THINKING ABOUT TAXES – DEFER OR DEFLECT?
THINKING ABOUT TAXES
The French philosopher Rene Descartes said, “I think, therefore I am.” Since we are all creatures of our own thoughts, let’s engage in some thinking about income taxes which too often present problems resolved in darkness. In fact, when Descartes also said “Everything is self evident,” I doubt that he had in mind our modern obscure tax system.
TAX 101 – DON’T STAMPEDE TO DEFER TAX
During the 1970s and 1980s there was an epidemic of tax deferral fever. Many seemed to think that a dollar of tax postponed was akin to a dollar saved. In theory, tax deferrals make sense in limited circumstances:
1. As an arbitrage strategy to shift income to a year in which a lower tax bracket will apply. This tactic was more sensible during the era of the 70% top tax bracket.
2. As a deduction maximization strategy to average out bunched up income and thereby avoid phase out rules for various tax benefits (e.g., itemized deductions); or, to shift specific kinds of income to avoid the AMT. The AMT is not as common for Florida taxpayers as for those in high state income tax localities; and, itemized deductions now only partially phase out.
3. As a time value of money strategy to shift income that the tax payments delayed can be invested at well above average returns with little risk (often a pipe dream except for the owner of a successful growing small business); or for the executive receiving stock options.
4. As a pre-tax wealth accumulator in certain tax favored retirement accounts such as an Individual Retirement Account. With regard to IRAs, one can choose to defer current earned income with a regular IRA and also shelter investment earnings on the account; or, forego the earned income tax deferral with a Roth IRA that also shelters investment earnings but allows tax free qualified distributions. Which strategy makes sense depends upon ones’ particular circumstances.
5. As an estate planning tactic to take advantage of the step up in basis occurring upon the death of the owner of property which eliminates the built in gain.
In practice some of these strategies were distorted into senseless and counterproductive measures that actually worked against the sound financial interests of most. Thus:
1. High income professionals shifted income from high bracket years to high or higher bracket years accomplishing no rate arbitrage benefit and at times even increasing the tax burden. The postponed tax was often placed in low yielding passive investments or worse spent on lavish lifestyles.
2. Hard earned wages or savings were invested in very risky ventures that promised tax deferrals by questionable means. Instead, both the investment and tax benefit were lost and IRS charged harsh penalties and interest.
THINK ABOUT STRATEGIES THAT DEFLECT TAX
There is a big difference between a tax deferred and a tax deflected. A deferral merely postpones the day of reckoning. A tax defection actually eliminates the tax altogether or lowers the tax from what it otherwise would have been. The special capital gains rate of 15% is an example of a tax shelter that deflects income tax and results in a real and permanent tax savings.
This year there is another reason to be cautious about tax deferrals. The U.S. economic horizon is not very pretty. Unprecedented budget deficits and continued unbalanced foreign trade mean that tax rates will not be lower in the future or even remain the same. Often, procrastination merely serves to make paying the tax painfully more expensive. Therefore, think carefully about what you are trying to accomplish before embarking on a tax deferral strategy such as a 1031 real estate exchange or postponing a bonus to 2010.
Steinberg Talks Tax (TM), Volume 3, No. 9, September 15, 2009. Copyright 2009 by Robert S. Steinberg, All rights reserved.