An effective tax strategy is a year-long process. It requires planning, evaluation and review. While eliminating taxes is nearly impossible, tax deferral strategies allow you to delay payment and lower your overall tax obligation. If you have a high net worth, are in a high-income bracket or intend to sell highly appreciated assets, you could owe a hefty tax bill unless you take steps to offset or lower your taxes.
Why Should You Implement Tax Deferral Strategies?
Deferring your taxes doesn’t necessarily mean you avoid paying them forever. However, it does prevent you from paying a large sum in any given year. The benefits of tax deferment include:
- Increased retirement savings: Many strategies give you more income for retirement, helping you secure a comfortable living.
- Increased control: While you may still owe taxes, deferment strategies place you in the driver’s seat. You have much more control over when you pay your taxes and how much you owe in any given year.
- Increased wealth: Using strategies that allow you to invest your money in tax-deferred products prevents you from paying taxes until you draw on the money and increases your wealth through investment returns and compounded interest.
- Reduced taxes: When you draw down on tax-deferred investments, your income may put you in a lower tax bracket, reducing how much you pay in the long run.
Tax deferral strategies allow you to put your money to work for you, improving your current and future financial security.
What Strategies Are Used Most Often?
The best approaches are the ones that offer you the greatest benefits now and into the future. Here are four methods that often allow you to get the most mileage from deferring your taxes.
1. Contribute to Retirement Accounts
Whether you work for a company that offers retirement benefits, you can contribute to retirement accounts. Your options include:
- Employer-sponsored plans: Employer-sponsored retirement plans include 401(k), 403(b) and 457 plans. The government allows you to contribute up to a specified pre-tax amount. In 2023, the total contribution limit is $22,500 for those under 50. If you’re 50 or older, you can bump that amount up to $30,000. Annually, you can contribute up to $6,500 or $7,500 if you are at least 50.
- Traditional individual retirement accounts: If you don’t have an employer-sponsored plan, you can open a traditional IRA with the same limits as employer-sponsored plans. If you participate in a 401(k), 403(b) or 457 plan, you may still be able to make pre-tax contributions to a traditional IRA, but the limit decreases as your income increases.
If you are self-employed, you can choose between any of the retirement vehicles.
2. Invest in Tax-Deferred Investment Vehicles
In addition to retirement account contributions, other investment vehicles qualify for tax deferment.
Cash-Value Life Insurance
Cash-value life insurance is among the most popular tax deferral strategies for high income earners. While your beneficiaries generally won’t pay taxes on the death benefits they receive when you take out a life insurance policy, cash-value life insurance, such as whole life policies, provides a tax benefit to you.
You still pay taxes on the amount you pay into the policy. However, the cash value portion of your premiums grows through interest and investment returns. You won’t pay taxes on those earnings unless you draw money from the account (another benefit of these policies).
529 Education Plan
Another tax-deferred investment vehicle is a 529 education plan. These plans allow you to save money for education expenses. Like cash-value life insurance, you pay taxes on contributions, but they grow tax-free. However, you won’t be taxed on withdrawals if they are for qualified education expenses.
Health Savings Account
Health savings accounts work the same way as 529 education plans, except you must use the money for qualifying medical expenses to receive the full tax benefits.
Annuities
An annuity is an agreement between you and an insurance provider. You make one or more payments to the insurer in return for an income stream at a later date. The money you pay grows tax-free, but you’ll owe taxes when you begin receiving payments.
3. Invest in Municipal Bonds
Municipal bonds are loans to a local or state government. When you enter into a loan agreement, the government makes monthly payments to cover the interest on the money you loaned. The interest payments you receive are tax-free at the federal level but may incur taxes at the state or local level.
Once the bond reaches maturity, the government pays you the amount it borrowed in full. Unless you reinvest it using another tax deferral strategy, you will owe taxes on the loan amount. However, you can choose short-term bonds that mature in one to three years or long-term bonds that won’t mature for 10 years or more, giving you control over when you pay taxes.
4. Open a Deferred Sales Trust
A deferred sales trust is one of the best capital gains tax deferral strategies. If you have highly appreciated assets (such as real estate, jewelry or art), selling them can lead to a high tax bill. Though long-term capital gains are generally taxed at 0%, 15% or 20%, the government taxes short-term capital gains as regular income.
A deferred sales trust allows you to delay and potentially reduce capital gains taxes while growing the profits from a sale and providing a future income stream. Reef Point works with you to establish a trust before you sell the asset. You agree on the terms, including when you will start receiving payments and how much you will receive monthly.
After the asset’s sale, the profits go to the trust, and the trustee invests in suitable investment vehicles. You won’t pay taxes on the money as long as it is in the trust. Once you begin receiving payments, you will owe taxes for the amount you receive in a given year. Often, these payments place you in a lower tax bracket, reducing your overall tax burden.
Talk to a Reef Point Advisor
Reef Point’s sole purpose is to help you implement tax deferment strategies to save money and improve your financial security. Contact us today to find out if a DST is suitable for you.
Sources:
https://www.irs.gov/newsroom/401k-limit-increases-to-22500-for-2023-ira-limit-rises-to-6500
https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people