A tax shelter is any legal strategy that you undertake in order to reduce the amount that you owe in taxes.
When you think about the term tax havens and tax shelters, what immediately comes to mind is greedy 0.1% billionaires trying to hide away their wealth on a remote desert island.
You may be thinking that tax shelters are not something that a normal person can utilize.
However, that’s not the case.
Read on for more information about how you can use completely legal methods to make your money go that little bit further, and help yourself out for your future investments and retirement.
With a little bit of investment, planning, and knowledge, you can make the system work for you, it may sound devious and fraudulent, but the reality is that anyone can utilize these systems to keep some more money aside for a rainy day.
Whilst, of course, there are unscrupulous practices that people can abuse, the simple act of learning about tax shelters and utilizing the legal options available is a great way to legally make savvy investments and protect your income from unnecessary costs from the government.
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What Are Tax Shelters?
The first thing to make abundantly clear is that tax shelters are not the same as tax avoidance.
There are perfectly legal and respectable ways to make sure your money is protected, that we will go into in this article.
A tax shelter can be defined in many different ways. In basic terms, it is anything that can be used to limit a person’s liability on income tax.
This means tax shelters basically include any strategy or savvy ways to deduct your expenses and lower your total income which then means you pay less tax on it.
However you decide to utilize tax shelters, the goal of them is to legally lower what taxes you pay on your assets and income over the year.
As a member of a society that works hard and pays their fair share of taxes, the aim is to pay everything that you owe, and be meticulous that you are not overpaying by making poor investment choices, and taking advantage of ways that you can save your income without avoiding paying any legally owed taxes.
What counts as a tax shelter does change regularly, so it is important to keep up to date with current laws and regulations so that you can stay legal and pay what you owe.
Many people do not realize that they can legally lower their taxes by claiming deductions. This is a perfectly legal way to limit the tax that you pay to the IRS.
Know The Law
Just because you claim that something is legal, or change its name to reflect a different practice, doesn’t make it so.
Tax shelters are not the same as tax avoidance so don’t get caught on the wrong side of the law by misinformation.
The IRS asks taxpayers to utilize a strategy called “substance over form”, this basically means that you can’t get away with an illegal tax strategy just by switching its name.
As an example, you legally cannot transfer the income that you earn to another member of your family in a lower tax bracket and claim that you have to pay fewer taxes on it.
If you earn that money, you yourself are the one who has to pay the tax on it.
So, this doesn’t suddenly become legal if you set up a corporation and add that lower income-tax-paying family member to the payroll in an effort to pay less tax.
This counts as tax fraud and you still have to pay the tax accrued by yourself even if you claim it is part of the corporation’s earnings.
This may make it easier to hide tax avoidance from the IRS, but it does not make it a legal way, therefore it is not an appropriate tax shelter.
The penalties for tax avoidance and illegal tax shelters are pretty clear and straightforward, but they are also very harsh indeed.
Not only can you lose a huge amount of money in fines for deliberately hiding your taxes, but you can also be at risk of doing jail time.
Illegal tax shelters are considered tax fraud and the IRS can charge you 75% of your underpaid tax in response to your illegal tax scheme, along with the potential of criminal prosecution and jail time.
These strict laws often mean that many everyday people who do not know what is legal or not, avoid even looking into tax shelters and other ways that they can legally pay less tax, even if they qualify for it.
But, if you know the law, and get to grips with what you can legally do and how you can utilize tax shelters properly, you can pay the correct amount of tax, rather than overpaying out of fear of the IRS on your case.
What To Avoid With Tax Shelters
Because many people do not know what they are looking for when it comes to tax shelters, it can be easy for complex investment strategies to convince people that they are making a legal and safe investment, leading you into a scam.
That is why it is essential for you to research tax shelters and every investment opportunity that comes your way thoroughly.
If it looks too good to be true, the majority of the time- it is.
One good example of this is Captive Insurance companies.
These types of companies, which are owned by the insured person, allow a person to subtract premiums paid, and when no claims are made, they may eventually have these payments refunded.
Whilst this can be a legal strategy, there are businesses that take advantage and set up these captive insurance companies, offering questionable value coverage, before deducting insanely high premiums from their customers.
If you do utilize complicated tax shelters, you are required to submit a form called an 8886.
Just the submission of this form alone can greatly increase your likelihood of getting called up for an audit by the IRS, even if you follow the letter of the law.
Here are a few other things to look out for when researching tax shelters.
If you are using a tax-deferred account as a retirement or health savings account, you will of course limit your own immediate access to that cash.
If you do withdraw that money, you could open yourself up to penalties and fines.
And if you spend that health savings money on something that is not health-related you could also get yourself into some sticky situations.
If you are not aware of the ins and outs of your tax shelters and the legalities behind them, you could lead yourself into some tight spots and be hit with a tax penalty unintentionally.
Keep up to date with the times as well, and make sure that you are not relying on information that is no longer valid. Tax rules and regulations change all of the time.
This means that what is legal one year may not be the next. Don’t get caught out by listening to old knowledge that no longer applies.
Retirement Accounts
Did you know that almost anybody is able to open up a retirement account?
You can open up a tax-favored retirement account pretty easily, and this can be a great way to start lessening your taxes, as well as beginning to start saving your income for the long term.
