Tax Deferral

Tax deferral refers to a financial strategy whereby the taxpayer can postpone the payment of income tax on the earnings made from specific investments until a future date. Thus, it allows the investor to reap the compounding benefit by reinvesting the returns over the period.

It aims to foster tax-deferred growth of investments, i.e., not incurring any immediate tax liability on the underlying gains and focusing on wealth maximization in the long run. Moreover, it encourages the taxpayers to save and invest more for the future, thus making it a critical part of a taxpayer's tax planning strategy.

Tax deferral is a program that allows investors or taxpayers to delay their tax liability on the income generated from a particular investment plan to a future date. Usually, when people are working and earning actively, they fall into a high-income bracket for tax purposes. Thus, their taxable income and the rate of taxation are also high. However, when these individuals retire, their income also decreases, putting them in a lower tax bracket. Thus, deferring taxes on qualified investment plans can save them a significant amount on income tax when payable at a future date after their retirement.

One such plan is the 1031 exchange tax deferral, which allows capital gain benefits to property owners who swap a property used for business or investment with another real estate for the same use. Another excellent option for employees is the 401k tax deferral plan, in which employers contribute to employees' retirement benefits.

Nonetheless, as commonly believed, there are better plans than delaying taxes. Taxpayers should consider future tax brackets, potential tax rates, and their investment strategy before pursuing any tax deferral strategy. Also, in some situations, taxable accounts may be better due to preferential taxation on returns, tax-loss harvesting, and favorable treatment for estate planning purposes. On the other hand, tax-deferred accounts are often suitable for picking investments with high taxation, postponing immediate tax consequences, expecting lower future tax rates, planning Roth IRA conversions, or earmarking assets for charity. Hence, taxpayers must extensively plan their moves to achieve long-term financial success.

The individuals require proper tax and retirement planning to devise suitable strategies based on individual needs, as discussed below:

1. Life Insurance: Life insurance plans often provide deferred tax benefits since the tax liability is imposed at the time of withdrawal on maturity or distribution of money to the beneficiaries. Also, some plans offer tax-free income to the beneficiaries.
2. Traditional Individual Retirement Accounts (IRAs): The IRAs provide financial freedom after retirement. In traditional IRAs, taxpayers can put money from their pre-tax income. However, any early withdrawals will result in a 10% penalty for the account holders.
3. Employer-Sponsored Retirement Plans: Employers can contribute to various employer-sponsored retirement plans for their employees, most of which have the tax deferral benefit. Some of these are 401(k), 457, 403(b), SIMPLE IRA, SEP IRA, and pension plans.
4. Employee Stock Options: The employee stock options are the compensation received by the workers in the form of equity. The employees can avail themselves of tax-free redemption by exercising the employee stock options that are eligible for incentive stock options (ISOs). 
5. Annuities: The annuity plans allow individuals to deposit premiums with their insurance company for a secured future, i.e., in return, they would receive a steady future income or save the principal investment. Such income is often tax deferred until claimed or distributed.
6. Health Savings Account: Similar to IRAs, the contribution in HSAs is made from income before taxation; however, its primary purpose is to cover the holder's medical costs. The money in such an account is compound tax-free until withdrawn for qualified healthcare expenses.
7. Non-Qualified Deferred Compensation (NQDC) Plans: Under an NQDC plan, the employers enter into a contract with the employees whereby they assure them of compensation payable at a future date. Such an income is subject to deferred tax payment, i.e., on the date when it will be realized.

Now that we know how tax deferrals help individuals, especially the high-income group, to save taxes by delaying such liability to a future date, let us have a look at some instances of deferring tax liability:

Example #1

Suppose there are two employees, A and B. Employee A has taken out a taxable investment plan in 2022. In contrast, Employee B has taken a tax deferral plan, say a traditional IRA tax deferral, on the same day. Now, if they both invest $1,000 annually and receive 10% annual interest, their tax liability at present is 30% according to their slab, but it will be 15% when they retire from their job after 30 years. Therefore, A and B will have the following gains after tax on reaching the retirement age:

Solution:

Employee A:

After 30 years:

Principal Amount = $30,000

Interest = $46,500

Total Tax Liability = 30% of 46,500 = $13,950

Net Gain After Tax = $62,550

Employee B:

After 30 Years:

Principal Amount = $30,000

Compound Interest = $1,80,943.42

Total Tax Liability = 15% of 1,50,943.42 = $22,641.513

Net Gain After Tax = $1,78,678.90

Hence, we can see that employee B gets a higher after-tax return due to the capital gain tax deferral.

Example #2

Due to COVID-19 concerns, President Trump's executive order on payroll tax deferral has created uncertainty among employers and employees. The order is similar to a paycheck advance, except it must be repaid later. It applies to those earning less than $104,000 from September to December 2020. However, there needs to be more clarity about employees' ability to opt-out, the repayment process, and whether companies will pass the savings to workers. Moreover, people are worried about the potential legal challenges and logistical complexities, like the impact of tax deferring on individuals who would change jobs during this period. Ultimately, the order has brought a lot of confusion that needs clarification from the IRS and the Treasury Department of the US.

If done efficiently, tax deferrals can provide potential tax planning benefits immediately and in the long run; some of these advantages are as follows:

• Provides Compounding Benefit: It encourages the investors to keep their money invested (both principal and gains) to yield higher after-tax returns in the future.
• Reduces Current Tax Liability: The taxpayers can curtail their current income tax liability when they fall in a higher tax bracket by deferring taxes on specific investments. 
• Encourages Retirement Savings: The deferring of taxes through savings in IRAs, annuities, health plans, etc., can help taxpayers save and grow money for their retirement.
• Brings Financial Discipline: When the current tax burden is decreased, the individuals get motivated to spend less and invest or save more, fostering a sense of financial discipline.
• Future Wealth Accumulation: Such plans leave the taxpayers with much more gains compared to the fully taxable investments, thus accumulating wealth in the long run.
• Delays Tax Liability: The gains from such investments may be taxable at a lower rate since they would be withdrawn after the taxpayer's retirement when they would fall in a lower tax bracket.