Smart Tax Moves: How to Defer Income to Next Year

Smart Tax Moves: How to Defer Income to Next Year

Interested in how to defer income to next year? Here’s a quick guide:

1. Postpone Year-End Invoicing: Delay invoicing until after December 31.
2. Maximize Retirement Contributions: Increase contributions to 401(k) or IRAs.
3. Defer Bonuses and Compensation: Arrange to receive them in January.
4. Use Like-Kind Exchanges: Swap properties to delay capital gains.

Deferring income can be a savvy tax planning strategy that helps manage your finances more efficiently. By postponing some of your income to the next fiscal year, you could lower your current tax liability and potentially fall into a lower tax bracket when you finally report the income.

I'm Russell Rosario, an experienced financial expert and CPA. I've helped numerous businesses and individuals, including startups and law firms, master how to defer income to next year using advanced AI-driven tools like Huxley.

Let’s dive deeper into how income deferral works and its benefits.

Understanding Income Deferral

Deferring income means postponing some of your earnings to a future tax year. This strategy can help you lower your current tax liability and, if planned well, place you in a lower tax bracket when you finally report the income.

Benefits of Deferring Income

Tax Savings: By deferring income, you can reduce your taxable income for the current year. This can lead to significant tax savings, especially if it helps you fall into a lower tax bracket. For instance, contributing to a traditional 401(k) plan allows you to defer taxes until you withdraw the money, potentially at a lower tax rate during retirement.

Investment Growth: When you defer income, you can invest the money you would have paid in taxes. This can lead to compounded growth over time. For example, the cash value in permanent life insurance grows tax-deferred, allowing for greater accumulation over the years.

Lower AGI: Lowering your Adjusted Gross Income (AGI) can make you eligible for more tax deductions and credits. This is particularly beneficial for deductions that are limited by your AGI, such as medical expenses. By deferring income, you can strategically reduce your AGI and maximize these deductions.

Risks and Considerations

Tax Reform: Tax laws can change, which might affect the benefits of deferring income. For example, changes in tax brackets or deductions could impact your overall tax savings. It’s essential to stay informed about potential tax reforms and adjust your strategy accordingly.

Collection Issues: Deferring income might delay your cash flow, which can be problematic if you need the money sooner. For example, postponing year-end invoicing might push your cash receipts into the next year, potentially affecting your ability to meet current financial obligations.

Financial Planning: Effective income deferral requires careful planning. You need to consider your future income needs and tax rates. If you expect to be in a higher tax bracket in the future, deferring income might not be beneficial. It’s crucial to consult with a financial advisor to create a strategy that aligns with your long-term goals.

By understanding the benefits and risks of deferring income, you can make informed decisions that optimize your tax situation and support your financial goals.

Next, we’ll explore specific strategies to defer income to next year, including postponing year-end invoicing and maximizing retirement plan contributions.

Strategies to Defer Income to Next Year

For cash-basis taxpayers, one effective way to defer income to next year is to delay year-end invoicing. By postponing the issuance of invoices until late December or even early January, you can ensure that payments from customers are received in the following year. This simple strategy can significantly reduce your taxable income for the current year. However, be cautious not to compromise your ability to collect payments.

Example: If you typically invoice clients on December 20th, consider sending out invoices on January 2nd instead. This small shift can push the income into the next tax year, potentially lowering your tax liability for the current year.

Contributing to retirement plans is another excellent way to defer income. Options include:

• 401(k) Plans: You can contribute up to $22,500 for 2023. If you're over 50, you can add an extra $7,500 in catch-up contributions.
• Traditional IRA: Contribute up to $6,500 (or $7,500 if you're over 50). These contributions are deductible, lowering your taxable income.
• SEP IRAs: Especially beneficial for self-employed individuals, allowing contributions up to 25% of your net earnings.
• Non-Qualified Deferred Compensation (NQDC) Plans: These plans allow you to defer a portion of your salary or bonus to a future date, potentially when you're in a lower tax bracket.

Example: If you contribute the maximum amount to your 401(k), you can defer a substantial portion of your income, reducing your current tax liability while growing your retirement savings.

If you're an employee, you might be able to negotiate with your employer to defer compensation or year-end bonuses to the following year. This strategy is especially useful if you expect to be in a lower tax bracket next year. You can defer part of your salary or bonus, paying taxes on it when you receive it in the future.

Example: Suppose you are due to receive a $10,000 bonus in December. By deferring this bonus until January, you can push the income into the next tax year, potentially lowering your current year’s taxable income and tax rate.

For those involved in real estate or other property investments, like-kind exchanges can be a powerful tool for deferring capital gains taxes. Under IRS Section 1031, you can exchange a business or investment property for another of "like kind" without immediately recognizing capital gains.

Example: If you sell a rental property and use the proceeds to purchase another rental property, you can defer the capital gains tax on the sale. This allows you to reinvest the full amount into your new property, deferring tax liability until you eventually sell the replacement property.

If you have been granted Incentive Stock Options (ISOs) by your employer, holding onto these options can defer both income tax and capital gains tax. By holding the stock for more than one year after exercising the options and two years after the grant date, you can qualify for long-term capital gains treatment, which is typically lower than ordinary income tax rates.

