What Is a Tax Shelter? | Taxes

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The term tax shelter could have you thinking about wealthy people and businesses tucking away money in shady offshore accounts to avoid paying taxes.

“Typically, tax shelter is kind of a dirty word,” says Bill Smith, managing director of the national tax office for financial firm CBIZ MHM.

However, there are a number of perfectly legal and respectable ways to shelter money from taxes. These include tax-deferred savings, savvy investments and even your home. Keep reading for everything you need to know about tax shelters and six options that could work for you.

What Is a Tax Shelter?

Depending on who you ask, a tax shelter can mean different things. For instance, those in the finance sector may see a tax shelter as a specific type of investment.

“You make an investment, and the tax benefits in the year of the investment are more than the investment itself,” Smith says. Using this definition, a tax shelter might allow you to invest, for example, $100 and then take a deduction for $400 at the end of the year.

More broadly, a tax shelter can be anything used to minimize a person’s income tax liability. That means tax shelters can include strategies for deducting expenses to lower your adjusted gross income or paying for workplace benefits with pretax dollars.

What to Know About Tax Shelter Risks

Not all tax shelters come without risk. Some complex investments can skirt the law, and it can be easy to fall victim to a scam if you don’t properly research a proposed strategy.

“Some of these things do get misrepresented by people,” says Mike Repak, vice president and senior estate planner for financial advisory firm Janney Montgomery Scott.

He uses captive insurance companies as an example. These companies, which are owned by the person insured, are clearly allowed by the tax code. They allow a person to deduct premiums paid and then, assuming no claims are made, those premiums may eventually be refunded. However, some businesses have set up captive insurance companies offering coverage of dubious value then deducting exorbitant premiums. The IRS has won at least one court case against a business after it was determined their captive insurance policy amounted to tax evasion.

Even if you follow the letter of the law, some complex tax shelters could make your life more difficult if they include reportable transactions that require the submission of Form 8886. “It’s a bit like attaching a note … to the IRS asking for an audit,” Smith says.

Other tax shelters are less risky, but they still have drawbacks. For instance, tax-deferred accounts for retirement or health savings may limit your access to the cash. If you withdraw money too quickly from a retirement account or spend money from a health savings account on a non-medical expense, you could get hit with a tax penalty.

6 Legal Tax Shelters to Consider

If you are looking for a way to reduce your taxes legally, here are six tax shelters that may be available to you:

  • Retirement accounts
  • Workplace benefits
  • Medical savings accounts
  • Real estate
  • Business ownership
  • Complex investments

Retirement Accounts

Almost anyone can open a tax-favored retirement account, making them a good place to start for minimizing taxes. “The most prevalent tax shelters that are out there now are qualified retirement plans,” Repak says.

Traditional IRAs, 401(k)s and similar retirement savings vehicles allow people to deduct their contributions. In 2021, employees can make up to $19,500 in deductible contributions to a 401(k) with workers age 50 and older entitled to deduct an additional $6,500 in catch-up contributions. Deductible IRA contributions are limited to $6,000 for workers younger than 50 and $7,000 for those age 50 and older.

With traditional retirement accounts, taxpayers get an upfront tax deduction and then pay income tax on withdrawals in retirement. However, Roth accounts allow people to contribute after-tax dollars which then allow retirement withdrawals to be made tax-free. A finance professional can help you determine which will result in the larger tax savings based on your circumstances.

Workplace Benefits

Workers who buy group insurance coverage through their employer may be able to pay premiums with pretax dollars. These benefits typically include coverages such as life, disability, vision, dental and health insurance. Paying for these with pretax dollars has the effect of lowering your taxable income.

Prior to the Tax Cuts and Jobs Act of 2017, workers could also deduct unreimbursed expenses such as mileage. Since tax reform eliminated that deduction for everyone but the self-employed, workers may want to negotiate reimbursements for these expenses instead. Any workplace reimbursement has the added benefit of not being taxable.

If you have children, don’t overlook the option to use a dependent care flexible spending account, or DCFSA, to pay for child care costs. Many employers offer these accounts which allow parents to deposit up to $5,000 in pretax dollars each year to be used for expenses such as child care, summer day care, before- and after-school care and nannies.

However, be aware that expenses paid for with a DCFSA are not eligible for a child and dependent care tax credit. What’s more, money deposited in a flexible spending account typically must be used that same year or be forfeited.

Medical Savings Accounts

Flexible spending accounts and health savings accounts are two ways to shield money spent on health care from taxes.

“(HSAs) offer three major tax advantages to account holders: tax-free contributions, tax-free growth and tax-free withdrawals,” says Jeff Bakke, chief strategy officer for the benefits division of payment solutions provider Wex. However, for withdrawals to be tax-free, money must be used for qualified medical expenses.

In 2021, those with family insurance plans can contribute up to $7,200 to an HSA and deduct that amount from their taxes. Single policyholders can contribute and deduct up to $3,600. In either case, workers age 55 and older can deposit an additional $1,000 in catch-up contributions.

You’ll need an eligible high-deductible health insurance plan to contribute to an HSA. If you don’t have one, your employer may offer flexible spending accounts, or FSAs, for all workers. These accounts work similar to the DCFSA but for qualified health care costs. While the balance of an HSA will roll over year to year, money in a FSA usually must be spent during the year is was contributed or be forfeited.

Real Estate

There are several tax perks that come from buying real estate. Mortgage interest and property taxes can be deducted by those who itemize deductions on their federal tax returns.

What’s more, property typically appreciates, or gains value, each year. When you sell your home, so long as you have lived at the property for two of the past five years, you can exempt up to $500,000 of the appreciated value from capital gains tax. With a normal investment, such as stocks purchased through a brokerage account, all the gains are subject to tax.

Rental real estate can also provide tax benefits, but there are rules about who can take deductions for rental properties and how they are calculated. If you’d like to invest in real estate to lower your tax liability, talk to a finance professional for guidance.

Business Ownership

Since the Tax Cuts and Jobs Act significantly reduced the number of deductions available to employees, business ownership has become a more attractive option to some people.

Self-employed workers and small business owners can deduct a variety of expenses such as internet and wireless service, computer software and office supplies. Those who work from home may also be able to deduct expenses related to a home office.

While these expenses may reduce taxable income, the savings can be negligible if you are spending more just to get a deduction. “People will sometimes take deductions more liberally (with a business),” Repak says, “but it’s still cash out of pocket.”

Complex Investments

Tax-sheltered investments have the potential to provide the greatest savings, but they also come with the highest risk.

In recent years, captive insurance has become a popular option for investors looking to avoid taxes, as have syndicated conservation easements. “One of the benefits of captive insurance is if it doesn’t have claims after a period of time, you get your premiums back,” Smith says.

However, there is concern the IRS has been targeting these deduction strategies for elimination, and you should be wary of anyone offering investment returns that sound too good to be true. Get a second opinion if you aren’t sure about the investment’s legitimacy or the credibility of the person trying to sell it to you.

For a safer way to get a tax break on investment gains, try municipal bonds. Their returns are often modest, but the gains may be exempt from both state and federal taxes.



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