Money Matters: When delay can pay

Most of the time, it’s smart to get a job done sooner rather than later. When it comes to paying taxes, though, the opposite is often true: putting the taxman off as long as the law allows can be a powerful tool in building wealth, assuming the cost of deferring isn’t too steep.

One easy way to take advantage of this tool is to contribute to a tax-deferred retirement account. You can think of the tax deferral as a government loan on favorable terms. You can also think of you and the government as partners. If your investment does well, you’ll make more and so will the government. If you lose money, you and the government will share in the loss.

What is this partnership worth to you? Say you’re in a combined 40 percent tax bracket (using a round number for simplicity’s sake) and you invest $10,000 within a qualified plan. The account earns 50 percent, growing to $15,000. You withdraw the money, pay your 40 percent in taxes, and are left with $9,000. Here’s the interesting part: the $9,000 is exactly what you would have been left with had you paid the 40 percent ($4,000) in taxes up front, placed the remaining $6,000 in a non-retirement account, and earned the same 50 percent tax-free. The benefit of deferring taxes through a pension contribution is essentially the ability to invest the after-tax amount—your portion of the deal, if you will—tax-free. This can be powerful.

For business owners, it can be even more powerful through defined-benefit pensions (including the hybrid cash-balance plan). While contributions to plans such as 401ks cannot exceed $59,000 in 2015 (including employer contributions and catch-up allowances for those over age 50), those to a pure defined-benefit or hybrid cash-balance plan can potentially be far higher, particularly as you approach retirement age. Of course, to adopt such a plan, a business owner must contribute for employees as well and pay administrative costs, so the decision that is right for one owner may be wrong for another.

Not to be overlooked in the pension decision is the possibility, even for wealthy individuals, that taxes will not only be deferred but ultimately paid at a lower rate, either because workplace income has ended or one has moved to a state with lower tax rates (or no income tax at all).

Holding appreciated securities offers another prime way to defer taxes. The potential benefit here is generally smaller than with retirement plans, in part because only the gain is taxable; thus, only that gain benefits from additional deferral. However, in cases of very long holding periods or steep appreciation (Microsoft in the 1990s, Apple since then), earnings can make up the vast majority of the position.

But let’s not forget about risk. The risk specific to tax-deferred retirement accounts largely concerns lack of liquidity—you may not be able to take the money when you need it, at least without paying a penalty. With appreciated stocks, meanwhile, the risk of concentration in one security can be substantial, even reckless. Tax benefits can be intoxicating and get in the way of smart decisions. For perspective, consider that the potential tax cost of diversifying a concentrated position, translated into the expected return, can be a lot lower than diversifying from stocks into high-quality bonds. And many savvy investors make the latter decision every day to reduce volatility.

Weighing risk and return isn’t a casual undertaking; the variables include not only risk and return of individual assets but also the correlations between them. Tax deferral can add to return and should be a fundamental part of the equation.

Paul Palazzo, a Certified Financial Planner, is the managing director at New York-based Altfest Professional Wealth Management.