Tax Deferral
March 31, 2009
Definition
Tax deferral is the payment of taxes in the future for earnings in the current year. It is an instance where taxpayers can holdup paying taxes to some future time. Theoretically, net tax paid ought to be equal but practically, due to the changing value of money over time, it is thought that paying taxes at a future time is fairer, hence tax payers prefer to ‘forward’ or postpone.
Tax deferral can also refer to investment earnings, e.g. dividends, interests and capital gains that are left to accumulate tax-free until the investor decides to take possession by withdrawing. Common examples where this is applicable is on individuals on retirement accounts (IRAs) and deferred annuities. Thus, by postponing tax on the returns of an investment, investors reap benefits in two ways;
Firstly, the investors enjoy a tax-free growth – as an alternative of paying tax on the returns of your investments, you will pay the tax at a later date, therefore allowing your investment to grow unimpeded. The other benefit you will reap as in investor is that when you are earning high income, you will make the investments and you will be taxed at a high tax rate; and when you are don’t have an income or are earning very little, when withdrawals will be made from your investment account you will be taxed at a considerably lower rate.
Chances of being taxed at a lower rate in the future are higher, in addition to the probability of deferring tax indefinitely. A rule of thumb in taxation is that when a taxpayer opts to pay taxes, the total payable amount will possibly be lower.
Corporate tax deferral
Enterprises or corporations may frequently be permitted to defer tax because in principle, the future times taxes ought to be higher. For instance, by applying accelerated depreciation, the taxes, such as profit taxes, are reduced by either lowering the declared revenue presently, or by increasing the corporation’s expenses.
Deferring Income Tax
A majority of jurisdictions allow income tax to be deferred to future times through various means. For instance, in future, income may be identified by the use of income tax deductions. Alternatively, particular expenses may be offered as deductions presently rather than in the future times.
In a government where progressive taxation is applied (meaning income tax as a percentage of income is higher for high income earners, thus creating a high marginal tax rate), will result in lower payable taxes, regardless of the value of money at the time of taxation.
Tax Deferral on Individual Retirement Accounts (IRAs)
A lot of jurisdictions have different types of retirement savings account which all have different characteristics, but typically, the IRAs allow tax deferral on retirement accounts by allowing individuals declare their income later on in life. The retirement saving plans between the tax payer and the government shelters what would usually be the taxable income earned within the account, until a later date or when the taxpayer withdraws. All the profits such as capital gains and dividends are eventually taxed as income.
This aims at allowing the tax payer use the money, which otherwise would have gone to the government, to invest. Ultimately you will pay the taxes, but not before using the money to make more money. Be advised that if the taxpayer’s income is lower, the eventual tax paid will substantially be lower too.
The income of the individual which is expected to be lower after retirement, thus low taxation rate, coupled with the latent tax savings at the period of contribution, makes IRAs a worthwhile tax management tool for taxpayers in the long run.
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