Tax Deferment in 2023: What is it?

Tax deferment is a strategy that allows taxpayers to postpone paying taxes until a later date. By deferring taxes, taxpayers can reduce their current tax liability and potentially increase their future after-tax income. However, tax deferment is not a permanent tax avoidance method, and it may have some drawbacks depending on the individual or business situation. In this blog post, we will explain what tax deferment is, how it works, what are the common tax deferment strategies, and how to spot tax deferment opportunities in 2023.

Why Defer Taxes?

Taxes are an inevitable part of life, but they can also be a significant burden on your finances. Whether you are an individual or a business owner, you may be looking for ways to minimise your tax bill and maximise your net income. One of the ways to achieve this goal is to use tax deferment strategies.

Tax deferment is the process of delaying the payment of taxes on certain income or gains until a later date, usually when the taxpayer is in a lower tax bracket or has more deductions or credits available. By deferring taxes, the taxpayer can benefit from the time value of money, which means that a dollar today is worth more than a dollar tomorrow. The taxpayer can invest the money that would otherwise go to taxes and earn interest, dividends, or capital appreciation. The taxpayer can also reduce their current taxable income and lower their marginal tax rate, which is the percentage of tax applied to the last dollar of income.

However, tax deferment is not a free lunch. There are some trade-offs and risks involved in using this strategy. First of all, tax deferment does not eliminate taxes; it only postpones them. The taxpayer will eventually have to pay taxes on the deferred income or gains, plus any accumulated earnings, at their future tax rate. Depending on the type of income or gain and the tax rules at the time of realisation, the future tax rate may be higher or lower than the current one. 

Second, tax deferment may limit the taxpayer’s access to their money until they meet certain conditions or pay a penalty for early withdrawal. For example, if the taxpayer defers taxes by contributing to a retirement account, they may not be able to withdraw their money until they reach a certain age or face a 10% penalty. 

Third, tax deferment may expose the taxpayer to legislative risk, which is the possibility that the tax laws may change in the future and affect their tax situation unfavourably. For example, if the government decides to raise tax rates or eliminate certain tax benefits in the future, the taxpayer may end up paying more taxes than they expected.

Therefore, before using any tax deferment strategy, it is important to understand how it works, what are the benefits and drawbacks, and what are the alternatives. In the following sections, we will discuss some of the common tax deferment strategies for individuals and businesses and how to spot tax deferment opportunities in 2023.

Understanding Tax Deferral

Tax deferment can be applied to different types of income or gains, such as earned income, passive income, capital gains, dividends, interest, etc. Depending on the source and nature of the income or gain, there are different ways to defer taxes on them. Some of these ways are:

Benefits of Tax Deferral

The main benefit of tax deferment is that it can reduce your current tax liability and increase your future after-tax income. By deferring taxes, you can:

• Save money on taxes by paying them at a lower rate in the future.
• Invest the money that you save on taxes and earn more income from it.
• Reduce your taxable income and lower your marginal tax rate.
• Take advantage of certain tax credits or deductions that may not be available in the future.

For example, suppose you are an individual who earns $100,000 in 2023 and expects to earn $80,000 in 2024. You are in the 24% federal income tax bracket in both years. You have an opportunity to defer $10,000 of your income from 2023 to 2024 by contributing to a traditional IRA (individual retirement account). By doing so, you can save $2,400 in taxes in 2023 ($10,000 x 24%) and pay $1,920 in taxes in 2024 ($10,000 x 19.2%), assuming that your marginal tax rate drops from 24% to 19.2% due to your lower income. You can also invest the $2,400 that you save on taxes and earn $240 in interest at a 10% annual rate. Therefore, by deferring $10,000 of your income from 2023 to 2024, you can increase your after-tax income by $720 ($2,400 - $1,920 + $240).

Differences Between Tax Deferral Strategies for Individuals and Businesses

Tax deferment strategies can be used by both individuals and businesses, but there are some differences in how they work and what are the implications. Some of these differences are:

• Individuals can defer taxes on their earned income by contributing to retirement accounts, such as traditional IRAs, 401(k)s, 403(b)s, etc. Businesses can defer taxes on their profits by reinvesting them in the business or by using depreciation or amortisation methods that spread the cost of an asset over its useful life.
• Individuals can defer taxes on their passive income, such as interest, dividends, or royalties, by investing in tax-deferred or tax-exempt vehicles, such as annuities, municipal bonds, or qualified opportunity zones. Businesses can defer taxes on their passive income by using accrual accounting methods that recognize income when it is earned and expenses when they are incurred, rather than when they are received or paid.
• Individuals can defer taxes on their capital gains by holding their assets for more than a year and paying a lower long-term capital gains tax rate, or by using strategies such as like-kind exchanges, instalment sales, or opportunity zone investments. Businesses can defer taxes on their capital gains by using similar strategies or by reinvesting them in qualified small business stock or qualified opportunity zone property.
• Individuals and businesses can both defer taxes on their deferred compensation plans, such as bonuses, stock options, or pensions, by receiving them in a later year when they are in a lower tax bracket or have more deductions or credits available.

Common Tax Deferral Strategies

There are many tax deferment strategies available for individuals and businesses, but some of the most common ones are:

Retirement Accounts

One of the most popular ways to defer taxes on earned income is to contribute to a retirement account, such as a traditional IRA, 401(k), 403(b), etc. These accounts allow you to deduct your contributions from your taxable income in the year that you make them and pay taxes on your withdrawals in the year that you take them. 

The advantage of this strategy is that you can reduce your current taxable income and lower your marginal tax rate, as well as invest your money and let it grow tax-deferred until you retire. The disadvantage is that you may have to pay taxes at a higher rate in the future if your income increases or the tax rates change. You may also have to pay a 10% penalty if you withdraw your money before you reach the age of 59.5, unless you meet certain exceptions.

