Tax Deferral Strategies You Should Know About

Tax deferral is a financial strategy that postpones the payment of taxes on investment gains or other income. This legal method delays, not eliminates, tax obligations. By deferring taxes, the money that would have been paid to the government remains invested and can continue to generate earnings. This allows an investment to grow without the annual reduction from taxes on interest, dividends, or capital gains.

This uninterrupted compounding can lead to a larger accumulated sum over time compared to an investment in a taxable account. Taxes are paid when funds are withdrawn, often during retirement when an individual may be in a lower tax bracket.

Utilizing Retirement Accounts for Tax Deferral

Employer-sponsored retirement plans are a common vehicle for tax deferral, with the Traditional 401(k) being a primary example for private sector employees. Contributions to a Traditional 401(k) are made on a pre-tax basis, reducing current taxable income. For instance, if an individual earns $80,000 and contributes $10,000, they are only taxed on $70,000 of income for that year. The invested funds benefit from tax-deferred growth, and withdrawals in retirement are taxed as ordinary income.

The 403(b) plan offers similar tax deferral for employees of public schools, certain non-profit organizations, and churches. Contributions are pre-tax, and withdrawals are taxed in retirement. Some 403(b) plans have a special catch-up provision for employees with at least 15 years of service, allowing for additional contributions beyond standard limits.

The Traditional Individual Retirement Arrangement (IRA) is an option for those without an employer plan or who wish to save more. Contributions may be tax-deductible, depending on income and coverage by a workplace retirement plan. Funds benefit from tax-deferred growth, and withdrawals in retirement are taxed as ordinary income.

Self-employed individuals and small business owners can use specialized retirement plans. The Simplified Employee Pension (SEP) IRA allows an employer, including a self-employed person, to make tax-deductible contributions for employees. The Savings Incentive Match Plan for Employees (SIMPLE) IRA allows contributions from both the employee and employer. While SIMPLE IRAs have lower contribution limits than SEP IRAs, they can be less complex to administer.

Deferring Taxes on Investment Gains

Under Section 1031 of the Internal Revenue Code, a like-kind exchange allows a real estate investor to defer capital gains taxes by selling an investment property and reinvesting the proceeds into a new one. This strategy is limited to business or investment properties. The term “like-kind” is broad; for example, an apartment building can be exchanged for raw land.

A 1031 exchange has strict timelines. An investor must identify a replacement property within 45 days of the original sale and complete the acquisition within 180 days. To fully defer the tax, the replacement property’s value and debt must be equal to or greater than the property sold. Any cash or other non-like-kind property received, known as “boot,” is generally taxable.

Investing in Qualified Opportunity Zones (QOZs) is another method to defer capital gains. An investor can defer tax on gains from any asset sale by reinvesting them into a Qualified Opportunity Fund (QOF) within 180 days. A QOF is a fund that invests in economically distressed communities designated as QOZs.

The reinvested capital gain is not taxed until the investment is sold or December 31, 2026, whichever comes first. If the QOF investment is held for at least 10 years, any appreciation on the fund investment itself can be permanently excluded from capital gains tax upon its sale.

Business and Executive Compensation Strategies

Under Section 453 of the Internal Revenue Code, an installment sale allows a business owner to defer taxes when selling a company or asset. This structure involves receiving at least one payment after the tax year of the sale, allowing the seller to recognize the taxable gain as payments are received. Spreading the gain can spread out the tax liability and potentially keep the seller in a lower tax bracket each year.

The seller reports the gain on Form 6252. If installment obligations from certain sales exceed $5 million, the seller may owe interest to the IRS on the deferred tax. This strategy is not available for sales of inventory or publicly traded securities.

Incentive Stock Options (ISOs) offer tax-deferred compensation, primarily for executives. Unlike Non-qualified Stock Options, exercising an ISO does not immediately trigger regular income tax on the difference between the stock’s market value and the exercise price. This tax is deferred until the employee sells the shares.

If the employee holds the stock for at least two years from the grant date and one year from the exercise date, the entire gain is taxed at long-term capital gains rates. The gain from exercising an ISO is an adjustment item for the Alternative Minimum Tax (AMT), which could create a tax liability in the year of exercise.

Leveraging Other Tax-Advantaged Accounts

A Health Savings Account (HSA), available to those with a high-deductible health plan (HDHP), offers a triple tax advantage that includes tax deferral. Contributions are tax-deductible, the funds experience tax-deferred growth, and withdrawals for qualified medical expenses are tax-free. Unlike a Flexible Spending Account (FSA), HSA funds are not subject to a “use-it-or-lose-it” rule. The balance rolls over annually, allowing it to compound over the long term.

A 529 plan is designed for education savings and utilizes tax deferral. While federal contributions are after-tax, many states offer a tax deduction or credit. The primary benefit is that funds experience tax-deferred growth and can be withdrawn federally tax-free for qualified education expenses. Qualified expenses can include:

• Tuition and fees for college
• K-12 education, up to $10,000 per year
• Apprenticeship programs
• Certain student loan repayments