Understanding Tax-Deferred Investing

Article Highlights:

• Income Deferral
• Earnings Deferral
• Individual Retirement Accounts
• Retirement Accounts
• Bank Savings
• Short- and Long-Term Capital Gains
• Education Savings Accounts
• Health Savings Accounts
• Installment Sales
• Tax Deferred Exchanges
• Qualified Opportunity Funds

When you are attempting to defer the taxability of a capital gain, save money for your children’s future education or plan your retirement finances, you may do so in several ways, including investing in the stock market, buying real estate for income and appreciation, or simply putting money away in education savings accounts or retirement plans.

Knowing how these various tax savings vehicles and income deferral opportunities function is important for choosing the ones best suited to your circumstances. Let’s begin by examining the tax nuances of IRA accounts.

Individual Retirement Account (IRA) – There are two types of IRA accounts—the traditional and the Roth—and even though they are both IRAs, there is a huge difference in their tax treatment.

• Traditional IRA – Contributions to a traditional IRA are generally tax-deductible unless you have a retirement plan at work, and then the IRA contribution may not be deductible if you are a higher-income taxpayer. All the earnings from a traditional IRA are tax-deferred, meaning they are not taxable currently but will be when funds from the account are withdrawn. And since the contributions were tax-deductible, everything you withdraw from the traditional IRA will be taxable. An exception to that last statement is when you didn’t claim a deduction for money that you contributed to the IRA, either by choice or when the law didn’t allow a deduction. In this case, withdrawals from a traditional IRA would be prorated as partly taxable and partly tax-free.
• Roth IRA – Roth IRA contributions are never tax-deductible, but the earnings are never taxable if the account meets a 5-year aging rule and the distributions begin after you reach age 59.5.   

So, which is best? Well, that depends upon your circumstances. If you need the tax deduction to fund the IRA, then by all means use the traditional IRA. However, if you can afford to the contribute without the deduction, then the Roth IRA will be the best because everything is tax-free when withdrawn, usually at retirement.  

Retirement Plans – The tax code provides for a variety of retirement plans, both for employees and for self-employed individuals. These include: 401(k) deferred compensation plans, Keogh self-employed retirement plans, simplified employee plans (SEP), tax-sheltered annuity (403(b)) plans – most commonly for teachers and employees of nonprofits), and government employee plans (457) plans.

For the most part, the consequences of these arrangements are the same as for a traditional IRA, allowing the amount contributed to be excluded from income (deferred), and then the distributions are fully taxable when they are taken. However, 401(k) and 457 plans may have a Roth option, under which there is no income exclusion for the contributions but the distributions at retirement are tax-free. If individuals have used both methods, the non-Roth contributions are deferred, and the earnings are fully taxable.

Bank Savings – When money is put away into a bank savings account or CD, the earnings are fully taxable in the year earned. However, after the tax on the annual earnings is paid, the full balance in the account is available, without any further tax.

Short- and Long-Term Capital Gains – Capital gains refers to the gain from the sale of capital assets – typically stocks, bonds, and real estate. Short-term capital gains are taxed at ordinary tax rates, while long-term capital gains enjoy special lower rates. For lower-income taxpayers, there is actually no tax on capital gains; for very high-income taxpayers, the capital gains rate maxes out at 20%, whereas the top regular tax rate for high-income taxpayers is 37%. However, for the average taxpayer, the capital gains rate is 15%, which provides a significant savings over the regular tax rates. To qualify for long-term treatment, the capital asset must be held for at least a year and a day. 

Education Savings Accounts – The tax code provides two tax-advantaged plans that allow taxpayers to save for the cost of college for each eligible student: the Coverdell Education Savings Account and the Qualified Tuition Plan (frequently referred to as a Sec. 529 Plan). Neither provides tax-deductible contributions, but both plans’ earnings are tax-deferred and are tax-free if used for allowable expenses, such as tuition. Therefore, with either plan, the greatest benefit is derived by making contributions to the plan as soon as possible—even the day after a child is born—to accumulate years of investment earnings and maximize the benefits.

