Taking steps to defer your current individual federal income-tax bill is often a good idea, especially if you expect to be in the same or lower tax bracket in future years.
In that situation, making moves to lower this year’s taxable income will at least put off the tax day of reckoning and give you more cash to work with until the bill comes due. If your tax rates turn out to be lower in future years, deferring taxable income into those future years will cause the deferred amount(s) to be taxed lower rates.
Small business owners have the most opportunities to defer taxable income. Read more here. If your business uses the cash method of accounting for tax purposes, you can prepay deductible expenses near year-end and send out invoices late enough that they will not be paid until next year. You can also take advantage of generous first-year depreciation breaks offered by the Tax Cuts and Jobs Act (TCJA) and make deductible contributions to retirement plans. (This is not a complete list of small business tax deferral opportunities.)
If you are not a small business owner, you can defer taxable income by prepaying expenses that give rise to higher itemized deductions, making installment sales of property, and arranging for like-kind exchanges of real estate. (As before, this is not a complete list of tax deferral opportunities.)
Here is the point: In today’s federal income tax environment, you could potentially have “too much” deferral. Here are the two biggest reasons why that could happen.
Future tax rates could go up
Thanks to the TCJA, we know what the individual federal income tax rates and brackets are for this year and next year (see below). The 2020 brackets will probably be about the same as those for 2019, with modest adjustments for inflation.
Table: 2019 individual rate brackets
Single Joint Head of household 10% tax bracket $0 - $9,700 $0 - $19,400 $0 - $13,850 Beginning of 12% bracket $9,701 $19,401 $13,851 Beginning of 22% bracket $39,476 $79,851 $52,851 Beginning of 24% bracket $84,201 $168,401 $84,201 Beginning of 32% bracket $160,726 $321,451 $160,701 Beginning of 35% bracket $204,101 $408,201 $204,101 Beginning of 37% bracket $510,301 $612,351 $510,201
But after 2020, we don’t know if the TCJA’s individual rate cuts will be allowed to survive through 2025, as scheduled, or if they will be scrapped because the Democrats control the government. If the Democrats are in charge, you can bet rates will go up, especially for upper-income folks. And they could go up by a lot.
The Message: Think twice about deferring income past 2020. Work with your tax adviser to formulate projections about what would happen to your future tax bills in various scenarios.
Potential negative impact of tax deferral on the pass-through business income deduction
For 2018-2025, the TCJA established a new personal deduction for up to 20% of your qualified business income (QBI) from pass-through entities (meaning sole proprietorships, partnerships, LLCs, and S corporations). However, the QBI deduction cannot exceed 20% of your personal taxable income calculated before any QBI deduction and before any net capital gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
So moves that reduce your QBI and/or your taxable income — such as claiming 100% first-year bonus depreciation and making deductible retirement plan contributions — can potentially have the adverse side effect of reducing your allowable QBI deduction.
While most moves that defer taxable income (such as 100% first-year bonus depreciation and deductible retirement plan contributions) just create timing differences for when taxable is recognized, the QBI deduction creates permanent tax savings.
You claim the deduction, and you don’t ever have to give it back. But it’s a use-it-or-lose-it proposition because it’s only scheduled to last through 2025. If the presidency and Congress change hands, it probably won’t last that long. So beware of over-indulging on tax deferral moves if they would significantly reduce your QBI deductions.
The bottom line
Work with your tax pro to identify the optimal overall tax planning strategy for your specific situation, taking into account the TCJA changes (including the QBI deduction) and the possibility of higher tax rates in future years. Be careful out there.
This story was updated on March 7, 2019.
