What is a tax shelter?
A tax shelter is a method of lowering taxable income for individuals or companies. Although some tax shelters are permitted under U.S. and international law, there are tax shelters that stretch or break the law. There are a wide variety of methods for sheltering income from taxation; common examples include employee-sponsored 401(k) plans and home ownership.
Making investments for the sole purpose of avoiding taxes is illegal. If you’re caught, you could be forced to pay penalties and fees associated with the act of tax evasion, and repeat offenders can face prison time. On the other hand, minimizing the amount of taxes owed through legal tax shelters is a very common strategy.
Tax avoidance is a way of using tax law to pay the least amount of taxes possible. In many cases, the tax code offers various tax credits, exemptions and deductions that may be used to reduce or offset taxable income; these can be considered tax shelters. The Internal Revenue Code offers a variety of other legal tax shelters that help people lower their taxable income in exchange for promoting beneficial savings and investment.
The Internal Revenue Service (IRS) maintains an annual ranking of the 12 most common abusive tax schemes, called the “Dirty Dozen.” Avoiding taxes by hiding money or assets in unreported offshore accounts — a classic illegal tax shelter strategy — is usually at or near the top of the list.
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Tax shelter examples
Many investors buy tax-free or reduced-tax municipal bonds as a form of tax shelter. Municipal bonds produce lower yields than many other fixed-income instruments, but offer more favorable tax treatments.
The 529 college savings plan is a form of tax shelter that many parents choose to fund college expenses for their children. The 529 plan can reduce taxable income for some state income taxes (but not federal income taxes) when contributions are made; funds in the plan are not taxed at the time when they are used for many qualifying college expenses.
Limited partnerships are business arrangements that allow people to minimize many of the tax liabilities involved in incorporation. Master limited partnerships (MLPs) offer another form of incorporation that reduces corporate tax liabilities and maximizes the payout of earnings to investors.
Home ownership can be considered a form of tax shelter. Interests paid on mortgage loans and property taxes are deductible, and some taxpayers can even write off their private mortgage insurance premiums entirely. Under many circumstances, the sale of one’s primary residence can be free of capital gains taxes.