What is a tax shelter (2024)?

How do tax shelters work?

A tax shelter works by reducing the amount of tax you owe, either now or in the future. Some common ways to do this is by putting money into a tax-advantaged investment account or it could mean taking actions that will earn you more deductions and credits on your tax return.

Sometimes, a tax shelter means that you pay less tax. Other times, it means that the tax is only deferred, not completely gone. A deferral now may mean a higher tax bill later — unless that future tax is also offset by other factors, like business losses, future tax credits, or a lowered income.

Types of tax shelters

There are many different types of tax shelters or tax reduction strategies. Some are more applicable to the average American, while others are focused specifically on businesses in specific industries, such as oil and gas. Here are some of the most common types of tax shelters.

Retirement plans

One of the most common tax reduction strategies for Americans is retirement savings. Low-to-moderate income earners may be eligible for the saver’s credit, which directly reduces their tax bill by up to 50% (or $1,000) of their yearly contributions to certain retirement accounts. These accounts include:

• Traditional and Roth individual retirement accounts (IRAs)
• Elective salary deferral contributions to a 401(k), 403(b), governmental 457(b), SARSEP or SIMPLE plan
• Voluntary after-tax employee contributions made to a qualified retirement plan (including the federal Thrift Savings Plan) or 403(b) plan
• Contributions to a 501(c)(18)(D) plan
• Contributions made to an ABLE account for which you are the designated beneficiary (beginning in 2018)

This is in addition to the tax benefit of contributing to a traditional IRA or other pretax retirement account, which is available to anyone. The saver’s credit is intended to “reward” low-income Americans for saving for their retirements.

Let’s take a closer look at two of the most common retirement vehicles. Each has a tax reduction strategy baked into it, but the tax shelter is at opposite ends of the account.

• Traditional IRA: A traditional IRA is funded with pretax money. This means that in the year the money goes into the account, your taxable income will be lower. For example, if you ordinarily would have a taxable income of $75,000, but contributed $5,000 to a traditional IRA, your taxable income that year would be only $70,000. On the other hand, when you retire and withdraw that same $5,000 from the account, you will pay tax on it at your current tax rate. This is a good option for Americans who expect that they will be in a lower tax bracket when they retire, as they will pay less tax on the money when it comes out than they would have paid when it goes in.
• Roth IRA: A Roth IRA, on the other hand, is funded with after-tax dollars. This means that in the year of the contribution, you’ve already paid tax on that money. After retirement, though, the money can be withdrawn tax-free. This account is meant for Americans who intend to be in a higher tax bracket when they retire.

Real estate investments

Real estate can offer several different varieties of tax shelters, including different forms of depreciation and allowable business losses.

Depreciation is an expense that the IRS allows for business owners. It allows them to offset the cost of “using up” large business assets, such as buildings, vehicles, and machinery, over the asset’s life. This extra expense reduces taxable income a bit every year over the course of the asset’s useful life.

For real estate, this means that the building itself, as well as other assets within the building that the landlord owns (like the furnace), can be gradually expensed over time. The amount of depreciation varies by the asset itself and the method of depreciation used. A good tax accountant is very important when calculating depreciation on real estate or any other asset.

College savings plan

College savings plans, like the 529 Plan, are state-sponsored plans that offer tax-advantaged growth and tax-free withdrawals when used for qualified education expenses (college, K-12 tuition, etc.). Contributions may also offer state-level tax deductions.

Charitable contributions

Donating to qualified charities is a way to support causes you believe in while also gaining tax benefits. When you itemize deductions, you can deduct the fair market value of donated goods or cash contributions to qualified non-profits.

Business deductions

Businesses have access to a wide array of tax deductions. In addition to real estate, here are some key examples:

• Startup costs: Expenses incurred during the creation of a business can sometimes be deducted.
• Business expenses: Ordinary and necessary costs related to operating your business are usually deductible.
• Home office deduction: If you use part of your home for business, you may be able to deduct related expenses.
• Travel and meals: Costs associated with business-related travel and meals may be deductible.

Medical and dental expenses

Health savings accounts, or HSAs, are another great way to reduce taxable income while saving for health expenses. Like IRAs, there are limits to how much you can contribute every year, but the benefits are real: the money is deposited tax-free and can be withdrawn tax-free if used for qualified medical expenses. HSA money can also be withdrawn tax-free after 65 for any reason, not just medical expenses. Despite what the name implies, it isn’t just a savings account, either — money in the HSA can be invested in another vehicle for even more tax-free growth.

Municipal bonds

Investing in municipal bonds can be a small way to reduce taxes. Ordinarily, interest earned on investments is taxable, but municipal bond interest is not. The idea is to “reward” Americans for buying municipal bonds, which raise important revenue for state and local projects.

Advantages of tax shelters

The biggest advantage to using tax shelters is, clearly, the tax reduction. This leads to a cascade of other financial benefits, both for you and for society. Whether you are an individual or a business, less money going to taxes means more money in the bank.

More money in the bank means more money for all the tax-advantaged things: retirement savings, health expenses, and business ownership. All of these things benefit the individual, as well as the greater society as a whole. More retirement and health savings mean better quality of life for Americans, as well as less reliance on government assistance. More businesses, especially small businesses, make a stronger economy, which benefits everyone.

How to use tax shelters responsibly

There is nothing wrong with sheltering the legal maximum amount of your income from tax. However, there are right and wrong ways of doing this. Tax sheltering can quickly move from tax reduction, which is legal, to tax evasion, which is not.

• Keep good records. Excessive tax deductions can flag your tax return for fraud at the IRS, and having good records is one of the best ways you can protect yourself. What does this look like?
  • Retirement contributions: bank statements or pay stubs with direct deposit to retirement accounts
  • Tax-free HSA purchases: receipts or invoices for health-related expenses
  • Business expenses and depreciation: accounting records, invoices, and receipts

  It also means keeping tax returns for at least three years, or seven if you have business losses to carry forward.

• Be able to justify your deductions. This is part of why keeping records is so important. It may be tempting to claim nonmedical expenses as health-related expenses from an HSA account, but in the case of an audit, there would be no justification for that expense. This may leave you open for unwelcome consequences such as back taxes owed, fines, and late fees.
• Consult an expert. When hunting for every last tax deduction and credit, there is no one better than a good tax accountant. While most CPAs are familiar with the common tax credits, the various forms of real estate depreciation may require someone who has more experience with that specific area.

Risks of misusing tax shelters

The IRS offers tax shelters, but they generally show no mercy towards those who abuse these shelters by using them for tax evasion.

Evasive activities can include underreporting or failing to report income on your tax return, even money in tax-sheltered accounts. It can also look like taking inappropriate tax deductions that cannot be justified. Tax evasion can lead to recalculation of tax, back taxes, fines, fees, and even legal prosecution and jail time.

Bottom line

Tax shelters offer various legal ways to reduce your tax burden. Understanding your options and working with a tax professional unlocks the potential to keep more of your hard-earned money.