June 4, 2008
Windfall Strategy: Planning for Higher Income Years
by: Kevin Leeser, Partner
Professional
athletes and entertainers aren’t the only people who experience windfalls. If
you’re recognizing large and nonrecurring income from exercising stock options
or a payout from a deferred compensation program, you may indeed be in the same
boat. In fact, any number of situations can cause your income and marginal tax
bracket to be high for a short period and then drop.
The classic tax planning strategy of deferring income and accelerating deductions takes on a much greater importance if you temporarily find yourself in a high tax bracket.
Deferring income
If you’re in the same tax bracket from one year to the next, deferring the tax for one year will save you only the interest cost on the tax. For example, assuming a 5% interest rate and the maximum federal tax rate of 35%, the savings from a one-year tax deferral when tax brackets will be the same is only 1.75%. But if your tax bracket will drop next year from, say, the highest 35% bracket to the 28% bracket, you’ll have a permanent savings of 7% on top of the time value of money savings of 1.75%. If you’re in a state with graduated income tax rates, your savings may be even greater.
If you’re able to defer the recognition of income, perhaps by contributing some of your salary into a deferred compensation program, consider doing so. But if the financial risks are too high, take the money now and pay the tax. If your money won’t be earning interest during the deferral period, be sure to consider that as well.
Accelerating deductions
Accelerating deductions may be easier to accomplish, at least in small amounts. To move deductions forward one year, you can pay such items as real estate or state income taxes by Dec. 31 even though they aren’t due until the following spring.
Charitable contributions present the biggest shifting opportunity because you can pay them whenever you like. To achieve a more substantial acceleration, consider creating a private foundation to which you can contribute a large deductible amount in one year, and then use the fund to pay the charities for years to come.
Tax projections important
In any such planning, remember that projecting your taxes accurately is crucial. If you’re subject to the alternative minimum tax, your marginal tax bracket may not be as high as you think and your deductions may not all be usable.
In addition, deductions are subject to various limitations that may affect their use. But shifting tax liability into lower tax-bracket years is a powerful strategy that merits consideration.
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