In a traditional IRA, 401k, or a similar retirement savings account, you are legally able to deduct your contributions from your taxable income.
Employees can make up to $20 000 in tax-deductible contributions to their pension accounts (though check to make sure yearly what that amount is, as it changes often to keep up with rising inflation).
On top of this, if you are over 50 years of age, you can add an additional $6 500 to your retirement account as a catch-up contribution.
Many of these 401k accounts are implementing an after-tax bucket, which means that people can fund their 401k’s with after-tax dollars.
Whilst this may sound counter-intuitive as a tax shelter, it paves the way for high earners to put away more into a Roth retirement account, making your money work for you and help protect it into old age.
The difference here is that in a regular retirement account, the taxpayer gets an upfront deductible from their income tax and then has to pay tax on the money when they withdraw it in retirement- something many people forget about when putting away their hard-earned savings.
Roth accounts work a little differently: as you can put in after-tax dollars, you can instead have tax-free retirement withdrawals.
And, as the unstable market is always changing, this can save you so much stress, and now is the best time to invest in your future, and avoid any potential big hikes in tax that we may see in the future.
Though the Roth accounts are limited to those of a certain income level, almost anyone can legally make their pension contributions with after-tax dollars, and then transfer that balance to a Roth account.
Workplace Benefits
If you are a worker who buys group insurance through your employer, you could be entitled to pay your premiums with pre-tax dollars.
That means that you can make these payments without first being taxed on your total income.
This overall lowers the income that you have to declare, whilst still paying off what you need to pay off, and leaves you paying less tax in the long run.
This insurance coverage can typically include things such as health, life, dental, disability, or vision.
By paying off these types of premiums with pretax dollars, you can spend what you need to spend, without having to be taxed on the money you use first.
Tax reforms and changes are constantly happening in regards to what workers can spend money on pre-tax, so again, always check what the federal tax laws regarding this are.
If you are self-employed, you also may be able to negotiate reimbursements from your workplace when it comes to these expenses instead, and these reimbursements are not taxable which is another bonus.
If you are a high-earner, this is a great tax-advantaged strategy to use, as you can leverage your workplace benefits to pay for these sorts of necessities without having to get these (usually pretty hefty) premiums coming out of your after-tax income.
Again, if you have kids, you can also potentially use a dependent care spending account to pay for child-care costs with pretax dollars which many employees offer, allowing you to deposit up to $5000 of your pre tax paycheck each year and use it for expenses that you would have to spend anyway.
These could include things like childcare, nannies, or after-school care.
Medical Savings Accounts
You can shield your income from taxation by using a health savings account, or a flexible spending account, dependent on your health insurance plan.
You need to contribute to an HSA if you have an HSA-eligible health insurance plan.
You can save yourself some serious money by putting your money into an HSA account, which will be used to pay the premiums on your Health insurance with tax-deductible money.
Any money you put aside there can also be withdrawn tax-free if you are spending it on qualified medical care or expenses.
To do this, however, you will, of course, need an HSA-eligible health insurance plan.
If this isn’t what you are currently on, you could potentially see whether or not your employer offers a flexible spending account, (as mentioned above in workplace benefits).
Property
As mortgage interest and property taxes are deductible if you itemize them in your tax return, getting involved in the property market is a great way to invest your money and get a little bit back for the money you put in.
As a property, for the most part, tends to hold or increase its value over time, it’s usually a pretty solid investment of your money in the long term.
Money from a sale of a home could end up being tax-free as well.
For your home to qualify when you sell it, it must meet these parameters- you must have lived in the home for at least two of the past five years.
If that is the case, you can exempt up to $500 000 in value from the capital gains tax of the sale, so long as the value of the house has increased by that amount.
Even if your house does not qualify, and it is a property you haven’t lived in, capital gains tax is still far less than income tax, so you’ll still be a winner.
Lowering your tax liability with real estate is a good way to go, but there are lots of hoops, ifs, ands, or buts to look into so it’s worth talking to a financial expert for more information about any investment properties.
Owning A Business
Because of the recent Tax Cuts and Jobs Act of 2017, there are now seriously fewer opportunities for employees to claim deductions to income tax.
This has made the idea of owning a business seem far more attractive to many people because of the tax deductibles it can entitle you to.
If you are self-employed, or you are a small business owner, you can deduct many things from your taxable income that you would not be able to do otherwise.
This involves things such as your internet, computers or office equipment, computer software, and other things that are considered essential to running a business from your home or small office.
Again, what you can deduct is pretty dependent on your line of work, so going to a pro can help you get a bit more clarity.
It also requires you to be on top of your expenses and track what you are spending on your business.
Tax Sheltered Investments
Whilst these sorts of investments can be the best bang for your buck, they can also be the riskiest.
One tax-sheltered investment is tax-deferred annuities or municipal bonds. Whilst the bonds are modest in their returns, these returns are exempt from taxation.
Final Thoughts
With tax-sheltered investments, smart ways to use pretax dollars, and investing in real estate available, there are many ways that you can use your money to the best of your ability, whilst still legally paying every cent of tax that you owe.
It’s all about knowing the law, what is open to you right now, and making smart choices about how you use your money to work for you.
By taking the time to know what is available for you in your workplace, and looking into smart opportunities, you can legally and safely pay what you owe, and make smarter choices with your annual income.
