What is a Tax Shelter? Definition, Overview, and how it works

Using a tax shelter to minimize your tax bill lawfully can be a sensible move.

The word “tax shelter” may conjure up images of wealthy individuals and organizations stashing cash in shady offshore accounts to avoid paying taxes.

“Typically, tax shelter is regarded as a terrible word,” explains Bill Smith, managing director of CBIZ MHM’s national tax office.

There are, however, several totally legal and respectable ways to avoid paying taxes. Tax-advantaged savings, wise investments, and even your property are examples.

Continue reading to learn everything you need to know about tax shelters and other choices that may be beneficial to you.

What Is a Tax Shelter?

Individuals or organizations use a tax shelter to reduce or eliminate their taxable income and, as a result, their tax liability. Tax shelters are lawful, and they can range from favorable tax treatment for assets or investment accounts to activities or transactions that reduce taxable income through deductions or credits.

Employer-sponsored 401(k) retirement plans and home equity loans are two common instances of tax shelters.

Examples of Tax Shelters

#1. Home Equity

Many families or individuals gain property, either outright or with the help of a mortgage loan. They refer to the worth of a house that a buyer possesses free of any debt to as home equity. The tax shelter element of home equity arises if the individual sells their home in the future.

The Internal Revenue Service (IRS) exempts individuals from paying capital gains tax on the first $250,000 of their home’s sale price.

#2. 401(k) Accounts

A 401(k) account is a tax shelter, but it isn’t a long-term one. The amount of income that the government can tax decreases as an individual contributes to their 401(k) account with pre-tax income.

Besides that, funds in the account may accrue interest without being taxed by the government.

The tax shelter isn’t permanent because the individual will have to pay taxes on the income in the future. Once the individual withdraws funds from the account, they will make regular tax deductions.

A classic individual retirement account (IRA) is a type of tax shelter that functions similarly to a 401(k) account.

How Do Tax Shelters Work?

There are several laws that can ‌decrease a person’s or company’s tax burden, either temporarily or permanently. When these resources are used to reduce a tax burden, we refer to the entity as “sheltering” its taxes.

A taxpayer’s tax shelter route to lower or erase his tax liability can be legal or illegal, thus it’s critical that the individual or organization assess the tax reduction tactics to avoid being penalized by the Internal Revenue Service (IRS).

The government has created several tax shelters to assist citizens in lowering their tax burden. For example, tax deductions are sums of income that can be deducted from a person’s taxable income.

Individuals will pay less tax because of the reduced tax rate applied to their lower taxable income. Deductions for charitable contributions, student loan interest, mortgage interest, and some medical expenses are just a few of the tax shelters available as tax deductions.

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The IRS, for example, allows charitable contributions to be tax deductible up to 50% of an individual’s adjusted gross income (AGI).

A taxpayer with an annual income of $82,000 can lower his taxable income to $70,000 by donating $12,000 to a qualifying charity organization. He would save $2,640 in taxes because he is in the 22 percent marginal tax bracket (12,000 x 22 percent ).

Here are six tax shelters ‌you might be eligible for if you’re looking for a legal way to lower your taxes:

  • Accounts for retirement
  • Workplace advantages
  • Accounts for medical expenses 
  • Investing in real estate
  • Ownership of a company
  • Complex Investment 

Almost everyone may open A tax-favored retirement account, making it an excellent place to ‌avoid taxes. “Qualified retirement plans are the most common tax shelters out there right now,” adds Repak.

#1. Account For Retirement

People can deduct their contributions to traditional IRAs, 401(k)s, and other retirement savings vehicles. Employees can make deductible contributions to a 401(k) of up to $19,500 in 2021, with workers 50 and older able to deduct an extra $6,500 in catch-up contributions.

They limit contributions to a deductible IRA to $6,000 for workers under 50 and $7,000 for those 50 and older.

Traditional retirement plans provide a tax credit upfront, but taxpayers must pay income tax on withdrawals after retirement. Roth accounts‌ allow consumers to contribute after-tax cash ‌for tax-free retirement withdrawals.

Based on your circumstances, a finance specialist can assist you in determining which option will cause the largest tax savings.

#2. Workplace Advantages

Pretax monies may be available to employees who purchase group insurance through their company. Life, disability, vision, dental, and health insurance are common examples of these benefits. Using pre-tax cash to pay for these items reduces your taxable income.

Workers may also deduct reimbursed expenditures like mileage before the Tax Cuts and Jobs Act of 2017. Workers may want to negotiate payments for these expenses instead because tax reform abolished that deduction for everyone saves the self-employed. Any workplace reimbursement has the added advantage of being tax free.

If you have children, consider using a dependent care flexible spending account, or DCFSA, to cover child care expenses. Many businesses provide these accounts, which allow parents to put up to $5,000 in pretax money into them each year to spend for things like child care, summer daycare, before- and after-school care, and nannies.

However, keep in mind that DCFSA expenses are not qualified for the child and dependent care tax credit. Furthermore, funds deposited in a flexible spending account must be spent within the same year or they will be forfeited.

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#3. Accounts For Medical Expenses

Flexible spending accounts (FSAs) and health savings accounts (HSAs) are two ways to deduct health-care expenses from taxes.

“(HSAs) give account holders with three significant tax benefits: tax-free contributions, tax-free growth, and tax-free withdrawals,” explains Jeff Bakke, chief strategy officer for payment solutions provider Wex’s benefits business. To be tax-free, however, withdrawals must be used for eligible medical costs.

Those with family insurance policies will ‌contribute up to $7,200 to an HSA in 2021 and deduct that amount from their taxes.

