A tax shelter is a (legal) place to put your money where it will be safe from the long arm of the Tax Man. Common examples of tax shelters are home equity and 401(k) accounts. A tax shelter is different from a tax haven, the latter being a country where money can be stashed to avoid U.S. taxes. Here’s our guide to tax shelters:
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Tax Shelter: Deductions
What is a tax shelter, you ask? The definition of a tax shelter is a way of minimizing or eliminating your tax liability, either permanently or temporarily. For example, making a donation to a qualified charity, itemizing your deductions and deducting that donation reduces your tax liability in that year. You’ll never have to pay taxes on the money you gave to your favorite charity. You can also deduct extraordinary medical expenses, mortgage interest and student loan interest, to name just a few tax liability-minimizing strategies.
Tax Shelter: Retirement Accounts
A tax-deferred retirement account is also a tax shelter, though not a permanent one. When you contribute to a 401(k) or a deductible traditional IRA, your taxable income is reduced by the amount of your contribution. Your money grows tax-deferred, meaning that it can accrue interest and earnings that are not taxed from year to year. You do, though, pay taxes on that money when you start taking distributions in retirement. You can’t “shelter” that money from the IRS forever.
401(k)s and traditional IRAs aren’t the only retirement accounts that offer shelter from tax liability. The 403(b) retirement account also goes by the name Tax-Sheltered Annuity. Employees of public schools and certain non-profit organizations are those who may have access to a 403(b) plan. Like a 401(k), a 403(b) lets employees contribute pre-tax dollars to a retirement account that grows on a tax-deferred basis.
Tax Shelter: Home Equity
One of the reasons that buying a home is such an important financial milestone is that home equity increases your net worth. While paying down your home mortgage is liberating financially and emotionally, if you never sell your house, you won’t reap the benefits of that home equity unless you take a home equity loan or home equity line of credit. If you do sell, though, you’ll see why home equity is such a valuable tax shelter. The IRS exempts the first $250,000 (or $500,000 for a couple) of home sale profits from capital gains taxes. That’s right. You and your spouse could reap a $500,000 profit from a home sale and not pay taxes on it. That’s one heck of a tax shelter.
Tax Shelter: Investments
What if you’re already on track with your retirement savings, you’ve taken all the relevant deductions and you still have money that you want to shelter from the IRS? In that case, there are a few tax-sheltered investments that you can turn to. For folks with high incomes who make foreign investments, foreign tax credits can knock a chunk off their tax bill. Then there are tax-free municipal bonds, which earn tax-free interest.
Tax Shelter: College Savings Plan
The popular 529 college savings plan is both a tax shelter and a way to save for your children’s education. States and educational institutions sponsor 529 plans, allowing parents to save for future higher education costs. Earnings from those savings are not subject to federal income taxes if they are eventually used for qualified educational expenses. In addition to being a tax shelter for federal income tax purposes, some state-sponsored 529 plans also allow savers to deduct their contributions from their state income taxes.
Tax Shelters Gone Wrong
Folks who stretch the law in pursuit of tax shelters will find themselves facing IRS penalties and, possibly, a prison sentence. If you try to take deductions you’re not entitled to, for example, the IRS could catch you in an audit. Not good. And beware of people or companies offering to hook you up with a tax shelter. According to the IRS, these groups often promote tax schemes in violation of the IRS Code. They’ll offer to help move income you earned into accounts linked to foreign debit and credit cards, for example, dodging taxes in the process. Like many things in personal finance, if it sounds too good to be true it probably is.
Rather than seeking increasingly obscure (and possibly shady) ways to limit your tax liability, why not stick to tried and true tactics like saving for your retirement or your kids’ college, itemizing your deductions and investing in real estate? Decisions made just to minimize tax liability without consideration of your overall financial health and goals tend to be sub-optimal decisions anyway. If you’ve exhausted the tax minimizing options above and you still face a substantial tax liability – well, you might just be rich.
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