lower tax bracket is the key benefit of a 401K.
Another vehicle for deferring tax is through a Traditional IRA. But there is a catch to Traditional IRAs. If you or your spouse has access to a retirement plan at work, then the benefit of pre-tax contributions can vanish. The lines are drawn according to earnings limits and how you file your taxes. Check the IRS web site to see the earning limits.
But even if your Traditional IRA contributions are “non-deductible” (after-tax), the contributions can still grow in the account tax free, thereby avoiding capital gains taxes that would be applied in a regular account.
Like a 401K, funds in Traditional IRAs are taxed as ordinary income when they are withdrawn in retirement, when your tax rate is (hopefully) lower.
There is one other account we should mention: A Roth IRA. These accounts are not tax-deferred accounts. You contribute after-tax money, so the tax advantages do not involve deferring your tax. But there are significant tax benefits to these accounts. The funds in these accounts can grow tax free like in a traditional IRA and 401K. But best of all, once you retire, your withdrawals are “tax exempt.” You’ve paid tax on these funds before they went it, so your withdrawals are tax-free.
There are earning limits associated with these accounts. If you earn too much, you will not be eligible for a Roth IRA. To see the earnings limits, check the IRS web site here.
One very important thing to note with all of these accounts is that they are geared towards retirement. If you need to access these funds before retirement, you will incur a 10% penalty on the withdrawal as well as all applicable taxes. This will result in a substantial loss of savings. Make sure any money you put into these accounts doesn’t need to be accessed before you retire.
One final way the US tax system allows for tax deferrals is through a 1031 like-kind exchange. These are specifically created for people using property as an investment. It allows for the deferral of capital gains taxes on the sale of an investment property if the proceeds are rolled into a “like-kind” property that is identified within 45 days and bought within 180 days. It is a very specific, very complicated benefit, but one that can defer capital gains tax indefinitely.
We should also note that this benefit does not apply to second homes or vacation properties. Sorry! The property in the sale must be an investment property. But property can include things like art or antiques, as long as they were purchased as an investment.
In the end, you can’t really avoid paying tax. You’ll have to pay them some time. But you can defer it into the future giving you some flexibility about when you want to pay. Hopefully these opportunities will leave a bit more money in your pocket when you most need it and help you save for the future.