However, there are different limitations for the two plans, in that only $2,000 per year per student can be contributed to a Coverdell account, while huge amounts can be contributed to Sec. 529 plans, limited only by the estate-planning issues of each contributor and each state’s cap on account contributions, which goes into six figures.

Health Savings Accounts – A health savings account (HSA) can generally be established by taxpayers only if they have high-deductible health plans. The contributions are tax-deductible, the earnings accumulate tax-free, and the distributions are tax-free if used for qualified medical expenses. When part of an employer-sponsored plan, HSA contributions are excluded from the employee’s wages rather than being a deduction on the tax return. Once the account owner reaches age 65, taxable but penalty-free distributions can be taken, even if they are not used to pay for medical expenses or to reimburse the taxpayer for medical expenses previously paid for out-of-pocket. Thus, these plans can serve as a combination tax-free medical reimbursement plan and taxable retirement savings arrangement. The maximum annual contribution is inflation adjusted; for 2023, it is $3,850 for self-only coverage and $7,750 for family coverage. Like other tax-advantaged plans, the key is to allow the account to grow through income-excluded or tax-deductible contributions and the accumulated earnings.

Unqualified Withdrawals – Be careful about making unqualified withdrawals – those that are taken before reaching retirement age, in the case of retirement plans, and those taken for unqualified expenses, in the case of education savings accounts and health savings accounts. Doing so can result in costly tax ramifications and potential penalties.

Installment Sale – Using the installment sale method of receiving and reporting the proceeds when there’s a gain from the sale of a capital asset can spread that gain over multiple years and possibly avoid the higher capital gains rates as well as avoid or minimize the 3.8% surtax on net investment income. 

Here is how it works: If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what a bank charges. In future years, the payments you receive will be partly proceeds from the sale (generally taxed at your capital gains rate) and partly interest on the note (ordinary income). For a sale to qualify as an installment sale, at least one payment must be received after the year in which the sale occurs. Installment sales are most frequently used when the property that is sold is real estate and cannot be used to report the sale of publicly traded stock or securities.

Tax Deferred Exchange –Section 1031 of the Internal Revenue Code provides an exception that allows individuals and businesses to postpone paying tax on the gain from the disposition of real estate property if the proceeds are invested in other real estate as part of a qualifying like-kind exchange. 

Although these types of transactions are sometimes termed “tax-free” exchanges, that is a misnomer. Taxation on the gain is merely postponed until a future year when the property received in the transaction is disposed of other than by another exchange.

To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.

Both properties in an exchange must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. In addition, the property given, and the property received in an exchange must be real estate property and can be improved or unimproved and can be used in a business activity or held for investment. Due to the very complicated nature of 1031 exchanges, you should consult with this office prior to entering an exchange. 

Qualified Opportunity Fund – Individuals can defer both short- and long-term capital gains into what are referred to as Qualified Opportunity Zone Funds (QOFs). What is nice about a QOF is that only the actual amount of gain needs to be invested into a QOF to avoid taxes on the gain for the sale year. The gains invested in a QOF are deferred until you cash out of the QOF investment or December 31, 2026, whichever occurs first. This includes the gain from the sale of all capital assets, such as stocks or bonds, property, rentals, land, and even partnership interests that is invested in a QOF.

QOFs were originated in 2017 with gain deferral allowed through the end of 2026. However, with the deferral period now being for such a short time, QOFs have limited gain deferral application. 

If the QOF is held for 10 years or longer before it is sold, none of the appreciation since the QOF was purchased is taxable when it is sold. This provision applies only to the investment in the QOF made with deferred capital gains.

QOFs are investments in economically distressed communities and are not suitable for everyone’s investment risk tolerances. 

Like all things tax, nothing is simple, and a myriad of rules apply to the foregoing arrangements, so please contact this office for more information or a planning appointment.