What Is A Tax Shelter? Definition, Overview And How It Works in 2023

Tax shelters are legal and range from investments or investment accounts that provide fair tax treatment to activities or transactions that reduce taxable income through deductions or credits.

In this post, we’ll define a tax shelter, list some common examples, and understand how it works. Carefully read through.

What Is A Tax Shelter?

A tax shelter is a financial means used by individuals or organizations to reduce their taxable incomes. It ranges from investments or investment accounts that provide an adequate tax treatment, to activities or transactions that lower taxable income through deductions or credits.

Investopedia further defines it as a legal financial means to store assets to minimize current or future tax liabilities. This shelter should be distinguished from the illegal practice of tax evasion. 

As a financial tool, tax shelters allow individuals to keep more money they earn or get back some of the money they spent through deductions. It is a legal way of stopping the government from taxing part of one’s income.

How Does Tax Shelter Work?

By lowering your taxable income, a tax shelter can help you pay less tax to the federal government. There are many valid tax shelters available. Tax shelters, like most things, can be exploited for wrongdoing. 

The Internal Revenue Service (IRS)  in the United States keeps a tight eye on the usage of these shelters. The IRS has increased its surveillance in recent years as it has gained a better understanding of the often complicated workings of popular tax shelters.

A tax shelter helps reduce how much tax you pay the federal government by reducing your taxable income. Also, it usually includes investments or deposits in not heavily taxed accounts, such as retirement accounts.

Further reading: What are Index Funds? Full Guide to Investing

What Are The Types Of Tax Shelter? Tax Shelters To Consider

Here are the various tax shelters that the government legitimately approves:

  • Real estate investment
  • Retirement plans (401(k) and 403(b) plans IRAs)
  • Setting up your own business
  • Municipal bonds
  • Employer-sponsored benefits

1. Real estate investment

Real estate investment is a typical tax shelter. A real estate investment can help you create wealth over time, in addition to the deductions, it allows you to take — mortgage loan interest, mortgage insurance, and property taxes.

2. Retirement plans

Contributions to an IRA or 401(k) account allow one to defer taxes until you withdraw funds. If that IRA is a Roth IRA, it means you have to pay those taxes up front, but can withdraw from the account without paying taxes. Regardless of the type of IRA or 401(k) in which you invest, capital gains earned while your money is in that account are tax-free.

3. Setting up your own business

A popular method of avoiding federal income tax is to invest a portion of your principal income in setting up a side business. 

Here’s a clear example, Mr. Benson, an insurance sales associate with a passion for restoring vintage model trains, may, for example, start a business to advertise his repair and restoration abilities. Mr. Benson will use money from his major source of income as an insurance sales agent to fund his model train restoration business, perhaps lowering his tax liability. Mr. Benson can deduct various business expenses, including equipment and supplies, as long as he can establish to the IRS that he is trying to earn a profit with his side business.

4. Municipal bonds

Smaller governments (state, municipal, and county) employ municipal bonds to fund public works projects like filling potholes leftover from a harsh winter. The IRS does not tax the interest you earn on municipal bonds.

5. Employer-sponsored benefits

You can lower your taxable income by taking advantage of benefits provided by your employers, such as health insurance, life insurance, and education benefits. Before your tax withholding is determined, you usually donate a portion of your income to the benefit.

How To Use Deductions As Tax Shelter 

For one to save money, he or she has to spend money. It is true if you decide to use deduction as a tax shelter. 

Using deduction as a tax shelter means buying things that offer tax benefits. The money spent may be partially regained through a tax credit or tax reduction. The deduction is taken on a wide variety of things.

For instance, tuition can be paid to a college with a loan rather than a line of credit, and the student loan interest deduction can be used. In addition, many purchases or donations (many of which benefit charities) are at least partially tax deductible.

Can Tax Sheltering Be Abused?

An abusive way of thissheltering is by minimizing the amount of tax a taxpayer owes the government while providing no way for the taxpayer to make money. In effect, it’s the equivalent of stuffing your IRS debt into a piggy bank under your bed. 

Abusive tax shelters are frequently “multi-layer transactions,” in which money is “flowed” via businesses set up particularly to accept and store it, such as International Business Corporations (IBCs) [source: IRS]. When the IRS discovers a taxpayer has engaged in an abusive transaction, it imposes penalties and sends out bills for unpaid taxes and interest.

Tax Shelters Vs. Tax Evasion

Tax shelters can be used to lawfully avoid paying taxes, but they can also evade paying taxes. 

Tax evasion is an illegal attempt by individuals, corporations, trusts, and others to avoid paying taxes. Wikipedia defines it as the intentional misrepresentation of a taxpayer’s affairs to the tax authorities in order to reduce the taxpayer’s tax liability. It includes dishonest tax reporting, declaring less income, profits, or gains than the amounts actually earned, overstating deductions, bribing officials in countries with high corruption rates, and hiding money in secret locations.

If you make an investment solely to avoid or evade taxes, you may be obliged to pay additional taxes and penalties. 

An independent contractor or subcontractor, for example, will dodge taxes if she transfers all or a portion of her earned income to another individual who is subject to lower tax rates.

Planning your taxes helps you pay them on time and avoid tax debt. Discover: What is Tax Planning? Why do You Need It in 2023

FAQs On Tax Shelter

What is a tax shelter?

A tax shelter is a financial means used by individuals or organizations to reduce their taxable incomes.

What does a tax shelter do?

A tax shelter reduces how much tax you pay the federal government by reducing your taxable income.

What is a type of tax shelter?

One of the most common tax shelters is real estate investments. Real estate ownership entitles you to consider tax benefits, such as mortgage loan interest, insurance, and property taxes.

Can an LLC become a tax shelter?

Yes, an LLC can become a tax shelter because these businesses are limited in how much tax can be charged on their income.


It is prohibited to invest only for the aim of evading taxes. If you’re caught, you could face penalties and taxes related to tax evasion, as well as prison terms for repeat offenders. Using legal tax shelters to reduce the amount of taxes owed is a typical technique.



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