This might be a simplistic model, and the outcome may be avoidable by sufficient tax planning, but I'm sure some entrepreneurs have lost money this way.
Ancient History Item: Before the tax reform act in 1987, you had the ability to do income averaging across tax years to address this situation. It was reformed away.
1. In the first year, suppose you and a corporation (you own this corporation outright) makes no income.
2. In the first year, you make a loan to your corporation ($50k for instance)
3. In the first year, you also pay yourself a salary of $50k. You pay taxes on this "income". Yes, you're paying taxes on money you didn't really truly actually earn yet.
4. In the second year, suppose your corporation makes $100k of income. Your corporation repays your $50k loan. The loan repayment is tax-free, and the remaining $50k then becomes your salary for the year.
If you do not actually have $50k to perform steps 1-2, you do it repeatedly with small bank transfers until you've accumulated enough "loan" and enough "salary".
You then effectively pay two years of $50k income, instead of one year of $0 income and one year of $100k income.
While I'm working, I contribute the max I can to retirement savings (RSP, 401k, whatever it's called in your country) so I reduce my taxable income by that amount.
In the years I'm not working (don't want to, travel, etc.), I take money out of those retirement savings. If I take out less than the tax-free threshold ($10k/yr in Canada) I pay no tax on that money. If I take out more, it will be less than I earned in my working years, so I'll be in a lower tax bracket anyway.
In this way I'm averaging out the taxes I pay over many years, and it takes out the spikes and dips from working/not-working years.
The only downside to this is that once you've taken money out, you can't get that money back again onto your yearly contribution cap, so when I'm old and grey, my retirement savings likely won't be as high as they otherwise would be (but I don't believe in that anyway, so for me, it's not valid)
(I guess the notable exception is that contributions to a Roth IRA can be withdrawn with no penalty. Earnings would all face the penalty)
What's the penalty?
Lots of people think that of tax-free retirement savings (and people keep warning me of it) but in fact, the only penalty I've ever heard of is you must pay tax on that money along with other income.. so if you do it in a regular earning year, you pay lots of income tax. Do it in a year when you earn nothing else, and you pay none or very little. That's not a penalty
Let's say I don't earn any other income in a year and pull out $5k. What's my tax rate?
Let's say I pull out exactly the tax-free threshold. What's my tax rate?
(I ask for the clarification because here in Canada, they withhold a very large amount of whatever you take out.. because they are assuming you have other income. It all comes back at tax time though, based on whatever other income you do have. So I ask because I'm wondering if they force the 10% on you, or if they just withhold it and you can get it back at tax time)
If this withdrawal is your only income, and you keep the withdrawal below the tax-free limit (looks to be $9k), you won't pay any tax, and thus won't pay the 10% penalty either.
(For 2012, it's reported on line 58 of the 1040...)
Distribution means the money taken from the 401k
1040 is the main federal tax form in the U.S.
Line 58 is in the 'Other taxes' section of the form, where the amounts are figured using some basis other than the AGI. It also is where you would look in the 1040 instructions to see how the penalty is calculated.
In the author's case, you could imagine a fix; the author could somehow amortize the income over previous years and pay all the money at the appropriate rate. (Though I can imagine a number of fraud- and incentive-related issues there.) But you can't really do that with the pro athletes because a) you don't know when they'll actually stop making money and b) in the future they may not actually have it.
Edit: on second thought since star athletes are getting paid in the millions, prorating it over 20 years won't change that much in the grand scheme of things. Maybe something like 400k*20% each year before they hit the max bracket anyways.
> The Associated Press reported that Ichiro's contract extension defers $25 million of the $90 million at 5.5% interest until after his retirement, with payments through 2032
If he retires at the end of next year, he'll make that money over 18 years. If he made it all at once, today, he'd pay about 9.8 million of that 25 in taxes (just punching things into a naive tax calculator; I'm sure his accountants would improve things. OTOH, it's also slightly low because it puts him in a lower tax bracket for the first 400K, which he doesn't get because of the other income he has). Ignoring the interest for a moment, splitting 25 million over 18 years he pays a total of 8.9 million. So he saves a million dollars doing it this way. Not bad.
With the interest, he'd get paid more; it looks like 1.8 million per year for 18 years, so 32.4 million instead of 25. That's a bit of a raw deal if he has to pay that as regular income tax, since if he got the money now and put it in the market, it would perform about as well, but would get taxed at a capital gains rate.
All in all, I suspect this is a compromise with the Mariners to alleviate cash flow and luxury tax pressure more than it's a shrewd tax move.