Deferring income into the next year is one of the most common year-end tax planning devices. The idea is to push the income into a future year when your tax rates will be lower. Even if your tax rates will not be lower next year, deferring income still makes sense as long as your rate next year will not be higher. As long as the tax rates are the same, paying in the future is usually better than paying today.
How do you defer income? Here are some possibilities:
- Sell stocks, mutual funds, bonds, and other capital assets that have gains next year instead of this year.
- Do not buy a mutual fund between now and the end of the year as mutual funds typically pay out any capital and ordinary gains in the last month of the year.
- If you are self-employed and your business is on the cash basis, delay billing your customer(s) until closer to the end of the year or next year. Do not abuse this tactic. If your customer offers to pay you this year and you get them to hold the payment without a good business reason (i.e. a reason unrelated to taxes) then IRS will consider you to have received the income this year. IRS may also question delayed billings if you put it off too long. If you typically bill within 15 days of completing a job and decide to wait six months to defer the income, IRS can ignore the deferral. They will make the the argument that your customer would have paid before year-end if you billed them in a normal time frame. One way around this is to arrange the payment terms BEFORE you start the job (e.g. make it part of the contract terms).
- Do not exercise non-qualified stock options until next year. Watch out, do not let an in the money option expire just to save some tax. Some after tax income is better than none.
- Ask your employer about the possibility of a non-qualified deferred compensation plan. This is more for next year as the deferral has to be in place before the beginning of the year to which it applies. Be careful with this tactic as you can lose the deferred compensation if your employer goes bankrupt. The non-qualified part means the deferral is not subject to the normal protections provided to employer pension plans.
- Defer as much as possible into your retirement plans – 401(k), 403(b), etc.
Unfortunately, Congress has made planning difficult because of the Alternative Minimum Tax and all the phasing out of deductions and credits. So postponing income into next year may cost you a tax credit, deduction or increase your Alternative Minimum Tax in the future. When you plan, always consider the effect to both this year and future years.
Do not allow the “tax tail to wag the dog.” In other words, the most important thing is how much you have after taxes. For example, if the stock you want to sell has a big gain now, consider the cost of waiting to sell next year when its price may have dropped significantly.