What Is a Tax Shelter?
A tax shelter is a vehicle used by individuals or organizations to minimize or decrease their taxable incomes and, therefore, tax liabilities. Tax shelters are legal, and can range from investments or investment accounts that provide favorable tax treatment, to activities or transactions that lower taxable income through deductions or credits.
Common examples of tax shelter are employer-sponsored 401(k) retirement plans and municipal bonds.
- A tax shelter is a place to legally store assets so that current or future tax liabilities are minimized.
- A tax shelter is a tax minimization strategy, and should not be confused with the illegal practice of tax evasion.
- Qualified retirement accounts, certain insurance products, partnerships, municipal bonds, and real estate investments are all examples of potential tax shelters.
How Tax Shelters Work
There are various provisions available that can be used to reduce an individual or corporation’s tax burden, whether temporarily or permanently. When these resources are implemented to lower a tax bill, we say that the entity involved is sheltering its taxes. The tax shelter route that is taken by a taxpayer to reduce or erase his tax liability can be legal or illegal, hence, it is imperative that the individual or corporation evaluate the tax reduction strategies to avoid being penalized by the Internal Revenue Service (IRS).
There are numerous tax shelters that the government has provided to help its taxpayers lower the tax burden. Tax deductions, for one, are amounts of income earned 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, student loan interest deduction, mortgage interest deduction, deduction for certain medical expenses, etc.
For example, the IRS permits charitable donations to be tax deductible for up to 50% of an individual’s adjusted gross income (AGI). If a taxpayer with an annual income of $82,000 elects to donate $12,000 to a qualified charitable organization, his taxable income will be reduced to $70,000. Since he falls in the 25% marginal tax bracket, his marginal tax due will be 25% x $70,000 = $17,500, instead of $20,500 which he would have paid without the tax shelter provided through his charitable donation.
Tax shelters are also legally available in the form of investment and retirement accounts which shelter income from taxes. The tax shelter provided through these accounts serves as an incentive to income earners to save for retirement. Income contributions made to a 401(k), 403(b), or Individual Retirement Account (IRA) plan will not be taxable until the individual retires. This way, money that would have been taxed by the IRS accrues interest and earnings in the account until the funds are drawn. A taxpayer who takes advantage of the tax shelter provided through a 401(k), 403(b), or IRA reduces his taxable income by the amount of his contribution into either of the accounts. For individuals who expect to be in a higher income tax bracket by the time they retire, the Roth IRA and Roth 401(k) provide a way to shelter income from higher taxes. With these investment accounts, the contributed income is taxed before entering the accounts, but no tax applies when the funds are withdrawn. This way, if the taxpayer starts making distributions after he enters a higher tax bracket, he would already have paid taxes when he was in a lower income bracket.
Other Common Tax Shelters
Certain types of assets can also be invested in to provide tax shelters. Investors with foreign investments in their portfolios can take advantage of the 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 income tax liability. Some municipal bonds are also tax-exempt, meaning that any interest income that is generated is exempt from federal income taxes, and in many cases, state and local income taxes as well.
To encourage investment in companies of certain sectors (oil exploration, renewable energy, and mining, for example) which require heavy 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 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.
Mutual funds that invest in government or 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 debt securities is exempt from federal income taxes, so your investment generates annual income tax-free.
Tax Shelter vs. Tax Evasion
While tax shelters provide a way to legally avoid taxes, they can also be used 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 tax evasion, the 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. For example, if an independent contractor or subcontractor purposely transfers all or a portion of her earned income to another individual who is subject to lower tax rates, the contractor will be evading taxes. Also, companies who take advantage of favorable tax rates in certain countries by creating offshore companies for the purpose of evading taxes, will be heavily penalized by the IRS which treats such manipulative strategies as fraudulent activity subject to steep fees, criminal prosecution, and prison sentence. (For related reading, see "Why Delaware Is Considered a Tax Shelter")