How to Legally Lower Your Income Tax Bill Next Year

Every Spring I am on the other end of a conversation with a friend or family member who is  exasperated about the surprise income tax bill they owed during this latest filing season. There are deep sighs, complaints, and finally a vow to never let this happen again, only to lose sight of  the issue and be surprised and upset yet again the next year. Often, the surprise the following year is worse as wages typically go up, these individuals thus land in a higher tax bracket, and the cycle continues.

There are some simple deferral strategies that almost everyone should be utilizing to lower their taxable income. Contributing to your 401K, contributing to an IRA, enrolling in a Health Savings Account are just a few savings vehicles that will allow you to grow your wealth, plan for retirement, and lower your taxable income at the same time.

But what if you have maxed out the allowable contribution amounts to these vehicles? If you have been successful in your career, and are a good saver, there is a high likelihood that you have already utilized these vehicles to their fullest potential, and are looking for the next step.

One often overlooked strategy is to just take less income. If you have less taxable income, you will pay less in taxes. Problem solved. 🙂

Joking aside, there is a legitimate strategy here though. I don’t mean to go to your boss and ask for a demotion. What you should look for is to see if your company has a Non-Qualified Deferred Compensation Plan. With this type of plan, you can defer some of your compensation now, and defer that income to a later date when you actually need it. If you are someone who is facing a high tax bill during filing season, chances are you have been successful in your career, are in a high tax bracket, and additionally, can likely afford to defer some of your income.

Each company’s plan may be a little different, but the general idea is that you can defer a portion of your income to a later date of your choosing, have that deferred income invested into what is usually a list of investment vehicles, and then when the date you choose to receive the income (with the investment growth) arrives, you get it. This key to this lowering your taxes owed next year is that whatever income you defer, you are not taxed in the year of the deferral. These plans are used extensively as a way to attract high level employees who want more options to invest their assets and optimize their tax situation.

Some simple math can help inform the power of this plan. If you have been very successful and made it to the top tax bracket of 37%, every $1 made over ~$630,000 (married filing jointly), $.37 is going to the government. And this is before state and medicare surcharges apply. On Federal tax alone, if you defer $10,000, you will lower your federal tax bill by $3,700. If you are in this tax bracket, chances are you can afford this deferral. Further, you get to invest that $10,000 on a tax deferred basis.

“Thanks, but how is this different than a 401k plan?” It has similarities, but there are some important differences that must be considered. First, these plans (unlike 401k/Qualified plans) are exempt from ERISA requirements, meaning government oversight and protection are non-existent. Also, these plans do not need to be funded. Essentially, your deferred income is not protected in the same way that Qualified assets in a 401k are protected, and Non-Qualified assets can be taken by creditors if your company has serious problems. Additionally, Non-Qualified plans are discriminatory, meaning, they don’t need to be offered to everyone, they can only give it to certain employees of their choosing. And lastly, you will be taxed when you receive the income. All you are doing here is deferring the income until some later time when you actually need the money, well also taking advantage of growing this income tax deferred. I don’t mean to list these to scare you off from one of these plans, only to consider that they do carry different risks than a traditional Qualified plan.

Despite some nuances compared to typical Qualified plans, companies have a strong incentive to make these plans successful, as they are an important benefit to attract and retain talented employees. A Non-Qualified plan may not be for everyone, and if your company has financial or other issues, it may be wise to think carefully about your allocation to these plans. If your company is on solid footing, a Non-Qualified Deferred Compensation plan can be a very powerful tool to lower your current income taxes significantly, grow your wealth tax deferred, and allow you to continue saving efficiently outside of your current Qualified plan.