From the course: Accounting Foundations

Strategy 1: Shift income from one time period to another

From the course: Accounting Foundations

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Strategy 1: Shift income from one time period to another

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- Let's start with the first basic tax planning strategy, shifting income from one time period to another. Let's take a simple example. Suppose you have a small side business where you give music lessons to children. You've earned $1000 giving group clarinet lessons. Do you want to be paid at the end of December of year one, or at the beginning of January of year two? Now, think about that carefully because the timing of reporting of income for income tax purposes is typically based on when you receive the cash. If you receive payment near the end of December, you must report that on this year's tax return and pay tax on it with the rest of your year one income. But if you delay receiving payment until January of year two, yes, you may have to wait a little extra to get your money, but you can wait an entire year to report and pay tax on this income with the rest of your year two income. Just by pushing the receipt of cash back a little bit from December to January, you've pushed your tax obligation back an entire year. Now, why might you want to legally delay payment of your taxes? You're eventually going to pay tax, the same amount of tax, but during the year long delay, in our example, you can keep the money you would've paid as income tax and you can invest it and earn interest on it, or you can use it for some other personal purpose. You can see the benefit of this basic tax planning strategy, shifting income from one time period this year to another time period next year. In the United States, there are two common methods of legally delaying the taxation of income. The first method is a traditional individual retirement account, an IRA, which is created and managed by an individual. The second method is a 401k plan, which is created and managed by an employer on behalf of an individual employee. We'll look at both of these. First, let's look at the traditional individual retirement account, the IRA, which is created and managed by an individual. The concept of an IRA was approved by the US Congress to encourage US workers to save for retirement. During the year, the taxpayer makes an investment with a financial institution up to $7,000 for those under 50 years of age and up to $8,000 for those older than 50. Now, these are numbers as of 2025. The taxpayer designates that investment as an IRA and the taxpayer subtracts this amount from taxable income when completing the year's income tax return. Now, when do you pay the tax on that excluded income? Well, you pay the tax on the IRA contribution and subsequent earnings when you retire and start receiving distributions. You have delayed paying the tax. That's an IRA. A 401k plan is a similar concept. This tax rule also encourages US workers to save for retirement. During the year, an employer withholds from an employee's paycheck up to $23,000 or up to $30,500 for those over 50, and deposits that amount in the employee's name in a financial institution. Often, the employer will match all or part of the employee's investment. When the employee/taxpayer completes this year's income tax return, the amount the employee contributed to the 401k plan is subtracted in computing taxable income. You pay tax on the 401k contribution and subsequent earnings only when you retire and withdraw the money. Both a traditional IRA and a 401k are examples of the first basic tax planning strategy, legally delaying the taxation of income. Now, for you US residents, let me give you a quick word about the Roth IRA. A traditional IRA and a 401k are not taxed now, but you are fully taxed when you retire. A Roth IRA is different. For a Roth IRA, the contributions are taxed now, but there is no tax ever on subsequent earnings. The Roth IRA is especially attractive to individuals who have low income now and so pay little or no tax now. To review, the most common ways to shift income from one time period to another are with a traditional IRA or a 401k. Both of these tax strategies legally delay the taxation of some income until you've retired.

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