Deferring taxable income is usually a good idea, but here’s how it can work against you
Conventional wisdom says that taking action to defer your current individual federal income bill is almost always a good idea. That’s right, if you expect to be in the same tax bracket or in a lower tax bracket in the years to come, and you are right about it.
If so, taking steps to reduce taxable income this year will at least give you more money to work on until the bill comes due. If your tax rate drops, deferring taxable income to future years will result in the deferred amount (s) being taxed at lower rates. Awesome.
But is it really very likely? I do not think so. So, let’s discuss the possibilities for tax deferral and their relevance to you in today’s uncertain tax environment. Here is.
Tax deferral opportunities
Among individual taxpayers, small business owners have the most opportunity to defer taxable income. See this previous Tax Guy column for more details.
If you are not a small business owner, you can defer taxable income by prepaying expenses that result in higher itemized deductions, maximizing workplace pension contributions, making installment sales of goods and by arranging for similar exchanges of real goods. succession while you still can.
But wait: is tax deferral a no-brainer this year?
Uh no. You could have a “too big” tax deferral. Here’s why.
The current image
For 2018-2025, the Tax Cuts and Jobs Act (TCJA) reduced federal income tax rates for most individuals.
Currently, the top federal tax rate on ordinary income and short-term net capital gains recognized by individual taxpayers is 37%.
Those with higher incomes may be hit by the additional Medicare tax of 0.9% on a portion of their salary and / or net self-employment income.
The maximum federal rate on most long-term net capital gains is 20% for very high income earners. However, the vast majority will pay 15%, and those with modest incomes might pay 0%. The same preferential rates apply to eligible dividends.
High income earners may be subject to a Net Investment Income Tax (NIIT) of 3.8% on all or part of their net investment income, which includes capital gains and dividends.
The Biden tax plan is at stake
Higher tax rates before the TCJA are expected to return after 2025. But higher rates could be there much sooner if some or all of President Joe Biden’s tax increase proposals are passed by Congress. If that happens, they could go into effect as early as this year, but I think an effective date of 2022 would be a better bet.
The Biden plan would raise the top federal personal tax rate from 37% to 39.6%, apparently for single tax filers with taxable income above about $ 450,000 and married spouses with higher taxable income at around $ 500,000.
For those with taxable income over $ 1 million, Biden wants to increase the long-term capital gains rate to 39.6% plus the NIIT of 3.8%. This would equate to a maximum effective rate of 43.4% (39.6% + 3.8%), up from the current maximum effective rate of 23.8% (20% + 3.8%). Biden wants to make this increase retroactively effective, to touch the gains triggered as of April 1 of this year.
With possible tax rate increases on the table, think twice before deferring taxable income this year, as deferred amounts could end up being taxed at higher rates in 2022 and beyond. Or not, because it’s not clear whether Congress wants to raise taxes. That said, it’s hard to believe that the current relatively low rates will last too long.
Work with your tax advisor to make projections about what would happen to your future tax bills under various scenarios.
Consider tax-efficient measures that don’t involve tax deferral
Good idea. Here is some.
No tax deferral: Roth IRA
Since qualified Roth IRA withdrawals are free of federal income tax, Roth accounts offer the ability to avoid tax altogether, as opposed to deferring tax. So, making annual contributions to a Roth IRA (if your income allows it) is an attractive alternative to “too much” tax deferral for those who expect to pay higher tax rates during retirement. Good.
Converting a traditional IRA to a Roth account allows you to prepay your federal IRA income tax bill on the current IRA account balance at current low rates instead of paying higher future rates on the account balance. current and future income of the account.
No tax deferral: Roth 401 (k) accounts
The Roth 401 (k) agreement is essentially a traditional 401 (k) plan with added Roth account functionality. If your employer offers a 401 (k) plan with the Roth option, you can contribute after-tax dollars to a Roth Designated Account (DRA) created under the plan. The DRA is a separate account from which you can potentially take eligible distributions free of federal income tax. Thus, making DRA contributions is another attractive alternative to “too much” tax deferral for those who expect to pay higher tax rates during retirement.
Note that unlike annual Roth IRA contributions, the ability to make DRA contributions is not phased out at higher income levels. I will cover DRA contributions in detail in a future column.
No tax deferral: health savings accounts (HSA)
If you are covered by an under-generous health plan, you may be eligible to open and contribute to a Tax-Advantageous Health Savings Account (HSA).
HSA contributions are deductible and withdrawals are income tax free when used to cover eligible medical expenses. Thus, HSAs offer outright tax evasion as opposed to tax deferral.
For the 2021 tax year, you can make a deductible HSA contribution of up to $ 3,600 if you have qualifying individual coverage or up to $ 7,200 if you have qualifying family coverage (other than individual coverage). ). If you are 55 or over at the end of the year, the maximum contribution increases by $ 1,000.
You must have a qualifying high deductible health insurance policy and no other general health coverage to be eligible for the HSA contribution privilege. For 2021, a high deductible policy is defined as a policy with a deductible of at least $ 1,400 for single coverage or $ 2,800 for family coverage.
Even billionaires can contribute to health savings accounts if they have high deductible health insurance coverage and meet other eligibility requirements for HSA contributions.
For 2021, eligible policies may have maximum amounts of up to $ 7,000 for individual coverage or $ 14,000 for family coverage.
If you are eligible for an HSA contribution, you have until April 15 of the following year (adjusted for weekends and holidays) to open an account and make a deductible contribution for the previous year. So, there is a lot of time to open an account and make a deductible contribution for 2021, as the deadline is 4/15/22.
The write-off of HSA contributions is an above-the-line deduction. This means that you can write off even if you don’t detail. More good news: the HSA contribution privilege is not lost just because you have a high income. If you are covered by eligible health insurance with a high deductible, you can make deductible contributions and receive the resulting tax savings. Even billionaires can contribute if they have high deductible health insurance coverage and meet other requirements for HSA contribution eligibility.
No tax deferral: take withdrawals from your retirement account (gasp!)
This idea will make some tax advisers recoil in horror. But it still is: Consider withdrawing withdrawals from your tax-deferred retirement account (s) now when tax rates are low, rather than later when tax rates could be higher. .
You may be prevented from doing this with a business plan, such as a 401 (k), but you can do it with a Traditional IRA or a Independent SEP-IRA. However, making a traditional IRA withdrawal before the age of 59 and a half is usually a bad idea, as you’ll be subject to the dreaded 10% early withdrawal penalty, unless you qualify for an exception. For the list of exceptions, see this Tax Guy.
Also, don’t make withdrawals from a Roth account earlier than necessary. You want Roth balances to remain intact so that you can continue to earn tax-free federal income and earnings.
The bottom line
Work with your tax advisor to determine if you might have a “too” large tax deferral, taking into account what I believe to be the near-certainty of higher federal tax rates in the years to come. Higher rates are unlikely to happen this year and may not happen next year. But they’ll be here before too long, IMHO.