Optimizing your return is often one of the most important things you can do during tax season. One way to make the most of your tax situation is by using deductions to lower your tax burden. The mitigating factors to your taxable income are known as tax shields. A tax shield is a reduction in taxable income by claiming allowable deductions. Here is how it works and what you might be able to claim. For full tax planning help, consider working with a financial advisor.
What Is a Tax Shield?
A tax shield is a way to pay fewer taxes on your income. As a result, taxpayers financially benefit when they understand the deductions they qualify for, as it minimizes their tax burden. Both corporations and individuals can use tax shields to save money on their taxes.
You can calculate a tax shield with this formula:
Tax shield = Deduction value * Tax rate
So, if you had total deductible expenses of $15,000 and a tax rate of 20%, your tax shield is $3,000.
Types of Tax Shields
Tax shields aren’t always easy to implement and it may not be clear to the average taxpayer how to get started. Fortunately, taxpayers can use numerous tax shields to lower their taxes. Here are some of the most popular tax shields that you might be able to implement or that you could already be taking advantage of.
1. Interest Payments
Interest paid on mortgages and student loans can become a tax shield. You’ll have to itemize your deductions to deduct mortgage interest from your taxes. If you obtained a mortgage before December 17, 2017, you can deduct up to $1,000,000 of interest. Mortgages originating after that date are eligible for an interest deduction of up to $750,000.
However, you can deduct student loan interest whether you itemize or not. The catch is you can only deduct a maximum of $2,500 of student loan interest regardless of your filing status.
2. Medical Costs
Another deduction you can take if you itemize is medical expenses. If your out-of-pocket medical costs were more than 7.5% of your adjusted gross income (AGI) last year, you’ll gain this tax shield. For example, say your AGI last year was $50,000. This figure means all medical costs over $3,750 are deductible. You had $10,000 of medical costs last year, meaning you’ll receive a $6,250 deduction for medical expenses.
Giving to charitable organizations can shield you from a hefty sum of income taxes. Typically, you can deduct cash donations equal to 60% of your AGI and asset donations equal to 30% of your AGI. In addition, capital gains taxes receive a 20% deduction for the donated asset.
When you run a business, the equipment needed – such as computers and printers – wears out over time. Likewise, if you have investment properties or other assets that depreciate, you can quantify this loss of value in a tax deduction. For instance, IRS standards dictate that a commercial property generating revenue depreciates over 39 years. So, you can divide the value of your building by 39 to get your depreciation deduction amount. Unfortunately, depreciation for other assets is not as straightforward, so it’s best to work with a tax professional to calculate it.
5. Child Care
Child and dependent care is also a tax shield. For example, the child tax credit deducts up to $2,000 per dependent age sixteen or younger. In addition, paying for childcare can net you $3,000 for one dependent twelve or younger and $6,000 for two or more dependents.
6. Business Costs
Running a business costs money; fortunately, you can deduct the costs from your taxes. Tax shields from a business include operating expenses, travel and food for business purposes and acquisition cost for goods. Your home office can also provide a deduction. Lastly, launching a new business can earn you as much as a $5,000 deduction the year you create a startup.
Tax Shield Examples
You can use the tax shield formula for different deductions, such as the following.
- Interest Tax Shield: Suppose a company has $100,000 of business debt with an 8% interest rate. So, its interest for the year is $8,000. Its tax rate is 20%. Therefore, the value of the deduction ($8,000) times the tax rate (20%) equals a $1,600 tax shield.
- Depreciation Tax Shield: The formula also applies to depreciation scenarios. For instance, your real estate depreciates by $10,000 annually. With a 21% tax rate, you receive a $2,100 depreciation deduction.
- Individual Tax Shield: Individuals usually gain a tax shield from mortgage interest. So, say you paid $7,000 of mortgage interest last year. Your tax rate is 24%. So, $7,000 x .24 equals $1,680 as a tax shield.
Key Considerations When Adding Back a Tax Shield
Adding back a tax shield is a complex move that uses a different formula:
After-tax interest expense = Interest Expense x (1 – Tax rate)
Say you’re adding back a tax shield on the business debt from the above example – $100,000 with an 8% interest rate. You receive a $1,600 deduction, making your after-tax interest expense $6,400. So, $6,400 = $8,000 x (1-.08). When you add back the tax shield, you gain the $6,400 net interest expense as income, which is greater than a $1,600 tax break.
The Bottom Line
Tax shields can lower your tax burden, reducing taxes owed or creating a refund. Taking advantage of tax shields generally means itemizing deductions. This option has become less attractive since the Tax Cuts and Jobs Act of 2017 because it dramatically increased standard deductions for taxpayers. Therefore, it’s best to do your homework and ask a tax professional about tax shields before itemizing. If your deductions don’t add up to an amount greater than your standard deduction, you won’t get as large of a return by itemizing.
Tips for Tax Shields
- Taxes are among the most intricate financial topics to tackle. A financial advisor can bring their knowledge to you and help you get the most out of your tax situation. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Saving on taxes looks different depending on your tax bracket. If your income falls on the higher end of the spectrum, you can still save money when you file. Here are tax strategies for high-income earners.
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