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Conventional wisdom says that taking steps to defer your current individual federal income bill is almost always a good idea. True, if you expect to be in the same or lower tax bracket in future years, and you turn out to be right about that.
If so, making moves to lower this year’s taxable income will at least give you more cash to work with until the bill comes due. If your tax rate drops, deferring taxable income into future years will cause the deferred amount(s) to be taxed lower rates. Great.
But is that really very likely? I don’t think so. So, let’s discuss tax deferral opportunities and whether they make sense for you in today’s uncertain tax environment. Here goes.
Tax deferral opportunities
Among individual taxpayers, small business owners have the most opportunities to defer taxable income. See this previous Tax Guy column for more details.
If you’re not a small business owner, you can defer taxable income by prepaying expenses that give rise to higher itemized deductions, maxing out on retirement plan contributions at work, making installment sales of property, and arranging for like-kind exchanges of real estate while you still can.
But wait: is tax deferral a no-brainer this year?
Uh, no. You could potentially have “too much” tax deferral. Here’s why.
The current picture
For 2018-2025, the Tax Cuts and Jobs Act (TCJA) cut federal income tax rates for most individuals.
At this instant, the top federal income tax rate on ordinary income and net short-term capital gains recognized by individual taxpayers is 37%.
Higher-income individuals can be hit with the additional 0.9% Medicare tax on part of their wages and/or net self-employment income.
The top federal rate on most net long-term capital gains is 20% for very-high-income individuals. However, the vast majority will pay 15%, and those with modest incomes might pay 0%. The same preferential rates apply to qualified dividends.
Higher-income individuals can be hit with the 3.8% net investment income tax (NIIT) on all or part of their net investment income, which includes capital gains and dividends.
The Biden tax plan is in play
The higher pre-TCJA tax rates are scheduled to come back after 2025. But higher rates could be here much sooner if some or all of President Joe Biden’s tax increase proposals get through Congress. If that happens, they could kick in as early as this year, but I think a 2022 effective date would be a better bet.
The Biden plan would raise the top federal income tax rate for individuals from 37% to 39.6%, reportedly for single filers with taxable income above about $450,000 and married joint-filers with taxable income above about $500,000.
For those with taxable income above $1 million, Biden wants to raise the rate on long-term capital gains to 39.6% plus the 3.8% NIIT. That would equate to a maximum effective rate of 43.4% (39.6% + 3.8%), up from the current maximum effective rate of 23.8% (20% + 3.8%). Biden wants to make this increase retroactively effective, to hit gains triggered on or after April 1 of this year.
The message
With possible tax rate increases on the table, think twice about deferring taxable income this year, because deferred amounts could wind up being taxed at higher rates in 2022 and beyond. Or not, because it’s unclear if there’s much appetite in Congress for higher taxes. That said, it’s hard to believe that the current relatively low rates will last too much longer.
Work with your tax adviser to formulate projections about what would happen to your future tax bills in various scenarios.
Consider tax-smart moves that don’t involve tax deferral
Good idea. Here are some.
Not tax deferral: Roth IRAs
Because qualified withdrawals from Roth IRAs are federal-income-tax-free, Roth accounts offer the opportunity for outright tax avoidance, as opposed to tax deferral. So, making annual contributions to a Roth IRA (if your income permits) is an attractive alternative to “too much” tax deferral for those who expect to pay higher tax rates during retirement. Good.
Converting a traditional IRA into a Roth account effectively allows you to prepay your IRA federal income tax bill on the current IRA account balance at today’s low rates instead of paying higher future rates on the current account balance and future account earnings.
Not tax deferral: Roth 401(k) accounts
The Roth 401(k) deal is basically a traditional 401(k) plan with a Roth account feature added. If your employer offers a 401(k) plan with the Roth option, you can contribute after-tax dollars to a designated Roth account (DRA) set up under the plan. The DRA is a separate account from which you can eventually take federal-income-tax-free qualified distributions. So, making DRA contributions is another attractive alternative to “too much” tax deferral for those who expect to pay higher tax rates during retirement.
Note that unlike annual Roth IRA contributions, the ability to make DRA contributions is not phased out at higher income levels. I’ll cover DRA contributions in detail in a future column.
Not tax deferral: health savings accounts (HSAs)
If you’re covered by a not-very-generous health plan, you might be eligible to open up and contribute to a tax-advantaged health savings account (HSA).
HSA contributions are deductible and withdrawals are federal-income-tax-free when used to cover qualified medical expenses. So, HSAs offer outright tax avoidance, as opposed to tax deferral.
For the 2021 tax year, you can make a deductible HSA contribution of up to $3,600 if you have qualifying self-only coverage or up to $7,200 if you have qualifying family coverage (anything other than self-only coverage). If you are age 55 or older as of yearend, the maximum contribution goes up by $1,000.
You must have a qualifying high-deductible health insurance policy and no other general health coverage to be eligible for the HSA contribution privilege. For 2021, a high-deductible policy is defined as one with a deductible of at least $1,400 for self-only coverage or $2,800 for family coverage.
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Even billionaires can contribute to health-savings accounts if they have qualifying high-deductible health insurance coverage and meet the other HSA contribution eligibility requirements.
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For 2021, qualifying policies can have out-of-pocket maximums of up to $7,000 for self-only coverage or $14,000 for family coverage.
If you’re eligible to make an HSA contribution, you have until April 15 of the following year (adjusted for weekends and holidays) to open an account and make a deductible contribution for the earlier year. So, there’s tons of time to open an account and make a deductible contribution for 2021, because the deadline is 4/15/22.
The write-off for HSA contributions is an above-the-line deduction. That means you can take the write-off even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. If you are covered by qualifying high-deductible health insurance, you can make deductible contributions and collect the resulting tax savings. Even billionaires can contribute if they have qualifying high-deductible health insurance coverage and meet the other HSA contribution eligibility requirements.
Not tax deferral: take retirement account withdrawals (gasp!)
This idea will cause some tax advisors to recoil in horror. But here it is anyway: consider taking withdrawals from your tax-deferred retirement account(s) now, when tax rates are low, rather than later when tax rates might be higher.
You may be restricted from doing this with a company plan, like a 401(k), but you can do it with a traditional IRA or self-employed SEP-IRA. However, taking a traditional IRA withdrawal before age 59½ is usually a bad idea because you’ll get socked with the dreaded 10% early withdrawal penalty tax unless you qualify for an exception. For the list of exceptions, see this Tax Guy.
Also, don’t take withdrawals from a Roth account any sooner than you have to. You want to Roth balances untouched so you can keep earning federal-income-tax-free income and gains.
The bottom line
Work with your tax advisor to if you might have “too much” tax deferral, taking into account what I think is the virtual certainty of higher federal income tax rates in future years. Higher rates probably won’t happen this year and may not happen next year. But they will be here before too long, IMHO.
