What Is a Tax Shelter?
A tax shelter is a vehicle used by people or organizations to reduce or eliminate their taxable income and, as a result, their tax responsibilities. Tax shelters are lawful and may vary from tax-favored assets or investment accounts to activities or transactions that reduce taxable income via deductions or credits.
Employer-sponsored 401(k) retirement plans and municipal bonds are common instances of tax shelters.
- A tax shelter is a legal location to deposit assets in order to reduce current or future tax bills.
- A tax shelter is a tactic for reducing taxes and should not be confused with the unlawful activity of tax evasion.
- Potential tax shelters include qualified retirement accounts, some insurance products, partnerships, municipal bonds, and real estate assets.
Understanding Tax Shelters
There are many options available to minimize an individual’s or corporation’s tax burden, either temporarily or permanently. When these resources are used to reduce a tax liability, we refer to the entity as tax sheltering. A taxpayer’s tax shelter route to lower or erase his tax burden might be legal or unlawful; thus, it is critical that the person or organization assess the tax reduction tactics to avoid being fined by the Internal Revenue Service (IRS).
The government has offered many tax shelters to assist citizens in lowering their tax burden. For example, tax deductions are sums of money produced that may be deducted from an individual’s taxable income. The lower tax rate applied to the lower taxable income results in a smaller tax bill for the person. Tax deductions offer tax shelters such as charity donations, student loan interest deduction, mortgage interest deduction, deduction for certain medical expenditures, and so on.
For example, the IRS allows charitable contributions of up to 50% of an individual’s adjusted gross income to be tax deductible (AGI).A taxpayer with an annual income of $82,000 may lower his taxable income to $70,000 by donating $12,000 to a qualifying charity organization. He would save $2,640 in taxes since he is in the 22% marginal tax rate (12,000 x 22%).
Tax shelters are also permissible in the form of investment and retirement accounts that shield income from taxes. The tax break afforded by these accounts encourages income earners to save for retirement. Contributions to a 401(k), 403(b), or Participant Retirement Account (IRA) plan are tax-free until the individual retires. Money that would otherwise be taxed by the IRS accumulates interest and profits in the account until the funds are withdrawn. A taxpayer who uses the tax shelter afforded by a 401(k), 403(b), or IRA decreases his taxable income by the amount contributed to one of the accounts. Individuals who anticipate to be in a higher income tax bracket when they retire might use the Roth IRA and Roth 401(k) to shield income from higher taxes. Contributed income is taxed before entering these investment accounts, but there is no tax when the money are withdrawn. If the taxpayer begins making distributions after entering a higher tax bracket, he will have already paid taxes while he was in a lower income bracket.
Other Common Tax Shelters
Tax shelters may also be obtained by investing in certain sorts of assets. Investors with international interests in their portfolios may benefit from 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 may utilize the credit to decrease their income tax obligation. Some municipal bonds are also tax-exempt, which means that any interest income earned is free from federal income taxes, as well as state and local income taxes in many situations.
To encourage investment in companies in certain sectors (such as oil exploration, renewable energy, and mining), which require large capital investments and take several years to turn a profit, the government allows these companies’ exploration costs to be distributed to shareholders as tax deductions. The exploration and development expenditures are treated as shareholder expenses, and shareholders deduct them from their taxable income as if they had spent them personally.
Mutual funds that invest in municipal or government bonds are also popular tax shelters. Though you must pay income tax on your original investment when it is made, the interest created by these debt instruments is exempt from federal income taxes, so your investment creates tax-free yearly income.
Tax Shelter vs. Tax Evasion
While tax shelters allow you to lawfully avoid paying taxes, they may also be utilized to avoid paying taxes. Tax minimization (sometimes known as tax avoidance) is a fully legal method of reducing taxable income and lowering taxes due. Do not mistake this with tax evasion, which is the unlawful avoiding of taxes by deception or other ways. If you make an investment only to avoid or evade taxes, you may be obliged to pay extra taxes and penalties. For example, if an independent contractor or subcontractor transfers all or part of her earned income to another person who is subject to lower tax rates, the contractor is dodging taxes. 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, which considers such manipulative strategies to be fraudulent activity subject to steep fines, criminal prosecution, and prison sentence. (For further information, see “Why Delaware Is Considered a Tax Haven.”)
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