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Investments That Delay Taxation
Having control over when you pay income tax on the earnings of an investment can be attractive for several reasons:
Fortunately, there are several types of investments and investment accounts that provide some flexibility over when taxes are ultimately due.
Treasury bills - United States Treasury bills are obligations issued by the federal government that have maturities of one year or less. You buy the T-bills at a discount to their stated denomination and receive the par amount when they mature. For income tax purposes, you recognize the income when they mature. For example, if you buy a 90 day T-bill in November with a maturity the following year, you won't have to recognize the income until you file your tax return for the following year.
Stocks - Owning stock gives you control over taxes with your decision of when to sell the stock at a gain or loss. While you will pay tax on any dividends you receive in the year received, you can decide when to sell the stock and recognize any capital gain or loss. In addition, if you hold the stock for over one year and have a gain, you can get a break on the tax on the gain because it is considered to be a long-term gain. The top tax rate on long-term capital gains is 20% compared to rates up to 37% for ordinary income and short-term gains.
But remember that holding a stock for a longer period of time to delay the taxation (until the next year) or to receive capital gains treatment (more than one year) also subjects you to the risk that the value of the stock may decrease. Any tax benefit should be weighed against the risk.
Annuities - Annuities are insurance contracts that allow for the tax-deferred accumulation of earnings while the funds are within the contract. Fixed annuities pay a stated earnings rate and variable annuities provide tax-deferred earnings based on the underlying investments of the account. Earnings are taxed when funds are withdrawn. In addition, there may be additional taxes due if funds are withdrawn before the age of 59½. There are some exceptions so be sure to consult your tax advisor. Annuity contracts also can have other expenses and terms that should be fully understood before buying.
IRA accounts - Individual Retirement Accounts provide tax-deferral on the earnings of the funds within the account as long as the funds stay in the account. When you take withdrawals, the income is taxed as ordinary income. Withdrawals before the age of 59½ may be subject to an additional early withdrawal tax of 10% and withdrawals must start being made in the year when you reach age 70½. There are some exceptions to these rules that you may want to consider if you need funds from an IRA before age 59½. Consult your tax advisor. Contributions to an IRA may also be tax deductible if your income does not exceed certain levels or if you are not a participant in an employer sponsored retirement plan.
Roth IRAs provide the additional benefit of distributions not being subject to taxation at all. Contributions are not deductible and there are special rules for the conversion of a regular IRA to a Roth IRA. Roth IRAs can be very powerful financial planning tools, especially for younger individuals that expect to leave funds in the account for very long periods. Talk to a qualified advisor if this sounds attractive.
Qualified retirement accounts - Company sponsored retirement plans, like 401(k) plans, enable your retirement funds to grow tax-deferred and to be taxed only when withdrawn. Like IRAs, the income is taxed as ordinary income. In addition, there are required distributions once you reach age 70½. If you retire or change jobs and receive a lump-sum distribution from your plan, you can roll it into your new employer's plan (in most cases) or into an IRA. In any case, you have control over when you take distributions and pay the tax.
There are ways to delay taxation on some of your investments. Some of them involve risk (delaying the sale of a stock) and others are more procedural in nature. In many cases, the rules are complex and running afoul of the rules can be costly. The advice of a qualified tax professional can help ensure that you understand the rules and follow them to avoid any unpleasant consequences.