Tax shelters are legal strategies that can decrease or defer your tax liability. They come in a variety of different forms and methods and can offer significant benefits if used properly.
A tax shelter is a way to shield assets and reduce or defer taxes. Tax shelters are completely legal, and both individuals and businesses can use them. Remember, you can’t avoid taxes—that’s tax evasion and a federal crime—but tax shelters can help you minimize them legally. There’s a difference.
The most obvious tax shelter advantages are that they can reduce your tax bill or defer tax payments to a later time. With certain tax shelters, creditors can’t access the money you put into them. Also, tax shelters are available to just about anyone. They range in complexity from simple strategies like taking business deductions on your tax return to sophisticated investing in the capital market.
While tax shelters can offer significant benefits, they also come with risks. You want to be sure you’re not crossing over the line from tax avoidance to tax evasion. It’s important to do your research and consult with professionals to advise you on the process, particularly if you’re using an advanced strategy. For example, an investor may want to take advantage of another country’s lower tax rates. With foreign investments, you can apply the foreign tax credit to reduce your U.S. tax bill. On the other hand, creating an offshore company to funnel your income through to avoid U.S. taxes could land you in prison.
Another disadvantage of using tax shelters is limited accessibility to your money. You’ll be penalized for withdrawing money for a nonqualified purpose with certain tax shelters. Retirement accounts are a great example of this. Pulling money from your 401(k) before you turn 59½ will cost you.
Tax shelters come in two main forms: tax deferral and tax reduction. Let’s look at some examples of how tax shelters can defer or reduce your taxes.
Tax-deferred retirement plans are commonly-used tax shelters. Employer-sponsored 401Ks, Individual Retirement Accounts (IRAs), Roth 401Ks, and Roth IRAs are all vehicles that allow you to defer taxes on the income you contribute.
If you claim any deductions on your tax return, you’re using a tax shelter. Deductions like charitable donations, business expenses, home office expenses, etc., are all ways to reduce your taxable income.
Tax credits are another form of tax sheltering. Credits are a dollar-for-dollar reduction of the taxes you owe. You can get credits for certain types of purchases and investments.
“Tax havens” are another form of tax shelter. A tax haven is a place that has lower business or personal income tax rates. This can be a state or a foreign country. For example, Delaware is a tax shelter state for businesses because there’s no sales tax. Companies or individuals can keep assets in those tax havens and benefit from their favorable tax treatment.
The tax shelter definition is simple but encompasses a lot. With a properly implemented tax shelter, you can either lower or defer your taxes. Financial professionals like accountants, tax lawyers, and financial advisors can ensure that the tax shelter you use won’t get you into legal trouble.
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Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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