A tax shelter is a legal technique used by taxpayers, whether individuals or businesses, to reduce taxable income. The lower your taxable income, the less you pay in taxes. When you use a legal, legitimate tax shelter, you are avoiding taxes, which should not be confused with evading taxes.
Tax shelters include investments or deposits in accounts that are not heavily taxed, such as retirement accounts. Other shelters include "transactions that lower taxable income," such as charitable donations [source: Investopedia].
The primary difference between a legitimate tax shelter and an abusive tax shelter is the shelter's financial benefit. Legitimate shelters, such as retirement accounts and side businesses, usually generate income. An abusive tax shelter is simply a way to keep money from being taxed.
Many legitimate tax shelters are available to you. These shelters include:
Investing in real estate is a common tax shelter. In addition to the deductions it allows you to make — mortgage loan interest, mortgage insurance and property taxes — a real estate investment can help you grow wealth over time.
Retirement plans, such as pensions, 401(k) and 403(b) plans, and Individual Retirement Accounts (IRAs), have legitimate tax shelter qualities. A worker (and his or her employer) can make pretax contributions to these plans, which consist of a portion of the worker's income before it's assessed for federal withholding. Every plan is different and has its own regulations and contribution caps. The caps are there to keep people from dumping all of their money into a plan to avoid taxation.
When you withdraw money or receive payments from one of these plans, the IRS assesses the tax on the amount withdrawn, but often at a lower rate than it would have taxed the original income.
Putting a portion of one's primary income into a side business is a popular way to shelter oneself from federal income tax. For example, Mr. Boxcar, an insurance salesman with a knack for restoring old model trains, could set up a business to market his repair and restoration skills. Mr. Boxcar will take money from his primary income as an insurance salesman to fund his model train restoration business, which could reduce his taxable income. As long as Mr. Boxcar can prove to the IRS that he is attempting to make a profit with his side business, he can write off many business expenses, including equipment and supply costs.
Municipal bonds are used by smaller governments (state, municipal, county) to fund public works projects, such as taking care of those potholes left after a bad winter. Interest you earn on municipal bonds is not taxed by the IRS.
If your employer provides benefits like health coverage, life insurance and education benefits, you can reduce your taxable income by taking advantage of these opportunities. Typically, you contribute part of your income to the benefit before your tax withholding is calculated.
So now that you know what's legal when it comes to tax shelters, read on to find out about abusive tax shelters.