Single policyholders can donate up to $3,600 and deduct it from their taxes. In any instance, workers over the age of 55 can contribute an extra $1,000 in catch-up payments.

To contribute to an HSA, you must have a high-deductible health insurance plan that qualifies. Your firm may provide flexible spending accounts, or FSAs, to all employees if you don’t already have one.

These accounts work in the same way as the DCFSA, except they only cover qualified health-care expenses. While an HSA’s balance rolls over from year to year, money in an FSA must normally be spent within the year it was donated or it will be forfeited.

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#4. Investing In Real Estate

Purchasing real estate has several tax advantages. Those who itemize deductions on their federal tax returns can deduct mortgage interest and property taxes.

Furthermore, property often rises in value year after year. When you sell your house, you can deduct up to $500,000 of the appreciated value from capital gains tax if you have lived there for two of the previous five years.

All gains on a typical investment, such as stocks purchased through a brokerage account, are taxed.

Rental real estate can also give tax advantages, but there are limitations on who can claim rental property deductions and how they are calculated.

If you want to invest in real estate to reduce your tax liability, seek advice from a financial advisor.

#5. Ownership Of A Company

Since the Tax Cuts and Jobs Act drastically decreased the number of deductions available to employees, some people have found that owning a business is a more appealing choice.

Internet and wireless service, computer software, and office supplies are all items that self-employed employees and small business owners can deduct. Deductions for expenses linked to a home office may be available to those who work from home.

While these expenses may lower taxable income, the savings may be insignificant if you spend more merely to claim a deduction. “With a business, people may take deductions more liberally,” Repak adds, “but it’s still cashing out of pocket.”

#6. Complex Investments

Tax-advantaged investments have the potential to save the most money, but they also carry the most risk.

Captive insurance and syndicated conservation easements have both been attractive options for investors trying to dodge taxes in recent years.

“One advantage of captive insurance is that you get your premiums back if there are no claims after a certain length of time,” Smith explains.

However, there is a fear that the IRS is targeting certain deduction techniques for removal, so be skeptical of anyone promising investment returns that appear to be too good to be true.

If you’re not sure about the investment’s legitimacy or the reliability of the individual trying to sell it to you, get a second opinion.

Municipal bonds are a safer way to earn a tax advantage on investment returns. Their profits are often modest, but they may be tax-free on both a state and federal level.

What Are The Other Common Tax Shelters?

You can also get tax shelters by investing in certain assets. Investors with abroad investments can take advantage of the foreign tax credit, which is available to taxpayers who pay tax to a foreign government on their foreign investment income.

Individuals, estates, and trusts can use the credit to decrease their income tax liability. Some municipal bonds are also tax-exempt, so any interest income earned is exempt from federal income taxes and state and local income taxes in many situations.

The government allows exploration costs incurred by these companies to be distributed to shareholders as tax deductions to encourage investment in companies in certain sectors (for example, oil exploration, renewable energy, and mining), which require large capital investments and take several years to make profits.

The costs of exploration and development are treated as shareholder expenses, and shareholders deduct them from their taxable income as if they had incurred them personally.

Tax shelters include mutual funds that invest in government or municipal bonds. Though you must pay income taxes on your initial investment when it is made, the interest created by these debt instruments is not subject to federal income taxes, thus your investment creates tax-free annual income.

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What Is The Difference Between Tax Shelter vs. Tax Evasion?

Tax shelters can ‌avoid paying taxes lawfully, but they can also ‌evade paying taxes. The latter which is tax minimization (sometimes known as tax avoidance); is a fully legal approach to reduce taxable income and reduce the amount of taxes owed.

This is not to be confused with tax evasion, which is the illegal avoidance of taxes through deception or other ways. 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.

Furthermore, companies that take advantage of favorable tax rates in certain countries by forming offshore companies to evade taxes will be heavily penalized by the IRS. This will prosecute such manipulative strategies as fraud and subject them to steep fines, criminal prosecution, and prison sentences.
 

Frequently Asked Questions (FAQs)

Who qualifies as a dependent?

Dependents can include your child and, in some situations, other people who live with you or for whom you provide support.

What is the procedure for making a payment to the IRS?

The IRS website allows you to make 1040-ES estimated tax payments, balance due payments or set up an installment plan. Taxpayers can choose from a variety of payment alternatives.

How do I request a copy of my tax records or earning statements?

You can request your tax return transcript, wage, and income statement, and account statement through the IRS’s online application.

What is a tax credit, and how may it assist me in filing my taxes?

Annually, tax credits might help you minimize your tax liability. Some tax credits are refundable, meaning they will be added to your return, while others will just reduce your tax liability.

Conclusion

Why not stick to tried-and-true strategies like saving for retirement or your children’s college, itemizing your deductions, and investing in real estate instead of finding increasingly obscure (and probably nefarious) ways to reduce your tax liability?

Decisions taken just to reduce your tax liability without regard for your overall financial health and goals are likely to be sub-optimal.

Working with a financial advisor can help you make sure that everything is considered when making financial decisions. In addition, many financial consultants provide tax planning, which is a method of reducing your tax liability while keeping your overall financial goal in mind.

A matching tool can assist you in finding someone to work with who meets your requirements. You’ll start by answering a series of questions about your circumstances and objectives. The algorithm will then filter down your choices from thousands of advisors to just three fiduciaries who meet your requirements.

You then probably need to study their profiles ‌to learn more about them, have a phone or in-person interview with them, and choose who you desire to collaborate with in the future. This helps you to identify a solid match while the program takes care of a lot of the legwork.

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