Capital Gains Deferral

Another common way to defer taxes on capital gains is to hold your assets for more than a year and pay a lower long-term capital gains tax rate. The long-term capital gains tax rate is currently 0%, 15%, or 20%, depending on your income level and filing status.

The advantage of this strategy is that you can pay less taxes on your capital gains than you would if you sold them within a year and paid the short-term capital gains tax rate, which is the same as your ordinary income tax rate. The disadvantage is that you may have to pay taxes at a higher rate in the future if the long-term capital gains tax rate increases or if your income level changes.

Alternatively, you can use other strategies to defer taxes on capital gains, such as:

• Like-kind exchanges: This strategy allows you to exchange one property for another of the same kind without recognizing any gain or loss. For example, you can exchange one rental property for another rental property without paying any taxes on the difference in value. However, this strategy only applies to real estate and certain personal property used for business or investment purposes. It does not apply to stocks, bonds, or other securities.
• Instalment sales: This strategy allows you to sell an asset and receive payments over time rather than in a lump sum. By doing so, you can spread your gain over several years and pay taxes only on the portion of each payment that represents your gain. For example, if you sell a property for $100,000 with a $20,000 down payment and $80,000 in equal annual instalments over four years, you can pay taxes only on $5,000 of gain each year ($20,000 x 25%). However, this strategy may expose you to the risk of default by the buyer or changes in interest rates.
• Opportunity zone investments: This strategy allows you to defer taxes on capital gains by investing them in qualified opportunity zone funds within 180 days of selling your asset. These funds invest in designated low-income communities that offer economic development potential. 

By doing so, you can defer paying taxes on your original gain until December 31, 2026 or until you sell your opportunity zone investment, whichever comes first. You can also reduce your taxable gain by 10% if you hold your investment for at least five years and by another 5% if you hold it for at least seven years.

Moreover, you can exclude any additional gain from your opportunity zone investment if you hold it for at least 10 years. However, this strategy requires a long-term commitment and may involve high risk and uncertainty.

Deferred Compensation Plans

Another common way to defer taxes on earned income is to participate in a deferred compensation plan, such as a bonus, stock option, or pension plan. These plans allow you to receive compensation in a later year when you are in a lower tax bracket or have more deductions or credits available. 

The advantage of this strategy is that you can reduce your current taxable income and lower your marginal tax rate, as well as enjoy the potential growth of your compensation over time. The disadvantage is that you may have to pay taxes at a higher rate in the future if your income increases or the tax rates change. You may also lose your compensation if your employer goes bankrupt or fails to honour the plan.

Municipal Bonds

Another common way to defer taxes on interest income is to invest in municipal bonds, which are debt securities issued by state or local governments or their agencies. The interest income from these bonds is generally exempt from federal income tax and may also be exempt from state and local income tax, depending on where you live and where the bond is issued. 

The advantage of this strategy is that you can earn tax-free income and support public projects that benefit your community. The disadvantage is that municipal bonds may have lower interest rates than other bonds and may be subject to market risk, credit risk, or inflation risk.

Qualified Opportunity Zones

Another common way to defer taxes on capital gains or passive income is to invest in qualified opportunity zones, which are designated low-income communities that offer economic development potential. 

As mentioned earlier, this strategy allows you to defer taxes on capital gains by investing them in qualified opportunity zone funds within 180 days of selling your asset. You can also defer taxes on passive income by investing in qualified opportunity zone businesses that meet certain criteria, such as generating at least 50% of their gross income from active conduct within the zone. 

The advantage of this strategy is that you can defer paying taxes on your original gain or income until December 31, 2026 or until you sell your opportunity zone investment, whichever comes first. You can also reduce your taxable gain or income by 10% if you hold your investment for at least five years and by another 5% if you hold it for at least seven years. Moreover, you can exclude any additional gain or income from your opportunity zone investment if you hold it for at least 10 years. The disadvantage is that this strategy requires a long-term commitment and may involve high risk and uncertainty.

Spotting Tax Deferral Opportunities in 2023

Tax deferment opportunities may vary depending on your individual or business situation, your income level, your tax bracket, your goals, and the tax laws in effect. Therefore, it is important to consult with a qualified tax professional before using any tax deferment strategy. However, some general tips to spot tax deferment opportunities in 2023 are:

• Review your sources of income and gains and identify which ones are eligible for tax deferment.
• Compare your current and expected future tax rates and determine whether deferring taxes will benefit you in the long run.
• Consider your liquidity needs and risk tolerance and decide whether you can afford to lock up your money for a certain period of time or expose it to market fluctuations.
• Research the available tax-deferred or tax-exempt vehicles and choose the ones that suit your objectives and preferences.
• Monitor the changes in the tax laws and regulations and adjust your strategy accordingly.

Stay on Top of Taxes

Tax deferment is a strategy that allows taxpayers to postpone paying taxes on certain income or gains until a later date. By deferring taxes, taxpayers can reduce their current tax liability and potentially increase their future after-tax income. However, tax deferment is not a permanent tax avoidance method, and it may have some drawbacks depending on the individual or business situation. Therefore, before using any tax deferment strategy, it is important to understand how it works, what are the benefits and drawbacks, and what are the alternatives.

In this blog post, we have explained what tax deferment is, how it works, what are the common tax deferment strategies, and how to spot tax deferment opportunities in 2023. We, at Aniday hope that this information will help you make informed decisions about your tax planning and optimise your financial situation. And for any future Hiring and Payroll Solutions including consulting for Tax Deferral strategies for new hires, choose Aniday as your number one choice