What Is a Tax Shelter?

A tax shelter is a vehicle used by an individual or organization to decrease their taxable income and, therefore, their tax liabilities. It can be used legally or illegally. Legal tax shelters range from investment accounts that provide favorable 🎐tax treatment to activities thaꦚt lower taxable income through deductions or credits. Illegal tax shelters are used for tax evasion.

Understanding Tax Shelters

There are numerous tax shelters that the government has provided to help taxpayers lower their tax burden. 澳洲幸运5官方开奖结果体彩网:Tax deductions, for one, are amounts of income that can be deducted from an individual’s taxable income. The tax rate that is applied to the lower taxable income will translate into a lower tax bill for the individual. Some tax shelters that are provided in the form of tax deductions include deduction of charitable contributions, 澳洲幸运5官方开奖结果体彩网:student loan interest deduction, mortgage interest deduction, deduction for certain medical expenses, etc.

For example, the Internal Revenue Service (IRS) allows charitable donations to be tax deductible for up to 50% of an individual’s 澳洲幸运5官方开奖结果体彩网:adjusted gross income (AGI). If a taxpayer with an annual income of $82,000 elects to donate $12,000 to a 澳洲幸运5官方开奖结果体彩网:qualified charitable organization, for example, their taxable income will be reduced to $70,000. Since they fall in the 22% marginal 澳洲幸运5官方开奖结果体彩网:tax bracket, they would lower their tax bill by $2,640 ($12,000 x 22%).

Types of Tax Shelters

Retirement Accounts

Tax shelters are legally available in the form of investment and 澳洲幸运5官方开奖结果体彩网:retirement accounts that shelter income from taxes. The tax shelter provided through these accounts serves as an incentive to save for retirement. Contributions made to a traditional (non-Roth) 401(k), 403(b), or 澳洲幸运5官方开奖结果体彩网:individual retirement account🌄 (IRA) will not be taxable until retirement. This way, money that would have been taxed by the IRS accrues interest and earnings in the account until the funds are withdrawn, ideally when the taxpayer is in a lower tax bracket.

A taxpayer who takes advantage of the tax shelter provided through a 401(k), 403(b), or IRA reduces their taxable inco🤡me by the amount of t🍸heir contribution.

For individuals who expect to be in a higher income tax bracket by the time they retire, the Roth IRA and 澳洲幸运5官方开奖结果体彩网:Roth 401(k) provide a way to shelter income from higher taxes. With a Roth account, the contributed income is taxed before entering the account. Then there a💞re no taxes in retirement when the funds are withdrawn, as long as the account has been open for at least five years.

Foreign Investments

Investors with foreign investments in their portfolios can take advantage of the 澳洲幸运5官方开奖结果体彩网:foreign tax credit which applies to taxpayers who pay tax on their foreign investment income to a foreign government. The credit can be used by individuals, estates, or trusts to reduce their 澳洲幸运5官方开奖结果体彩网:income tax liability.

Oil and Energy

To encourage investment in companies of certain sectors (oil exploration, renewable energy, and mining, for example) which require heavy 澳洲幸运5官方开奖结果体彩网:capital investment and take several years to start making profits, the government allows the exploration costs incurred by these companies to be distributed to shareholders as tax deductions. The 澳洲幸运5官方开奖结果体彩网:exploration and development costs are taken as the shareholders’ expenses; shareholders deduct the expenses from their taxable income as if they directly incurred these costs.

Municipal Bonds

Some 澳洲幸运5官方开奖结果体彩网:municipal bonds are tax-exempt, meaning that any interest income that is generated is free from the obligation of 澳洲幸运5官方开奖结果体彩网:federal income taxes. And in many cases, it's exempt from state and local income taxes as well. Note that interest income from municipal bonds is generally not subject to the 澳洲幸运5官方开奖结果体彩网:Alternative Minimum Tax (AMT).

Mutual Funds

澳洲幸运5官方开奖结果体彩网:Mutual funds that invest in government or 澳洲幸运5官方开奖结果体彩网:municipal bonds are also common tax shelters. Though you still pay income tax on your initial investment when those dollars are earned, the interest generated by these 澳洲幸运5官方开奖结果体彩网:debt securities is exempt from 澳洲幸运5官方开奖结果体彩网:federal income taxes, so your investment generates annual income tax-free.

Real Estate

Physical 澳洲幸运5官方开奖结果体彩网:real estate in addition to 澳洲幸运5官方开奖结果体彩网:real estate investme🐈nt trust (REIT) vehicles may be used as a tax shelter. Taxpayers may receive favorable treatment due to 澳洲幸运5官方开奖结果体彩网:depreciation deductions. Taxpayers may also receive benefits by performing 澳洲幸运5官方开奖结果体彩网:1031 like-kind exchanges that allow for the sale of a property and avoidance of 澳洲幸运5官方开奖结果体彩网:capital gains of the proceeds. Landlords and real estate investors may also be able to deduct rental losses from their rental income, thereby reducing their taxable income.

Conservation Easements

In some cases, agreements between landowners and a conservation organization can result in a tax benefit. These easements often reduce the use of land in order to protect a natural resource. When a taxpayer donates a conservation easement, they may be able to claim a tax deduction based on the value of the easement.

Tax Shelter Strategies

There are two primary tax sheltering stratౠegies.

The first is trying to 澳洲幸运5官方开奖结果体彩网:minimize tax liability. This is done most often by minimizing taxable income by offsetting taxable income against taxable losses or by simply reducing taxable income. For tax avoidance strategies, the goal is to never pay that tax and avoiꦬd t♕axes altogether.

The second is tax deferral. Consider popular retirement accounts such as a 澳洲幸运5官方开奖结果体彩网:traditional IRA. The gains for a traditional IRA are taxable when withdrawn. That is, those taxes are deferred to the future. Therefore, a taxpayer can plan for the future and not worry about imme𝔉diate tax implications.

Tax Shelter vs. Tax Evasion

While tax shelters provide a legal way to avoid taxes, they can also be used illegally, to evade taxes. Tax minimization (also referred to as tax avoidance) is a perfectly legal way to minimize taxable income and lower taxes payable. Do not confuse this with 澳洲幸运5官方开奖结果体彩网:tax evasion, th🏅e illegal avoidance of taxes through misrepresentation or similar means.

If an investment is made for the sole purpose of avoiding or evading taxes, you could be forced to pay additional taxes and penalties.

Companies that create offshore companies for the purpose of evading taxes will be heavily penalized by the IRS. Such activity is subject to steep fees and criminal prosecution.

Tax Shelter vs. Tax Haven

A 澳洲幸运5官方开奖结果体彩网:tax haven is a country or jurisdiction that offers low tax rates. A tax haven may also offer taxpayers minimal or no tax reporting requirements alongside strong fဣinancial privacy laws.

Individuals and businesses use tax havens to avoid or evade taxes. Though tax shelters may accomplish some of the same outcomes 𝓰as a tax haven, t😼ax havens are often coupled with a lack of transparency and secrecy.

The Bottom Line

A tax shelter is a strategy or investment vehicle that is designed to reduce or defer tax liabilities. Tax s✨helters can be used by indivi🌱duals, businesses, or organizations. Legal tax shelters take advantage of deductions, credits, or other incentives provided by the tax code, whereas illegal tax shelters are used for tax evasion.