What is a Tax Shelter

Tax shelters can provide the legitimate potential for tax savings when utilized lawfully. Here is a look at what is a tax shelter.

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A tax shelter is a way to minimize your tax liability by putting money in certain investments. There are many different tax shelters, and when used correctly, they’re perfectly legal. In fact, Congress created tax laws and loopholes to allow certain individuals and companies to reduce their tax liability by making certain financial choices. On the other hand, you have to be careful that you’re not using tax shelters to purposefully avoid or evade taxes. That’s a crime that’s punishable by law. Examples of tax shelters include small businesses, real estate, and certain retirement plans.

Using Tax Shelters

Tax shelters are used to offset your income and lower the amount of taxes you owe. Losses on tax-sheltered investments may also allow you to reduce your taxable income. For example, a person could purchase a rental property and use interest, taxes, and depreciation deductions to offset their rental income.

Tax shelters allow taxpayers to lower their tax in one of several ways. The taxpayer may defer their taxes until another year when they would expect to be in a lower tax bracket. Investing money in a traditional IRA or another type of retirement account that defers taxes until the money is withdrawn can do this. This is the reason that many people max out their retirement contributions each year – so they can drop into a lower tax bracket, pay lower taxes, and of course, save up money for retirement.

Another tax shelter method is to convert ordinary gains which are taxable at 100% to gains with are 40% taxable. You can do this by investing in real estate. Or, you can hold your investments for a long enough time that they’ll qualify for long-term gains rates, which are lower than short-term gains rates. Taxpayers might convert capital losses, 50% tax-deductible, to ordinary losses, 100% tax-deductible by taking the loss as a business loss (you’ll need a legitimate, functional business to do this).

Increasing your itemized deductions is another way to shelter your tax. Itemized deductions include medical and dental expenses, taxes paid to other entities, home
mortgage interest, donations to charity, educational expenses, and business expenses.

The government also has R and D tax credits that reduce your tax dollar for dollar when you spend money in certain areas. Tax credits change frequently, so it’s a good idea to stay aware of current credits and their expiration.

Advantages and Disadvantages of Tax Shelters

One of the advantages of putting money in a tax shelter is that the usually sheltered from other creditors as well. For example, if you file bankruptcy or you’re faced with a lawsuit, your retirement accounts are typically exempt from creditor claims. And if you’re sending your kids to college, the money you have in a retirement fund won’t count in your child’s expected family contribution. The result, it’s easier for your child to qualify for financial aid.

One of the possible disadvantages of having your money in a tax shelter is that it’s less accessible. In some cases, withdrawing your money or otherwise liquidating the asset leaves you susceptible to penalties and taxes at your current tax rate.

There’s also the risk of being defrauded and losing your money in the investment. Chances are, the IRS won’t have sympathy on your losses considering you lost money trying to avoid taxes.

Abusive Tax Shelters

The IRS considers some tax shelters abusive, particularly those that have no benefit other than providing a tax deduction. For example, transferring income in offshore bank accounts to avoid paying income taxes may be considered abusive. Also using pass-through entities like trusts or corporations could be an abusive tax shelter. Often it’s not the actions themselves are not illegal. However, the intent to avoid paying taxes can result in fines or imprisonment or both.