Deferring income to a future year, or into retirement, can offer significant tax savings and other benefits. But there are some risks to this strategy, and it requires proper planning to be effective. A financial advisor can help you decide if a short- or long-term income deferral plan is right for you.
Key takeaways:
- By postponing the receipt of a portion of your income to a year (or years) when you expect to be in a lower tax bracket, you can help minimize your current tax bill and save more money for future goals.
- Although deferring income can help you save on taxes now, if tax rates rise in the future, or your employer becomes insolvent before you receive payment, it could put your future finances at risk.
- A long-term deferral plan can limit your access to money you’ve earned. If you’re concerned about liquidity, other tax-saving strategies may be a better fit.
When Shohei Ohtani signed a 10-year, $700 million contract this month to play baseball for the Los Angeles Dodgers, something interesting happened.
The deal’s unusually large deferred-payout structure got almost as much attention as the history-making amount of his compensation. Instead of getting $70 million annually for the length of his contract, Ohtani will receive only $2 million each year. After 10 years, the Dodgers will then pay him $68 million annually from 2034 through 2043. Which means an eye-popping $680 million of Ohtani’s salary (97%) will be deferred over the next decade.
Ohtani isn’t the first player in Major League Baseball to defer income. But the amount he’s deferring—without interest, by the way—is unprecedented. So why is he doing it?
Mostly because he can. Ohtani reportedly makes about $50 million each year just in endorsements. So, he won’t exactly struggle without the extra income. And his agent says Ohtani just really wants to win: Deferring a large chunk of his salary will make it easier for the Dodgers to build a better team to support their new superstar.
There’s also the matter of taxes. With a deferred income plan, Ohtani won’t have to pay federal or state income taxes on the money that’s been set aside until he actually receives it. If he’s earning less or retired and in a lower tax bracket when he gets the deferred funds—which could be the case, as he’ll be turning 40 in 2034—it could result in substantial tax savings.
But you don’t necessarily have to be a star athlete to benefit from deferring income. Highly paid executives as well as small business owners and contract workers also might choose to implement a deferred income strategy as part of their financial planning.
How Does Deferring Income Work?
Deferring income generally allows an employee to delay receiving a portion of his or her compensation until a predetermined date—often in retirement. The funds might be paid out in a lump sum on that date, or as with Ohtani’s contract, over a period of several years. The exact amount to be deferred and other specifics—including if and how the money might be invested or earn interest—is determined by an agreement between the employer and employee.
In the case of a freelance or contract worker, the deferral may be over a shorter term. A worker who is due a large payment, for example, might ask to be compensated in the next tax year in order to stay in a lower tax bracket in the current year.
What Are Some Benefits of Deferring Income?
Deferring a portion of your income until retirement—or to any year in which you might find yourself in a lower tax bracket—could mean significant tax savings. It may be especially useful if you’re already maxing out contributions to your workplace retirement plan and traditional IRA each year.
Deferring also can provide another reliable income stream in retirement (along with Social Security and a pension if you’ve earned one). And it can offer financial flexibility, even if the deferral isn’t timed to your retirement, as you can save now for something you expect to pay for later (e.g. a child’s education, wedding, home, etc.).
Are There Risks to Deferring Income?
There are a few things you’ll want to consider before you opt to defer income—especially if you’re looking at a long-term deferral like the one Ohtani signed up for.
- What might happen to future tax rates? Of course, no one can predict what tax rates might look like years from now. But we do know the low rates put in place by the Tax Cuts and Jobs Act of 2017 are scheduled to sunset at the end of 2025. Unless Congress acts, those rates will revert back to pre-TCJA levels in 2026, and many people will see their tax burden rise.
- Will the payer remain financially stable? Will your employer still be around—and going strong—when it’s time for your payout? If your deferred compensation will be in the form of company stock, will those shares retain their value in the future? Or, if you’re a small business owner, will the client you asked to delay payment be willing and able to follow through at a later date? If not, you’ll likely have to take legal action, and your finances could be at risk.
- Would it be better to invest the money yourself? If you aren’t yet making the maximum contributions to your 401(k) and traditional IRA, it might make sense to go that route before setting up a deferred compensation plan with your employer. You’ll get the tax deferral you want, but you’ll also have access to your funds if you find you need the money sooner than you thought. And you can expect a retirement account handled through a third-party administrator to offer more security than an agreement with your company.
Wondering if some type of income deferral could benefit you? An experienced financial advisor can evaluate the “big picture” by assessing your current and future cash flow, tax rates, investment opportunities, and other factors to help you make an informed decision. At JJ Burns & Company we understand the complexities and consequences involved with this type of planning. If you’re considering a large or small income deferral as part of a tax-saving strategy, don’t hesitate to connect with us today so we can help.
