Deferring Income Taxes: Is This Gaining Popularity?
Although paying your income taxes is rarely something that people like to think about, deferring your taxes has become a popular topic. Simply put, deferring taxes relies on legal strategies that let you pay taxes in a future year on money that you earn this year and it’s something that just about anyone can do. Deferring your taxes lets you hold on to your money longer and the longer you keep your money, the more opportunities you have to put it to work for you by investing the money instead of turning it over right away to the government.
Some of the most common ways to defer taxes are through certain types of retirement accounts, real estate transactions and some types of investments. Knowing this, it’s always a good idea to consult with a tax professional, such as an accountant or CPA, to understand your options. They can also help you make sure you’re choosing the best option for you.
Employer-Sponsored Tax-Deferred Retirement Accounts
There are several different kinds of employer-sponsored tax-deferred accounts that let you save money for retirement, earn interest on your savings and avoid paying taxes until you use the money. These accounts include 401(k), 403(b) and 457 accounts.
The most common and well known of these plans are 401(k) accounts. Employees can put money in these accounts on a pre-tax basis, which means that the money comes out of your check before taxes are calculated. Often, the employer will also contribute money into the account that matches all or part of your contribution. Because money is automatically deposited into your 401(k) account, you can build your savings without having to think about it. With 401(k) plans, you get a lower taxable income and free money from your employer and the best part is that you don’t pay taxes on any of it until you’re ready to use it.
Other retirement accounts such as 403(b) and 457 accounts work the same way as a 401(k) but are for employees who work for educational, non-profit or government employers. If you work for a company that offers a deferred retirement account, it usually smart to take advantage of it. While accounting professionals can walk you through this information, there are actually many free accounting that can help increase your financial savvy and awareness.
Tax-Deferred Individual Retirement Accounts
If you don’t have the option to invest in an employer-sponsored account or if you want to supplement your retirement nest egg, you can get many of the same tax-deferred benefits from an Individual Retirement Account, or IRA. An IRA works like a savings account, except that it has some important tax benefits. The two main types of IRAs are traditional accounts and Roth IRAs. The main difference between the two types is when you have to pay taxes on the money you put in the account. With a traditional 401(k), your contributions are pretax, meaning you get to subtract them from your taxable income and lower your taxes in the year you make the contribution. You don’t avoid taxes entirely, though; you’ll pay income taxes on your contributions and any investment earnings, when you withdraw the money. Typically, you will make withdrawals when you’re retired; the tax on your withdrawals is determined by your marginal tax rate (in the year you make a withdrawal). With a Roth 401(k), you pay income taxes on your contributions up front. Your contributions do not reduce your taxable income. But—and this is a big but—the money in your Roth grows tax free, so you won’t have to pay any tax on your withdrawals, including any investment earnings, when you retire, if certain qualifications are met
Deferring Taxes Using Real Estate
If you own rental properties, including residential and commercial properties, you can take advantage of a transaction called a 1031 exchange which lets you exchange your rental or business property for like-kind property. These transactions can get complicated, but many investors use them to defer capital gains taxes.
If you’re selling a property, you can also defer capital gains taxes until the following year by moving the closing date to the next tax year, assuming the buyer agrees. For example, by moving the closing date on the sale of your home forward from December 1, 2012 to January 1, 2015, instead of paying capital gains taxes when you file your tax return in April 2015, you don’t have to pay them until you file a return in April 2014.
Investments That Can Help You Defer Taxes
Some types of investments, like annuities, also let you defer taxes. You can invest in an annuity and avoid paying federal income taxes on the amount you invest and any interest you earn until you withdraw the money. Some investments also have the benefit of letting you invest pre-tax dollars. Like 401(k) plans and other deferred retirement accounts, these types of investments let you avoid paying taxes on your earnings, your original investment and the interest from your investment until you withdraw the money.
Deferring Taxes is a Smart Way to Save Money and Build Wealth
By deferring the taxes you pay on your income until you actually need it, you can save more money and build wealth more quickly. In addition, you may be able to pay less tax by withdrawing the money once you’re in a lower tax bracket. Tax brackets are determined by income levels, which tend to be higher during your prime working years and lower after retirement. For example, if you’re in a 28% tax bracket for the majority of your working years, you may drop to a 15% bracket once you retire. If you pay taxes on your earnings and investments during your working years, you would pay 13% more in taxes than if you wait, or defer, your tax bill until you retire. Deferred retirement accounts have the additional benefit of making it painless and easy to save for retirement.