Example: If you exercise ISOs and hold the stock for the required period, you can defer the recognition of income and potentially benefit from a lower tax rate on any gains.

By implementing these strategies, you can effectively manage your tax liability and optimize your financial situation. Next, we'll discuss how accelerating expenses can further reduce your current year taxable income.

Accelerating Expenses to Reduce Current Year Taxable Income

Prepaying Recurring Expenses

Accelerating your expenses can be a smart move to reduce your current year’s taxable income. One way to do this is by prepaying recurring expenses. This means paying for expenses you expect to incur in the next 12 months before the current year ends.

Example: If you usually pay your office rent monthly, you can prepay the next three months' rent in December. This allows you to deduct the prepayment in the current year, thus lowering your taxable income.

According to the 12-month rule, for prepaid expenses to be deductible, the benefit must not extend beyond 12 months from the date of payment or the end of the taxable year following the year of payment. This rule is particularly advantageous for cash-basis taxpayers.

Tip: Use credit card payments to prepay deductible expenses, such as insurance premiums or subscriptions. The IRS allows you to deduct the expenses in the year you charge them, even if the credit card bill is paid next year.

Bunching Deductions

Another effective strategy is bunching deductions. This involves concentrating your deductible expenses into one tax year to exceed the standard deduction threshold, allowing you to itemize and maximize your tax savings.

Example: If you have significant medical expenses, you can schedule elective procedures or purchase necessary medical supplies before the year ends. This can help you meet the 7.5% AGI threshold for medical expense deductions.

By strategically timing your deductions, you can alternate between itemizing deductions one year and taking the standard deduction the next, optimizing your overall tax savings.

Case Study: A small business owner, Sarah, decided to prepay her business's annual software subscriptions in December. She also scheduled her family’s dental procedures and paid property taxes for the next year. By bunching these deductions, Sarah was able to itemize her deductions and significantly reduce her taxable income for the current year.

These methods not only help in reducing your current year’s taxable income but also improve your cash flow management.

Next, we'll address frequently asked questions about deferring income.

Frequently Asked Questions about Deferring Income

Can I defer income from one year to the next?

Yes, you can defer income to the next year, especially if you're a cash-basis taxpayer. This means you only report income when you actually receive the cash or checks. For example, if you delay sending out invoices until late December, you might not get paid until January. This pushes the income into the next tax year, reducing your current year's taxable income.

However, be cautious. Don't delay invoicing if it risks your ability to collect payments. "You should never postpone invoicing if it will compromise your ability to collect payments from customers," as noted in our research.

How does deferred income work?

Deferred income works by shifting when you recognize income on your financial statements. Let's break it down with a simple example:

• Sales Invoice: Suppose you complete a project in December but don't send the invoice until January. You receive the payment in January. For a cash-basis taxpayer, this income is reported in the next tax year.
• Profit & Loss (P&L) Statement: This delay means the income won't appear on your current year's P&L statement, lowering your taxable income for this year.
• Balance Sheet: On the balance sheet, deferred income may appear as accounts receivable until it's collected. Once paid, it converts to cash and is recognized as income in the next year.

Can you defer expenses to the next tax year?

Unlike income, deferring expenses to the next year isn't typically advantageous. Instead, you might want to accelerate expenses to reduce your current year's taxable income. Here’s how:

• Prepaying Expenses: Pay for expenses like rent or insurance before year-end. For instance, prepaying January's rent in December can allow you to deduct it in the current year.
• Bunching Deductions: Grouping expenses into one year can help you exceed the standard deduction, making itemization worthwhile. This is useful for medical expenses or charitable donations.

Prepayment is subject to the 12-month rule, which allows you to deduct expenses if the benefit doesn't extend beyond 12 months or the end of the next tax year.

Next, we'll conclude our discussion by highlighting the key takeaways for maximizing your tax strategy.

Conclusion

In tax planning, deferring income can be a smart move for business owners. By carefully managing when you receive income and incur expenses, you can lower your taxable income for the current year and potentially save on taxes. But remember, this strategy requires careful planning and consideration of your overall financial situation.

At Russell Rosario, we specialize in helping businesses navigate these complex tax strategies. Our team at Profit Leap offers comprehensive financial consulting, strategic planning, and bookkeeping services. We leverage cutting-edge technology, including our AI advisor Huxley, to provide data-driven insights that help you make informed decisions.

Key Takeaways:

• Deferring Income: By postponing year-end invoicing or deferring compensation, you can reduce your current year's taxable income.
• Accelerating Expenses: Prepaying expenses and bunching deductions can help you maximize your tax deductions for the current year.
• Strategic Planning: Understanding the risks and benefits of these strategies is crucial for effective financial planning.

If you're looking to optimize your tax strategy and improve your financial efficiency, reach out to us at Russell Rosario. Our expert team is here to help you navigate the complexities of tax planning and achieve your financial goals.

By focusing on these key areas, you can ensure your business is not only prepared for the challenges of today but also positioned for future success.