Tax straddling, also known as income shifting, is a tax strategy used to manage and potentially reduce tax liabilities. It involves manipulating the timing of income and deductions to take advantage of differences in tax rates or situations between two or more tax periods. Here’s how it works:
- Timing of Income: This involves deferring income to a later year when the taxpayer expects to be in a lower tax bracket. For example, if a taxpayer expects their income to be significantly lower next year, they might delay invoicing for a job completed in December to January of the following year, shifting the income to a year with a lower tax rate.
- Timing of Deductions: Similarly, taxpayers might accelerate deductions into the current year when they expect to be in a higher tax bracket. This could involve prepaying expenses that are deductible in the current tax year or making charitable donations before the year-end.
- Capital Gains and Losses: Tax straddling can also be applied to capital gains and losses. For instance, an investor might sell investments that are in a loss position in a year when they have high income, using the capital loss to offset other taxable income.
- Retirement Contributions: Increasing contributions to retirement accounts in high-income years to reduce taxable income can be a form of tax straddling, as these contributions are often tax-deductible.
It’s important to note that while tax straddling is a legal way to manage taxes, it must be done within the rules set by tax authorities. Overly aggressive tax straddling can be seen as tax avoidance, which can lead to penalties. Taxpayers often consult with tax professionals to ensure they are compliant with tax laws while optimizing their tax situation.