- Let's start with the first basic tax planning strategy,
shifting income from one time period to another.
Let's take a simple example.
Suppose you have a small side business
where you give music lessons to children.
You've earned $1000 giving group clarinet lessons.
Do you want to be paid at the end of December of year one
or at the beginning of January of year two?
Now, think about that carefully
because the timing of the reported income
for income tax purposes is typically based on
when you receive the cash.
If you receive payment near the end of December,
you must report that on this year's tax return
and pay tax on it with the rest of your year one income.
But if you delay receiving payment until January
of year two, yes you may have to wait a little extra
to get your money but you can wait an entire year
to report and pay tax on this income
with the rest of your year two income.
Just by pushing the receipt of cash back a little,
from December to January, you pushed your tax
obligation back an entire year.
Now why might you want to legally delay payment
of your taxes?
Well you're eventually going to pay
the same amount of tax but during the year long delay,
in our example, you can keep the money
you would've had to pay as income tax
and you can invest it.
You can earn interest.
Or you can use it for some other personal purpose.
You can see the benefit of this basic tax planning strategy.
Shifting income from one time period to another
this year to another time period next year.
In the United States, there are two common methods
of legally delaying the taxation of income.
The first method is a traditional individual
retirement account, an IRA
which is created and managed by an individual.
The second method is a 401k plan
which is created and managed by an employer
on behalf of an individual employee.
We'll look at both of these.
First, let's look at the traditional
individual retirement account, an IRA,
which is created and managed by an individual.
The concept of an IRA was approved by the US Congress
to encourage US workers to save for retirement.
During the year, the tax payer makes an investment
with a financial institution up to $5,500.
The tax payer designates that investment as an IRA
and the tax payer subtracts this amount
from taxable income when completing
the year's income tax return.
Now when do you pay the tax on that excluded income?
You pay the tax on the IRA contribution
and subsequent earnings when you retire
and start receiving distributions.
You have delayed paying the tax.
That's an IRA.
A 401k plan is a similar concept.
This tax rule also encourages US workers
to save for retirement.
During the year, an employer withholds
from an employee's paycheck up to $18,500
and deposits that amount in the employee's name
in a financial institution.
Often the employer will match all or part
of the employee's investment.
When the employee slash tax payer completes
the year's income tax return, the amount contributed
to the 401k plan is subtracted
in computing taxable income.
You pay tax on the 401k contribution
and subsequent earnings only when you retire
and withdraw the money.
Both a traditional IRA and a 401k plan
are examples of the first basic tax planning strategy,
legally delaying the taxation of income.
Now for US residents, let me give you a quick word
about the Roth IRA.
A traditional IRA and a 401k are not taxed now
but you're fully taxed when you retire.
For a Roth IRA, the contributions are taxed now
but there's no tax ever on subsequent earnings.
The Roth IRA is especially attracted to individuals
who have low income now and so pay little or no tax now.
Now to review, the most common ways to shift income
form one time period to another
are with traditional IRA or a 401k.
Both of these tax strategies legally delay
the taxation of some income until you retire.